Profit Motive? Not Required for Subchapter V Eligibility

Background

Subchapter V was added to chapter 11 of the U.S. Bankruptcy Code in 2019 to make court-approved reorganizations more accessible to small businesses. Subchapter V went into effect in 2020 and provides small businesses a streamlined process for reorganizing and paying their debts over a three- to five-year period. Subchapter V became accessible to even more small businesses after Congress temporarily increased the debt limit to qualify for Subchapter V relief during the COVID-19 pandemic. There is pending legislation, filed with bipartisan support, to again increase this debt limit which, if adopted, likely will continue the trend of more Subchapter V filings.  

RS Air, LLC

RS Air, LLC (RS Air) was formed in 2001 to provide aircraft transportation services, acquire and sell interests in aircraft, and provide depreciation tax benefits for its sole member and manager. RS Air entered into a series of agreements to purchase or lease fractional interests in private jets from NetJets Aviation, Inc. and certain of its affiliates (collectively, “NetJets”).

On November 6, 2020, RS Air filed for chapter 11 and elected to proceed under Subchapter V. At the time, NetJets was RS Air’s largest creditor. NetJets objected to RS Air’s Subchapter V election on the basis that RS Air was not “engaged in commercial or business activities” as required by section 1182(1)(A). NetJets contended that RS Air had no flight operations since at least 2017, no revenue or income since as early as 2012, and no employees. NetJets also argued that RS Air had never been a revenue-generating business, and its sole purpose was to serve as the intermediary through which its sole member and manager acquired interests in and paid for the use of private jets.

Bankruptcy Court Finds RS Air Was Engaged in Commercial or Business Activities

The U.S. Bankruptcy Court for the Northern District of California found that NetJets bore the burden of establishing that RS Air was ineligible for Subchapter V relief and rejected NetJets’ argument that employees are required for eligibility, reasoning that many small businesses do not have employees. The Bankruptcy Court concluded that RS Air was engaged in commercial or business activities because it: (i) transformed its business from providing flight services to investigating and litigating with NetJets; (ii) intended to resume fractional jet ownership with a different partner; (iii) paid aircraft registry fees; (iv) remained in good standing as a Delaware LLC; and (v) filed tax returns and paid taxes.

NetJets Appeals to BAP

On appeal, the BAP held that the Bankruptcy Court erred in finding that NetJets bore the burden of showing RS Air was not eligible for Subchapter V. Most courts have held that the debtor has the burden of proving Subchapter V eligibility, which the BAP found reasonable given the many advantages Subchapter V offers debtors and that debtors are best positioned to prove they satisfy Subchapter V’s eligibility requirements.

The BAP, however, affirmed the Bankruptcy Court’s finding that RS Air was engaged in commercial or business activities. The BAP explained that the Bankruptcy Code does not define the phrase “engaged in commercial or business activities” and that case law on the topic is limited. Agreeing with most courts that have considered the issue, the BAP held that (i) the term “engaged in” is inherently contemporary in focus and not retrospective and (ii) a debtor need not be maintaining its core or historical operations on the petition date, but must be presently engaged in some type of commercial or business activities to satisfy section 1182(1)(A).

The BAP then addressed the types of activities that satisfy the requirement when the debtor is no longer operational. The BAP explained that courts have generally held the scope of commercial or business activities to be very broad, and apply a totality of the circumstances standard, but cautioned that “courts are less likely to find sufficient commercial or business activities for purposes of § 1182(1)(A) where the debtor is an individual who owns a non-operating business, especially when the business has been dissolved under applicable state law.”

In response to NetJets’ argument that RS Air’s activities lacked any motive to generate income or profit, the BAP observed that a few courts have held that section 1182(1)(A) does not require a debtor to be engaged in for-profit business. One such court relied on the legal definition of “business activities,” which can be either “the carrying out of a series of similar acts for the purpose of realizing a pecuniary benefit, or otherwise accomplishing a goal.” The BAP explained that “[t]his broad definition would include not-for-profit businesses, and would not be limited to those having only a benevolent purpose.” The BAP noted that Congress chose not to exclude nonprofits or other persons without a profit motive from qualifying for Subchapter V, which “makes sense, because churches, hospitals, and other nonprofit businesses are allowed to file for chapter 11 (or 7) relief.” The BAP concluded that a profit motive is not required for a debtor to qualify for Subchapter V relief, reasoning that “[t]o hold otherwise would wrongfully exclude nonprofits and other persons that lack such a motive.”

The BAP’s decision in RS Air demonstrates the breadth of what it means to engage in business or commercial activities and may make Subchapter V accessible to entities that until recently may have regarded themselves as ineligible for Subchapter V relief. However, Subchapter V is relatively new, and courts are still determining the contours of “engaged in commercial or business activities.” For example, the commercial and business activities requirement was recently raised in the Southern District of Texas in In re InfoW, LLC, et al., Case No. 22-60020 (S.D. Tex. 2022), where multiple motions to dismiss allege, among other things, that the debtors’ petitions were filed in bad faith and that the debtors do not qualify for Subchapter V because they are not “engaged in commercial or business activities.” These motions to dismiss are set for an evidentiary hearing on May 27, 2022.

In sum, debtors and creditors in Subchapter V cases should be cognizant of the developing case law, particularly with respect to a debtor’s eligibility for Subchapter V and the requirement to be engaged in “commercial or business activities.”