Subchapter V and § 543 “Custodian” Rules (In re U.S.A. Parts Supply)

By: Donald L Swanson

The case is, In re U.S.A. Parts Supply, Cadillac U.S.A. Oldsmobile U.S.A., L.P., Case No. 20-bk-241, U.S. Bankruptcy Court, Northern West Virginia (decided Aug. 17, 2020, Doc. 143).

On March 22, 2020, Debtor files a voluntary Chapter 11 petition under Subchapter V as a small business debtor.

Creditors promptly file a motion seeking two alternative forms of relief:

• a dismissal of Debtor’s bankruptcy for bad faith filing, based on pre-petition misconduct, or
• excusing a state court Receiver from turnover requirements of 11 U.S.C. § 543 so that a liquidation by the receiver can proceed outside of bankruptcy. [Fn. 1]

Debtor opposes the motion, contending that:

• Debtor filed its case in good faith and for a proper purpose, with a reasonable likelihood of rehabilitation; and
• the receiver cannot be excused from § 543 requirements because the receiver does not possess or control any of Debtor’s property.

In 2018, a Creditor obtains judgment against Debtor for $189,804.01 plus court costs, attorney fees, and post-judgment interest at 4.5%. Another Creditor obtains appointment of a Receiver of Debtor’s assets and obtains an uncontested summary judgment against Debtor for $300,000.

Following her appointment and before Debtor’s bankruptcy filing, the Receiver (i) examines Debtor’s books and records, (ii) employs an auctioneer to market and sell Debtor’s assets, and (iii) negotiates with Debtor to amicably resolve the receivership action. The negotiations fail, and Debtor files this Chapter 11 case.  Notably, the Receiver never takes control or possession of any of Debtor’s property.

Analysis

As noted above, the two Creditors seek to either, (i) dismiss Debtor’s Chapter 11 case, as a bad faith filing for the sole purpose of impeding prosecution of the receivership action, based on pre-petition misconduct, or (ii) excuse the Receiver from § 543 obligations, noting that the state receivership law is substantially like the Bankruptcy Code so the Receiver can accomplish a similar liquidation result in a non-bankruptcy forum.

Debtor opposes the Motion and both requests for relief for these reasons:

• As to dismissal, Debtor contends that it, (i) filed the case to reorganize its business, and (ii) can continue in business and pay all allowed claims in full; and
• As to § 543 issues, Debtor contends that the Receiver cannot qualify as a “custodian” under § 543 because she did not possess any of Debtor’s assets at the petition date.

“Good Faith” Filing—Legal Standards

11 U.S.C. § 1112(a) authorizes dismissal “for cause,” which includes a requirement that a bankruptcy filing must be in “good faith.”

The Bankruptcy Court declares: “It is well settled in this circuit that ‘a lack of good faith’ in filing a Chapter 11” means both “’objective futility’ and ‘subjective bad faith.'” That means:

• Objective futility focuses on whether a realistic possibility of an effective reorganization exists;
• Subjective bad faith asks whether a Chapter 11 petition is motivated by an honest intent to effectuate reorganization or by some improper purpose (i.e., where bankruptcy is filed to abuse the process, to cause hardship, or to invoke the automatic stay solely to cause delay);

“The overall aim” of this two-pronged inquiry is “to determine whether the purposes of the Code would be furthered by permitting the Chapter 11 petitioner to proceed past filing.”

“The burden of establishing this two-pronged requirement is very high,” because the power to dismiss a bankruptcy at the outset of a case “is obviously one to be exercised with great care and caution.”  That’s because denying access “at the very portals of bankruptcy,” before the total shape of the debtor’s situation becomes apparent, is “inherently drastic and not lightly to be made.”

Sec. 543 Turnover—Legal Standards

Under § 543, a receiver (i.e., a “custodian”) with knowledge of the bankruptcy filing may not make “any disbursement from” or take “any action in the administration of” Debtor’s property in the receiver’s “possession, custody, or control.”   A receiver must also to promptly deliver “any property of the debtor held by or transferred to such custodian” to the bankruptcy estate.

Thus, the practical effect of § 543 is to terminate a receiver’s role.  There are, however, two statutory exceptions to such termination (in § 543(d)):

1. When interests of creditors are “better served” by permitting the custodian to continue in possession; and
2. When the custodian is actually an assignee for benefit of debtor’s creditors, appointed more than 120 days before the bankruptcy filing. 

While the first of these two standards can apply to the present case, the second cannot.  A receiver appointed under state law is not “an assignee for the benefit of the debtor’s creditors”:

• In an assignment for benefit of creditors, a debtor’s voluntarily transfers all its assets to an assignee, to be administered for the benefit of creditors—that’s not what happens in a receivership; and
• Congress specifically elected, under § 543(d), to place the assignee in a different position than a state court receiver, because of the position of trust voluntarily granted by Debtor to the assignee.

Bankruptcy Court denies both requests for relief

The Bankruptcy Court denies Creditors’ Motion in its entirety—including both requests for alternative relief.

On dismissal, the Court declares that Creditors fail to satisfy their burden of showing both objective futility and subjective bad faith.

–Objective Futility

Regarding Objective futility:

1. Creditors elicited no testimony showing Debtor lacks a reasonable likelihood to rehabilitate its business—the closest they got was pointing out financial difficulties and questions on value of Debtor’s assets. Such evidence fails to establish objective futility.
2. The Receiver acknowledged that Debtors’ assets are more valuable with Debtor operating them, as corroborated by the Receiver’s willingness to let Debtor remain in possession for over a year after her appointment.
3. Debtor’s financial difficulties are due in part to the current pandemic and its effect on Debtor’s business.
4. Debtor generated income during 2018 and 2019, while not having an online presence, and is creating an online portal to better compete in the market.
5. If past is prologue, Debtor’s personal property has much more value than perceived by the Receiver and her auctioneer.
6. In any event, “the court cannot say that the Debtor lacks a reasonable chance at rehabilitating its business.”

–Subjective Bad Faith

Additionally, there is no proof of subjective bad faith. 

There is no proof of an improper purpose that would abuse the bankruptcy process, wrongly impair creditors’ collection efforts, or merely seek protection of the automatic stay.

Instead, the Bankruptcy Court “perceives this debtor to be like most that come before it on the eve of a judgment, foreclosure, or some other significant event”: facing imminent loss of its business, which operated for over thirty years, Debtor filed Chapter 11 as a last-ditch effort to reorganize and treat its creditors appropriately.

Subchapter V Effect

Debtor filed this case under the newly-enacted Subchapter V on March 22, 2020, and proposed a plan of reorganization on August 14, 2020.

Such timing leads the court to believe that Debtor possesses an honest intention to reorganize, particularly based upon the Debtor’s proposal to pay allowed claims a 100% dividend.

Further, a Subchapter V trustee is monitoring Debtor’s operation and the bankruptcy estate.

Statutory Exceptions

The Bankruptcy Court also denies Creditors’ motion for relief under § 543(d) because the Receiver does not meets either of the enumerated exceptions to the § 543 turnover requirements:

1. it is not in the creditors’ best interests to leave the Receiver in possession; and
2. the Receiver does not qualify as an assignee for the benefit of Debtor’s creditors.

Conclusion

The upshot of the In re U.S.A. Parts Supply case appears to be this:

First, turnover and other requirements of a “custodian,” under § 543, apply in a Subchapter V case in the same manner they apply in a regular Chapter 11 case.

Second, Debtor’s compliance with the early timing requirements of Subchapter V for filing a plan is additional evidence of a good faith filing.  

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Footnote 1.  11 U.S.C. § 543 provides in part:

(a) A custodian with knowledge of the commencement of a case under this title concerning the debtor may not make any disbursement from, or take any action in the administration of, property of the debtor . . . in the possession, custody, or control of such custodian, except such action as is necessary to preserve such property.

(b) custodian shall—(1) deliver to the trustee any property of the debtor held by or transferred to such custodian . . . on the date that such custodian acquires knowledge of the commencement of the case; and (2) file an accounting of any property of the debtor . . . that, at any time, came into the possession, custody, or control of such custodian.

. . .

(d) After notice and hearing, the bankruptcy court—(1) may excuse compliance with subsection (a), (b), or (c) of this section if the interests of creditors and, if the debtor is not insolvent, of equity security holders would be better served by permitting a custodian to continue in possession, custody, or control of such property, and (2) shall excuse compliance with subsections (a) and (b)(1) of this section if the custodian is an assignee for the benefit of the debtor’s creditors that was appointed or took possession more than 120 days before the date of the filing of the petition, unless compliance with such subsections is necessary to prevent fraud or injustice.

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