By: Donald L Swanson
What the heck does this mean:
“(1) Debtor.—The term ‘debtor’— . . . (B) does not include— . . . (Iii) any debtor that is an affiliate of an issuer, as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)”
—from Subchapter V’s eligibility statute, § 1182 (emphasis added).
Since the inception of Subchapter V, I’ve been trying to figure that meaning out.
Here’s the progression of thinking:
- at first read, it seems to mean that a debtor owned by a publicly traded company does not qualify; but
- the referenced Securities Exchange Act section has very broad language—like only debtors owned by individuals can qualify for Subchapter V; but
- that can’t be right, because it would blow a gaping hole in Subchapter V eligibility—surely Congress did not intend that!
Recent Opinion
Well . . . apparently, Congress did.
That’s according to a recent opinion, In Phenomenon Marketing & Entertainment, LLC, Case No.: 2:22-bk-10132, Central California Bankruptcy Court (issued 4/12/2022, Doc. 143).
In Phenomenon Marketing, a creditor objects to debtor’s Subchapter V eligibility, saying debtor is an “affiliate of an issuer.”
Debtor argues in response that none of its owners is a publicly-traded company.
The Bankruptcy Court sustains the objection. Here’s why.
Statutes
—Bankruptcy Code
Section 1182(1)(B)(iii) provides: the “term ‘debtor’ does not include any debtor that is an affiliate of an issuer, as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c).”
Section 101(2)(A) provides: an “affiliate” is an “entity that directly or indirectly owns, controls, or holds with power to vote, 20 percent or more of the outstanding voting securities of the debtor ….”
—Securities Exchange Act
Section 78c(a)(8) provides: an “issuer” is “any person who issues or proposes to issue any security.”
Section 78c(a)(10) defines a “security” broadly to include, among other things, any “stock” or “investment contract.”
Two Affiliates
Debtor is owned (100%) by Phe.no, Inc., which is owned (100%) by Phenomenon Holdings, LLC, which has three LLC owners, each with more than a 20% interest.
Accordingly, both Phe.no and Phenomenon Holdings are “affiliates” of Debtor, as defined in § 101(2)(A).
Two Issuers
—A Corporation
Phe.no is a Delaware corporation with stockholders, and therefore has either issued or is proposing to issue stock—a “security” under the Securities Exchange Act. Therefore, Phe.no is an “issuer” under thar Act.
—An LLC
Phenomenon Holdings is an LLC, and an LLC membership interest is a “security” under the Securities Exchange Act, if that interest is an “investment contract.” An investment contract is “(1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits produced by the efforts of others.”
In 2019, Phenomenon Holdings issues its own ownership interests to its former President. Such issued interests qualify as investment contracts—and as securities under the Securities Exchange Act. The former President would not have invested funds in Phenomenon Holdings without expecting a profit from efforts of others. So, Phenomenon Holdings is an “issuer” under the Securities Exchange Act.
—Conclusion = Two Issuer Affiliates
So, at least two of Debtor’s affiliates are “issuers” under the Securities Exchange Act—leaving the Debtor ineligible for Subchapter V.
Publicly-Traded Non-Issue
There is no merit to Debtor’s claim that an entity cannot be an “issuer” unless it is publicly-traded. Under the Securities Exchange Act, an “issuer” is “any person who issues or proposes to issue any security.” The Act’s definition of “security” is extremely broad, and is not limited to securities traded on public exchanges.
—Drafting Error?
Some commentators argue that Congress intended to exclude only affiliates of publicly-traded companies from Subchapter V eligibility. Accordingly, the broader exclusion contained in § 1182(1):
- is the result of a drafting error; and
- should not be followed because it produces an absurd result—the exception, as drafted, excludes too many otherwise-eligible debtors.
—An Absurd Result?
The “affiliate of an issuer” exclusion, as drafted, does not lead to an absurd result:
- Subchapter V is intended to ensure that mom-and-pop businesses, who fall on hard times, have a chance to recover and be successful; and
- Excluding entities owned within a sophisticated and complex corporate structure is something Congress could have intended.
—Debtor’s Circumstances
Here, the debtor is directly and indirectly owned and controlled by a variety of sophisticated investment entities with “well over 100 investments using … proprietary capital” that “range from modest commitments” to a “multimillion dollar single transaction.”
Excluding such an entity, with its sophisticated ownership structure, from eligibility under Subchapter V is far from absurd.
—Congressional Action
To the extent Congress did intend entities like this debtor to benefit from Subchapter V, it is the role of Congress (not this Court) to amend the statute accordingly.
Conclusion
Presently before Congress is legislation that would:
- change and limit the “affiliate of an issuer” exclusion to affiliates of publicly-traded entities only; and
- apply retroactively to all Subchapter V debtors—including the Phenomenon Marketing debtor in the case discussed above.
Here’s hoping the legislation passes!
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