Subchapter V: A Removed Debtor In Possession Problem

By: Donald L Swanson

A problem: What is a Subchapter V trustee to do when the Subchapter V debtor is removed from possession?

Authorizations

The Bankruptcy Code authorizes removal of a debtor in possession for cause—in both Subchapter V and standard Chapter 11.[Fn. 1]

And in a removed-debtor context, the Bankruptcy Code also authorizes both a Subchapter V trustee and a trustee in standard Chapter 11 to:

• run debtor’s business[fn. 2]; and
• sell bankruptcy estate assets “other than in the ordinary course of business” under § 363.

But . . . a removed debtor in possession retains the opportunity to be reinstated into possession—under both Subchapter V and standard Chapter 11.[Fn. 3]

A Plan/Conversion/Dismissal Difference

—In Standard Chapter 11

One “duty” of a trustee in standard Chapter 11 is to promptly “file a plan” or recommend conversion to another bankruptcy chapter (7, 12 or 13) or recommend dismissal.[Fn. 4]

•  Note:  A “duty” is something that must be performed by the trustee—as distinguished from a mere power or authorization to act.  

In othe words, once appointed in a standard Chapter 11, the trustee must proceed expeditiously in one of three ways:

   1.  file a plan, providing for liquidation or continued operations—or a combination of the two;

   2.  “recommend” conversion to chapter 7, 12 or 13; or

   3.  “recommend” dismissal of the bankruptcy case.

In the meantime, the trustee might:

• continue debtor’s business operations—or not; and/or
• liquidate some or all of debtor’s assets under § 363—or not.

—In Subchapter V

In Subchapter V by contrast, only the debtor is allowed file a plan.[Fn. 5]. In other words, the Subchapter V trustee has no authority, power or right to file a plan of any sort.  

Nor is a Subchapter V trustee explicitly authorized by statute to recommend conversion to another bankruptcy chapter or to request dismissal.

Question: But what about this trustee right as a “party in interest” under § 1109(b)): the trustee “may raise and may appear and be heard on any issue” in the case?[Fn. 6]

Answer: Presumably, the Subchapter V trustee may, like any other party in interest under § 1109(b), move to convert or dismiss the case.

Subchapter V Plan Filing Problem

So . . . a major Subchapter V problem is this: 

•  once a Subchapter V debtor in possession is removed for cause, what is the Subchapter V trustee to do?

One approach: the trustee is to begin immediate negotiations with the removed debtor to develop a plan that debtor will file—and if those negotiations fail, move to dismiss the case or convert it to Chapter 7.

Another approach: the trustee is to start liquidating debtor’s assets immediately under § 363—and once the liquidation is completed and all liens and costs of sale are paid (including the trustee’s fees under § 506(c)), deal with remaining funds by either:

• converting the case to Chapter 7; or
• interpleading the funds under Fed.R.Bankr.P. 7022.

Neither of those two approaches is satisfactory, it seems. 

So, it will be interesting to see how the courts wrestle with and resolve this problem.

Illustration of Problem

One of the early cases dealing with this removal problem is In re Young from the New Mexico Bankruptcy Court.[Fn. 7]

When faced with the choice of removing debtor in possession or converting the case to Chapter 7, the Court declines to convert and removes debtors from possession, instead, for two reasons:

• the Subchapter V Trustee already had familiarity with the case and could, therefore, liquidate estate assets efficiently; and
• a Chapter 7 trustee would incur substantial percentage-based fees (under § 326) that would make the Chapter 7 process more expensive.  

A few weeks later, however, Debtor moves successfully to convert the case to Chapter 7.

The result: we can’t learn any lessons from that case on the effectiveness of a Subchapter V trustee’s liquidation efforts after removal of the debtor in possession.

Conclusion

It will be interesting to see how the bankruptcy courts continue to grapple with the removed debtor problem in Subchapter V—and to see how long it will take for a consensus to develop on the best approach for a Subchapter V trustee to take.

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Footnote 1.  Subchapter V’s § 1185(a) says:  “the court shall order that the debtor shall not be a debtor in possession for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor, either before or after the date of commencement of the case, or for failure to perform the obligations of the debtor under a plan confirmed under this subchapter.”

Standard Chapter 11’s § 1104(a) says: “the court shall order the appointment of a trustee—(1) for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause . . . ; or (2) if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.

Footnote 2. Subchapter V’s § 1185(b)(5) says: “(b) Duties.—The trustee shall— . . . (5) if the debtor ceases to be a debtor in possession— . . . (B) be authorized to operate the business of the debtor.”

Standard Chapter 11’s § 1108 says: “Unless the court, on request of a party in interest and after notice and a hearing, orders otherwise, the trustee may operate the debtor’s business.”

Footnote 3.  Subchapter V’s § 1185(b) says: “(b) Reinstatement.— On request of a party in interest, and after notice and a hearing, the court may reinstate the debtor in possession.”

Standard Chapter 11’s § 1105 says: “the court may terminate the trustee’s appointment and restore the debtor to possession and management of the property of the estate and of the operation of the debtor’s business.”

Footnote 4.  § 1106(a)(5) says: “(a) A trustee shall— . . . (5) as soon as practicable, file a plan . . . , file a report of why the trustee will not file a plan, or recommend conversion of the case to a case under chapter 7, 12, or 13 of this title or dismissal of the case.”

Footnote 5.  Subchapter V’s § 1189(a) says: “(a) Who May File a Plan.—Only the debtor may file a plan under this subchapter.”  Additionally:

•  § 1181(a)’s list of Chapter 11 subsections excluded from Subchapter V specifically identifies § 1106 like this: “(a) In General.—Sections . . . 1106 . . . of this title do not apply in a case under this subchapter”; and

•   Subchapter V’s § 1185(b)(2) list of trustee duties incorporated from § 1106 does not include the plan/conversion/dismissal authorization of § 1106(a)(5).

Footnote 6.  § 1109(b) applies in Subchapter V and says: “(b) A party in interest, including . . . the trustee . . . may raise and may appear and be heard on any issue in a case under this chapter.”

Footnote 7.  The opinion is In re Young, Case No. 20-11844 in the New Mexico Bankruptcy Court (issued 3/26/2021, Doc. 174 & 175)

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