May 24, 2022 – A debtor who elects to proceed under Subchapter V of the Bankruptcy Code as a small business debtor must meet certain eligibility requirements. A ruling issued on April 12, 2022, by Judge Ernest Robles of the Central District of California Bankruptcy Court highlights what appears to be a substantial drafting error in the provisions of Subchapter V that could prevent certain small business debtors from proceed under Subchapter V than intended.
In In re Phenomenon Marketing & Entertainment, No. 2:22-bk-10132-ER, Judge Robles ruled that a debtor was not eligible to sue under Subchapter V because the debtor was a ” affiliate” of an “issuer” as defined in section 3 of the Securities Exchange Act of 1934 (15 USC § 78c) (the “Exchange Act”). Under Section 1182(1)(B)(iii) of the Bankruptcy Code, affiliates of issuers cannot be debtors under Subchapter V.
More importantly, Judge Robles concluded that the term “issuer” is not limited to publicly traded companies and includes private companies. Thus, a debtor with a non-public affiliated company may be excluded from the procedure provided for in sub-chapter V.
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In Phenomenon Marketing & Entertainment, the debtor (“PME”) filed a Voluntary Petition under Chapter 11 and elected treatment under Subchapter V. The court appointed a Subchapter V trustee and authorized SMEs to reject a commercial lease. The owner sought a finding that the SME was ineligible to proceed under Subchapter V because it was “an affiliate of one or more entities that were ‘issuers'”.
The debtor is responsible for proving his eligibility for sub-chapter V
As a preliminary point, the court observed that subchapter V does not specify who bears the burden of proving a debtor’s admissibility to subchapter V. The court followed the “vast majority of courts dealing with the matter “, holding that the debtor has the burden of proof to establish eligibility to sue under sub-chapter V.
The court expressly rejected the “minority approach”, which places the burden of proof on a creditor to prove that a debtor is ineligible, because “Subchapter V provides many benefits to debtors that are not available in the standard cases of Chapter 11”, in particular:
• A debtor does not have to submit a disclosure statement for approval.
•A debtor is not bound by the absolute priority rule.
• A debtor’s property interests are left intact when it is demonstrated that the debtor will make payments equal to his projected disposable income over the term of the plan.
PME failed to prove its eligibility to sue under Subchapter V because two of PME’s affiliates were issuers
Under Section 1182(1)(B)(iii) of the Bankruptcy Code, a debtor is not eligible for Subchapter V if it is an “affiliate” of an “issuer”. The Bankruptcy Code defines an “affiliate” as an entity that owns 20% or more of a debtor’s voting securities.
The definition of “issuer” incorporates the definition of the Exchange Act, which defines an “issuer” as the issuer of a “security”. The Exchange Act broadly defines the term “security” to include, among other things, a “stock” or an “investment contract”. The Exchange Act does not limit the definition to securities that are publicly traded.
In considering the owner’s motion, the court relied on PME’s statements that its sole member was Phe.no LLC (“Phe.no”) and that Phe.no’s sole member was Phenomenon Holdings, LLC (“Holdings”). The court ruled that Phe.no and Holdings were both affiliates of PME – and issuers – and therefore PME was not eligible to sue under Subchapter V. Specifically, the court found that Phe.no was an affiliate company because it owned 100% of SMEs. as its only member.
The court found that Phe.no was an issuer because it was a corporation – and a corporation, by definition, has issued or proposes to issue shares to its shareholders – even if the shares are not listed on the stock exchange.
The court also found Holdings to be an issuer. The court found that an interest in a limited liability company (an “LLC”) – such as Holdings – constitutes security if it is an “investment contract”. The court concluded that an investment contract is “(1) an investment of money, (2) in a joint enterprise, (3) with an expectation of profits to be produced by the efforts of others”. PME did not provide Holdings’ operating agreement and therefore the court made a negative finding that Holdings LLC’s interests constituted an investment contract.
An issuer does not need to be listed on a stock exchange
The court also ruled that an issuer does not need to be listed on a stock exchange. PME argued that it was eligible for Subchapter V because Sleeping Bear Capital, LLC (“Sleeping Bear”) – a board member of Holdings – was its only subsidiary and was not publicly traded. . The court rejected that argument, concluding that the term security is “extremely broad” and “not limited to securities that trade on public exchanges.” Citing the Exchange Act’s definition of a security, the court concluded that “an entity may still be considered an ‘issuer’ even if the securities it issues are not publicly traded.”
The court observed that at the meeting of Article 341 of the Bankruptcy Code, the SME manager testified that the objective of Sleeping Bear was to “make investments” and “ultimately to create value …and actually making money…for ourselves and our sponsors.” The court concluded that it would be “difficult to understand” how an entity like Sleeping Bear could operate without having issued securities.
The court recognized that a debtor may be unfairly disqualified from subchapter V because one of its major nonpublic shareholders is considered an issuer, and therefore recommended that Congress change the definition of issuer for the purposes of sub-chapter V to provide that an issuer must be listed on a stock exchange. . However, the court was obliged to follow the plain meaning of the law.
The decision also highlights another potential error in the drafting of the Subchapter V eligibility requirements: a debtor who is an affiliate of an issuer is not eligible for proceedings under Subchapter V. , while an obligor that is itself a listed issuer is eligible.
Parties to a potential Subchapter V case should carefully review a debtor’s organizational structure to ensure that it is eligible to sue under Subchapter V and to exclude any collateral liability that may arise from determination that an affiliate is issuing securities.
Phenomenon Marketing & Entertainment is a cautionary tale for Debtors, Creditors and Debtor Affiliates:
• Debtors should carefully consider the organizational structure as it is important to determine a debtor’s eligibility for Sub-Chapter V.
• Creditors who object to a debtor’s Subchapter V election should review the debtor’s organizational structure and determine whether the debtor has any non-individual stakeholders. If so, the obligor may be disqualified if the stakeholder is found to be an issuer. This case also makes it clear that a court is likely to find an LLC to be an issuer of securities if it has investors or an intention to make a profit.
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