Conflicting Court Rulings on Subchapter V Eligibility Leave Small Businesses in Limbo

The SBRA also established the eligibility criteria for subchapter V, which is determined as of the petition date, with challenges filed no later than 30 days after the conclusion of the meeting of creditors. Initially, eligibility was limited to debtors with aggregate noncontingent liquidated debts of approximately $2.7 million or less. During the COVID-19 pandemic, Congress temporarily raised the debt limit for subchapter V eligibility from $2.7 million to $7.5 million; the increased cap has been continued once by Congress, and currently is scheduled to sunset again on June 21, 2024. The American Bankruptcy Institute (ABI) recently concluded months of testimony and hearings regarding the success and flaws of subchapter V, with most witnesses testifying that the $7.5 million debt limit should be maintained and others testifying that it should be increased.

In determining subchapter V eligibility, a recurring issue is whether the debtor’s future payment obligations under unexpired leases and executory contracts count towards the debt limit. While the issue was first addressed in In re Parking Management, Inc., 620 B.R. 544 (Bankr. D. Md. 2020) (holding that future lease payments do not count towards the subchapter V debt limit), recently two bankruptcy courts reached opposite conclusions on the issue. In In re Macedon Consulting Inc., 652 B.R. 480 (Bankr. E.D. Va. 2023), the bankruptcy court found that the debtor was ineligible for subchapter V because future amounts due under its lease exceeded the $7.5 million debt limit. By contrast, the bankruptcy court in In re Zhang Medical P.C., No. 23-10678 (PB), 655 B.R. 403 (Bankr. S.D.N.Y. 2023) held that future liabilities under unexpired leases and executory contracts should “rarely, if ever, be counted toward the subchapter V debt cap.”

In re Macedon Consulting Inc.
The debtor in In re Macedon Consulting Inc. was the tenant under two commercial leases for office space where its future liabilities exceeded $14 million as of the petition date. The debtor filed a motion to reject both leases on the petition date, and the landlords responded by moving to dismiss the bankruptcy case. The landlords argued that the debtor was ineligible for subchapter V because the future amounts owed under the leases exceeded the statutory cap for subchapter V eligibility.

The debtor opposed the landlord’s motion to dismiss arguing that (i) the future lease liabilities were contingent, and therefore should not be counted towards the cap; and (ii) if not contingent, the amount of the debtor’s liability should be determined under the Bankruptcy Code’s cap on lease rejection damages. Specifically, section 502(b)(6) of the Bankruptcy Code limits a landlord’s claim for damages caused by termination of the lease to “the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease following the earlier of” the petition date or the date on which the landlord repossesses the property. The debtor’s position was that by applying the section 502(b)(6) cap, its debts would remain under subchapter V’s $7.5 million limit.

The proper calculation of the cap on a landlord’s rent rejection damage claim was the subject of a recent decision in In re Cortlandt Liquidation LLC, No. 20-12097 (MEW), 2023 WL 1483783 (Bankr. S.D.N.Y. Feb. 2, 2023) and a prior alert in this series. In that case, the court was required to determine the proper method for calculating the cap on lease rejection damages under section 502(b)(6), choosing between the “time approach” and the “rent approach.” The two approaches can yield different results; indeed, in Cortlandt Liquidation, the time approach, which the court ruled was the proper calculation method, resulted in a reduction of the landlord’s claim by approximately $2 million.

The Macedon Consulting court, however, did not address the section 502(b)(6) cap even though the debtor moved to reject the leases. Instead, the court rejected the debtor’s argument that its future liability under the leases was contingent reasoning that the debtor’s “liability arose pre-petition, on the dates the [l]eases were fully executed.” That some amounts were due in the future did not change the court’s view that those amounts were, in fact, due and consequently that they should be counted towards the subchapter V eligibility debt limit. The debtor’s decision to reject the leases on the petition date therefore played no role in the court’s decision. Because the court determined that the debtor’s liability under its leases should be counted towards the subchapter V eligibility cap, the bankruptcy court revoked the subchapter V designation.

In re Zhang Medical P.C.
Similar facts were present in In re Zhang Medical P.C., but the debtor moved to reject its office lease two months after the petition date. The bankruptcy court granted the debtor’s motion to reject, and thereafter the landlord objected to the debtor’s subchapter V designation, arguing that future rents owed under the lease exceeded subchapter V’s $7.5 million debt limit. In doing so, the landlord relied on Macedon Consulting.

While the bankruptcy court found the debtor ineligible for subchapter V because scheduled debts and proofs of claim exceeded $7.5 million, it rejected the landlord’s Macedon Consulting argument. The court explained that “[w]hile th[e] finding obviates the need for the Court to reach the Macedon Consulting issue, the Court addresses that issue nevertheless, because of the enormous—and in the Court’s view detrimental—impact that ruling, if followed, would have in limiting eligibility for subchapter V relief.”

In the bankruptcy court’s view, “until the debtor elects either to assume or to reject an executory contract or unexpired lease, the amount and nature of its obligations under that contract or lease are contingent and unliquidated …. Because the amount and nature of the debtor’s obligations, as well as whether these are even ‘debts,’ depend on an uncertain future event—the debtor’s election to either assume or reject—any eventual debt is both contingent and unliquidated prior to that election.” Consequently, the debtor’s eventual liability under the lease should not count towards the subchapter V debt cap.

Does Zhang Medical Represent an Emerging Trend?
Both Macedon Consulting and Zhang Medical relied on Parking Management. Although the Macedon Consulting court agreed with Parking Management’s finding that events occurring after the petition date should not affect subchapter V eligibility, the Macedon Consulting court disagreed with Parking Management’s ultimate holding that lease rejection claims do not count towards the subchapter V debt limit. Zhang Medical and Parking Management in contrast are aligned in holding that future rent or lease rejection damages are contingent debts on the petition date that should not be counted towards the subchapter V debt limit—potentially suggesting an emerging majority position.

As subchapter V eligibility disputes continue, it will be important to see if other courts align themselves with the holding in Macedon Consulting, which some may argue is supported by the Bankruptcy Code’s distinction between contingent and matured debts (such as in the definition of “claim” or in section 502(b)(1)). Yet neither the SBRA nor the Bankruptcy Code’s definition of “small business debtor” include matured debts for purposes of determining the debt limit. Was the exclusion purposeful? Future landlords may argue that Congress intended that future rent—as an unmatured liability that often is noncontingent and liquidated—count towards the subchapter V debt limit consistent with the holding in Macedon Consulting.

Conclusion
Because creditors have limited tools for preventing subchapter V debtors from confirming a plan over their objections, many will continue to exert pressure by challenging debtors’ subchapter V eligibility. Macedon Consulting and Zhang Medical, therefore, reflect an important and ongoing discussion concerning eligibility for a debtor to proceed under subchapter V of the Bankruptcy Code. The conflicting results reached by the courts could, depending on which precedent is followed, significantly impact the number of smaller businesses that are eligible for subchapter V. These issues will have even more significance if the subchapter V debt ceiling reverts from $7.5 million to $2,725,625, which is currently set to occur after June 21, 2024.

(This is another in our series of client alerts related to the intersection of bankruptcy and real estate.)