Judge Gargotta Nixes Non-Dischargeability Claim Against Corporate Su...


 Distinguishing a precedent from his own district and disagreeing with the Fourth Circuit, Judge Craig Gargotta has ruled that non-dischargeability only applies to human Subchapter V debtors. Adv. No. 22-5052, Avion Funding, LLC v. GFS Industries, LLC (Bankr. W.D. Tex. 11/10/2022).  The decision can be found here. The decision was especially sweet for me personally because the case it distinguished, New Venture Partnership v. JRB Consolidated, Inc. (In re JRB Consolidated, Inc.), 188 B.R. 373, 374 (Bankr. W.D. Tex. 1995), was one that I lost and always thought was wrongly decided. 

Introduction to Non-Dischargeability of Corporate Debts

Under 11 U.S.C. Sec. 523(a), there are certain debts which cannot be discharged in a bankruptcy case. Some debts are automatically non-dischargeable, such as domestic support obligations and certain taxes, while other debts must be proven to be non-dischargeable, such as fraud, defalcation in a fiduciary capacity and willful and malicious injury. Usually, it is easy to tell when non-dischargeability applies. Only a human being can receive a discharge in a chapter 7 case, 11 U.S.C. Sec. 727(a)(1) and only individuals can file chapter 13, 11 U.S.C. Sec. 109(e). Since chapters 7 and 13 account for 99% of all bankruptcies, the possible application of non-dischargeability to a corporation or partnership does not come up very often. Nevertheless, it happens enough to parse the statutes and wonder just what Congress was thinking. 

What makes this issue interesting is how different sections of the Code interact. Let's start with 11 U.S.C. Sec. 523(a). It states that "(a) discharge under (specified specific code sections) does not discharge an individual debtor from any debt" listed in the nineteen subsections which follow. That should make it really clear that only an individual can have a non-dischargeable debt, right? 

However, when you look at chapter 12, it says that a discharge under chapter 12 does not discharge a debtor from a debt "of a kind specified in specified in section 523(a) of this title." So, does the reference to "of a kind specified in section 523(a)" refer to the nineteen subsections only or does it include the limitation that section 523(a) only applies to individual debtors? In the JRB Consolidated case, Judge Larry Kelly, for whom my Inn of Court is named, concluded that "of a kind" meant the specific types of debts regardless of what debtor they applied to. 

Now what does Subchapter V say? In 11 U.S.C. Sec. 1192, Congress stated that upon conclusion of a plan, the court shall grant the debtor a discharge of all debts provided in section 1141(d)(1)(A) of this title" except for debts "of the kind specified in section 523(a) of this title."  Section 1141(d)(1)(A) doesn't offer any clarity since it simply refers to pre-petition debts and a few other debts determined as if they were pre-petition debts. However, 11 U.S.C. Sec. 1141(d)(1)(B) specifically says that in a legacy chapter 11 case that non-dischargeability only applies in an individual case.  

The Fourth Circuit has recently held that non-dischargeability can apply to a non-human Subchapter V debtor. In re Cleary Packaging, LLC, 36 F.4th 509 (4th Cir. 6/7/2022).

So, how did Judge Gargotta approach the problem?

Judge Gargotta's Interpretation

Judge Gargotta relied substantially on the preamble to section 523(a) to find that non-dischargeability in Subchapter V cases only applied to individuals. He gave three reasons for this conclusion.

First, § 1192(2)’s reference to § 523(a) only incorporates the list of nondischargeable debts, without expanding it. In other words, the language of § 1192(2) does not intend to except from discharge any debts that § 523(a) does not already except. Because § 523(a) unequivocally applies only to individuals, the language of § 1192(2) does not empower § 523(a) to cast a wider net than the text of § 523(a) permits. Had Congress included a phrase in § 1192(2) explicitly stating that the list found in § 523(a) applies to all debtors proceeding in Subchapter V, then the interpretation would be straightforward. Congress’s choice not to insert this language is instructive. 

Moreover, if Congress intended the list of debts to be applicable to corporate debtors, it knew how, because it did so in § 1141(d). Section 1141(d)(6) states: “the confirmation of a plan does not discharge a debtor that is a corporation from any debt (A) of the kind specified in paragraph 2(A) or 2(B) of section 523(a) that is owed to a governmental unit…”(emphasis added). Similarly, § 1141(d)(2) states: “A discharge under this chapter does not discharge a debtor who is an individual from any debt excepted from discharge under section 523 of this title.” (emphasis added). This language is evidence that Congress knew, when it drafted § 1192(2), how to distinguish dischargeability based on the type of debtor. Congress did not make this distinction in § 1192(2). Thus, in order to determine to which debtors § 1192(2) refers, one must look to the language of § 523(a), which unequivocally applies only to individuals. 

Second, the inclusion of § 1192 in § 523(a) would be rendered meaningless under any other interpretation. When Subchapter V was passed, Congress also amended § 523(a) to add the newly enacted § 1192 to the list of discharge provisions incorporated in the scope of § 523(a)’s discharge exceptions. § 523(a) now reads, “[a] discharge under section…1192…does not discharge an individual debtor…” (emphasis added). Section 1192’s addition is vital to the analysis because it evinces Congress’s intent. Section 1192(2) as written makes § 523 discharge exceptions applicable to “debtors” without regard to whether the debtor is an individual or a corporation. Critically though, had Congress intended § 523(a) exceptions to apply to entities as well, it would be unnecessary to add § 1192 to a statute that plainly applies to individual debtors only. The fact that Congress added § 1192 into § 523 demonstrates that Congress intended § 1192(2) to limit the § 523 exceptions in Subchapter V to individuals only. 

This conclusion is mandated by the canon of statutory construction against surplusage. When interpreting statutes, courts should “lean in favor of a construction which will render every word operative, rather than one which may make some idle and nugatory.” Antonin Scalia & Bryan  A. Garner, Reading Law: The Interpretation of Legal Texts 69, 174 (2012) (citing Thomas M. Cooley, A Treatise on the Constitutional Limitations Which Rest upon the Legislative Power of the States of the American Union 58 (1868)). Here, interpreting § 523 as excepting from discharge debts of corporate debtors in Subchapter V would be to ignore the import of § 1192 into § 523(a). The Court believes the correct interpretation is one which gives meaning to the amendment to § 523. This position compels the Court to conclude that discharge exceptions found in § 523 apply to an § 1192 discharge, but only as to individual debtors. 

Third, corporate debtors proceeding under Chapter 11 historically have been immune to dischargeability actions under § 523(a). It is well-settled law in this circuit that the § 523 exceptions to discharge apply only to individuals, not to corporations. See Garrie v. James L. Gray, Inc., 912 F.2d 808, 812 (5th Cir. 1990) (“the ‘willful and malicious injury’ exception to discharge, like all of the exceptions to discharge found in section 523(a), applies only to individual, not corporate debtors”) (citing Yamaha Motor Corp., U.S.A. v. Shadco, Inc., 762 F.2d 668, 670 (8th Cir. 1985)). As this Court itself has explained, it is clear from the language of the Chapter 11 discharge statutes “that corporate debtors in Chapter 11 are not subject to a complaint to determine dischargeability of debt under § 523(a).” New Venture Partnership v. JRB Consolidated, Inc. (In re JRB Consolidated, Inc.), 188 B.R. 373, 374 (Bankr. W.D. Tex. 1995). For Congress to suddenly depart from this well-established principle when it enacted Subchapter V defies reason. It is much more likely, and confirmed by the language used in Subchapter V, that Congress intended to expand, not discontinue, the principle that Chapter 11 corporate debtors are not subject to § 523(a) complaints to determine dischargeability. Because Subchapter V is merely a subchapter to the broader Chapter 11, this is the required result. More compelling, the provisions governing Chapter 11 discharge imply that § 523(a) should not apply to corporate debtors. Section 1141(d)(2) states, “[a] discharge under this chapter does not discharge a debtor who is an individual from any debt excepted from discharge under section 523 of this title.” (emphasis added). Had Congress intended that corporate debtors also be held to the provisions of § 523(a), then clarifying that only individuals under Chapter 11 are liable for § 523 exceptions to dischargeability makes little sense. 

In sum, the statutory language along with the broader Chapter 11 statutory scheme mandate this Court’s holding that corporate debtors proceeding under Subchapter V cannot be made defendants in § 523 dischargeability actions. Avion’s claims under § 523, therefore, must be dismissed for a lack of legal foundation.

Opinion, pp. 8-11.

Judge Gargotta was able to distinguish the prior JRB Consolidated decision primarily on the basis that it recognized a difference in the chapter 11 discharge. Judge Gargotta wrote:

The Court recognizes the similarities between the language of §§ 1228(a)(2) and 1192(2). Despite the similar language, the Court does not find its decision in this case as inconsistent with the ruling in In re JRB Consolidated. Critical to Judge Kelly’s decision was the difference between the operation of Chapter 11 corporate discharges and Chapter 12 corporate discharges. Judge Kelly pointed out that the provisions of Chapter 11 are narrower, only excepting from discharge 1) a liquidating corporate debtor that would otherwise be denied a discharge under § 727(a) (§ 1141(d)(3)); and 2) individual Chapter 11 debtors who have debts of the kind enumerated in § 523(a) (§ 1141(d)(2)). Given the limited exceptions to discharge in Chapter 11, Judge Kelly observed that “it seems clear from that language that corporate debtors in Chapter 11 are not subject to a complaint to determine dischargeability of debt under § 523(a).” Id. at 374. Because Subchapter V is not its own chapter of bankruptcy, but rather is a subchapter of Chapter 11, Judge Kelly’s analysis regarding Chapter 11 discharges remains applicable to the case here. Furthermore, Judge Kelly recognized the uniqueness of Chapter 12, stating that the broad language of § 1228(a), “would appear to be consistent with the intent of Congress to provide special treatment for certain kinds of debtors otherwise eligible to file for Chapter 12.” Id. In short, because Chapter 12 is only available to a small and specific subset of debtors, Chapter 12 cases have unique considerations that are not present in a Chapter 11 case. Therefore, the Court is not mandated to extend the holding that Chapter 12 corporate debtors are subject to § 523 dischargeability actions into Subchapter V notwithstanding the similar language between §§ 1228(a) and 1192(2). 

Opinion, p. 13.

I have set out the key areas of Judge Gargotta's reasoning because I think he (and his law clerk) do a masterful job of using the canons of statutory interpretation to determine what Congress intended on a subject that Congress probably never thought about. He gets bonus points for citing the Scalia text on statutory interpretation. Congress created this problem by blindly cross-referencing statutes that apply differently in different contexts. The Court can either take the plain meaning approach in a vacuum (as I believe Judge Kelly did in JRB Consolidated) or think about how the statutes work together (as Judge Gargotta did). While other courts may disagree with Judge Gargotta's analysis, they will find it hard to dismiss it as a principled approach to a problem foisted onto the courts by Congress.

What Should the Answer Be?

Setting aside statutory interpretation and Congressional intent, what should the answer be? I think that dischargeability is a concept uniquely applicable to individual debtors. I start with the proposition that bankruptcy is intended to benefit the "honest but unfortunate" debtor. Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This introduces a concept of morality that can only apply to human beings and not to artificial entities. 

The nineteen categories of non-dischargeable debts fall into four broad categories: those which contain an element of moral judgment, those which protect the public fisc, technical exceptions and a grab bag of special interest provisions tacked on over the years. 

The morality based exceptions include fraud (sec. 523(a)(2)), fraud or defalcation in a fiduciary capacity (sec. 523(a)(4)), willful and malicious injury (sec. 523(a)(6)), death or personal injury caused by drunken driving or boating (sec. 523(a)(9)), federal restitution obligations (sec. 523(a)(13)) and debts for violations of the securities laws (sec. 523(a)(19)).

The exceptions aimed at protecting the public fisc include taxes (sec. 523(a)(1)), domestic support obligations (sec. 523(a)(5)), student loans (sec. 523(a)(8)), fraud or defalcation while acting in a fiduciary capacity of a federally insured institution (sec. 523(a)(a)(11)), failure to maintain a commitment to contribute capital to a federally insured institution (sec. 523(a)(11)), and certain fees imposed on prisoners (sec. 523(a)(17)). 

The exceptions I would describe as technical include debts that are not listed or scheduled (sec. 523(a)(3)) and debts excluded from discharge in a prior case (sec. 523(a)(10)).

Of the nineteen categories of non-dischargeable debts there are many which can only apply to an individual, such as domestic support obligations, student loans, restitution, prisoner fines and drunken driving debts. While artificial entities can owe tax debts, they must pay priority claims in full in order to receive a discharge. 

When you eliminate the debts that could not be incurred by an artificial entity or must be paid by an artificial entity in order to reorganize, the main debts left are a subset of the morality-based exceptions to discharge, such as the fraud claim raised in the Avion Funding case.  Morality is a concept not easily applied to an artificial entity. Purdue Pharma is an example of an entity whose owners operated it in an egregiously immoral manner. However, it was able to reorganize because reorganization promoted the greater good.  If non-dischargeability had applied to that case, there would have been no reorganization since most debts would have escaped discharge. A corporate restructuring is more of a collective maximization of value than it is a vehicle for making moral judgments. Moral judgments, on the other hand, are particularly apropos in the case of an individual receiving a chapter 7 discharge. 

Beyond the question of whether morality should apply to artificial entities, a kind of morality is baked into the Code in other areas applicable to artificial entities. The good faith requirement of 11 U.S.C. Sec. 1129(a)(3) is designed to ensure that the bankruptcy process is not used for improper purposes. The priority given to taxes, employee wages and customer deposits all include an element of moral judgment. 

While the existing laws are rather murky, if Congress were writing on a clean slate, it should state that dischargeability only applies to human debtors.

Disclaimer:  Given that there are two viable alternatives for deciding whether non-dischargeability applies to a corporate debtor, I reserve the right to argue whichever position benefits my client.