Written by Thomas R. Phinney and Paul J. Pascuzzi*
Welcome to the eighth annual edition of our article covering recent developments in bankruptcy law. This article comes from a program we present for the Bankruptcy and Commercial Law Section of the Sacramento County Bar Association. Once again, we invite you to test your knowledge of recent developments in the area of insolvency law. Unless otherwise noted, all references are to the Bankruptcy Code. We provide a summary of the facts, issues, and holdings from a mix of ten recent important and interesting bankruptcy decisions. For MCLE credit, please answer the 20 true/false questions available at the CLA's website: www. calawyers.org. Good luck!
1. Profit Motive Not Required for Subchapter V Eligibility: NetJets Aviation, Inc. v. RS Air, LLC (In re RS Air, LLC), No. BAP NC-21-1227-BGT, 2022 WL 1288608 (B.A.P. 9th Cir. April 26, 2022).
This case involves the requirements and burden of proof for a debtor to be eligible to file a subchapter V chapter 11 case. Subchapter V is a certain type of chapter 11 case for smaller businesses to attempt to reorganize more quickly and efficiently, and with less stringent requirements, than would be possible in a typical chapter 11 case. Section 1182(1)(A) requires that for a debtor to be eligible for subchapter V it must be "engaged in commercial or business activities."
The debtor RS Air's business involved using and providing aircraft transportation services and acquiring and selling interests in aircraft. RS Air's revenue came from providing flight services to its sole owner, flying fragile technology prototypes to prevent damage from commercial baggage handling, and acquiring and selling fractional interests in aircraft. RS Air had agreements to purchase or lease fractional interests in private jets from NetJets Aviation. When one of NetJets aircraft was involved in a runway accident, RS Air ceased doing business with it, so that RS Air was not engaged in its normal flight operations when it filed chapter 11. Prior to bankruptcy, RS Air and NetJets had been involved in state court litigation, and NetJets held 98% of the total non-insider debt against RS Air.
RS Air elected subchapter V status in its chapter 11 case. NetJets objected, asserting that RS Air was not currently "engaged in commercial or business activities" because for years it had no flight operations, no revenue or income, and no employees. NetJets also argued that RS Air had never generated revenue and its sole purpose was to serve as an intermediary through which its owner acquired interests in and used private jets and received depreciation tax benefits. NetJets argued that the burden was on the debtor to establish its eligibility for subchapter V. The debtor argued that ongoing operations, employees, and profitability were not required for
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subchapter V eligibility. The debtor also argued that it was currently engaged in business activities by litigating with NetJets, intending to resume negotiating sales of its fractional jet interests, and was paying aircraft registry fees, keeping tax obligations current, and otherwise maintaining good standing as an LLC.
The bankruptcy court overruled NetJets' objection to eligibility, finding that the burden was on NetJets to establish the debtor was not eligible. The court found that the debtor was engaged in sufficient business activities on the petition date by litigating with NetJets, intending to resume fractional jet ownership with a different partner, and remaining in good standing as an LLC. Thereafter, RS Air filed its chapter 11 plan, to which NetJets objected, raising similar arguments in opposition to the plan. The bankruptcy court ruled that even if RS Air had no income, whether it generated income was not determinative. The court refused to revisit the eligibility issue based on law of the case, but noted that its interpretation of what were sufficient business activities for eligibility had been recognized by other courts and that those activities remained viable at confirmation.
NetJets appealed to the Ninth Circuit Bankruptcy Appellate Panel ("BAP"), which affirmed the bankruptcy court.
The BAP concluded that the bankruptcy court erred in ruling that NetJets had the burden on eligibility. That error was harmless because the record supported that the debtor could meet the burden. The BAP recognized that the statute and rules were silent on burden and the issue was one of first impression in the Ninth Circuit. The BAP followed cases regarding eligibility in subchapter V cases around the country in deciding that placing the burden on the debtor was correct.
On the issue of whether a profit motive was necessary for a debtor to be "engaged in business or commercial activity," the BAP found that the trend in subchapter V cases is that litigating, staying in good standing, and keeping current on tax obligations, coupled with the intent to reengage in buying and selling fractionalized interests, met the standards for commercial or business activities. The BAP affirmed the bankruptcy court's factual findings and held that a profit motive was not needed for eligibility.
The BAP also found that the bankruptcy court was entitled to revisit its interlocutory rulings on eligibility when making its final order confirming the plan. The court's refusal to do so here was harmless error since the plan confirmation record independently supported the debtor's eligibility. Thus, the BAP affirmed the bankruptcy court's rulings.
2. A Trustee Cannot Revisit the Value of an Exempt Asset if the Debtor Claimed "100% of FMV" and There Was no Timely Objection: Masingale v. Muding (In re Masingale), No. 22-1016 (B.A.P. 9th Cir. Nov. 2, 2022).
In a case of first impression, the BAP held that a debtor who claims a homestead exemption equal to "100% [of] fair market value" is entitled to retain postpetition appreciation in the value of the property, even if the chapter 11 case converts to chapter 7. The decision may also be important outside the exemption context: the court's analysis suggests that debtors in chapter 13 cases that convert to chapter 7 should retain postpetition appreciation regardless of whether the home was sold before or after conversion.
In Masingale, husband and wife debtors filed a chapter 11 petition in 2015. They scheduled their home as being worth about $165,000 and encumbered by a $130,000 mortgage. In the schedules, they claimed an exemption under § 522(d)(1) for "100% [of] fair market value." At the time, the Washington state exemption was $45,900. No one lodged an objection to the exemption claim within thirty days after the first meeting of creditors, as generally required by Federal Rules of Bankruptcy Procedure, rule 4003(b)(1).
In 2017, the debtors confirmed a plan providing that the debtors would keep the home and continue to pay the mortgage until maturity. The plan "appeared to claim [that] the entire fair market value of the home" was exempt, but also indicated that the home would not be exempt until all creditors were fully paid under the plan.
More than one year after plan confirmation, in 2018, the case was converted to chapter 7. Note that under rule 1019(2)(B)(i), a new time period for objecting to exemptions would have arisen if the conversion had occurred less than one year after the plan was confirmed, but here over a year had elapsed. A dispute arose regarding the extent of the debtors' exemption in the home. The bankruptcy court approved a sale of the home for $422,000, generating net sale proceeds of $222,000, and ruled that the debtors' share of the proceeds was limited to $45,900, the amount of the Washington exemption. The court directed the trustee to hold the sale proceeds pending an appeal by the debtors, who claimed the "100% [of] fair market value" exemption meant that they were entitled to all the sale proceeds.
The BAP agreed with the debtors. As a matter of first impression, the court ruled that the debtors' "claim of an exemption equal to '100% [of] FMV' includes postpetition appreciation and becomes incontestable if there is no timely objection." The decision was based upon § 522(l) ("Unless a party in interest objects, the property claimed as exempt
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on such list is exempt"); Federal Rules of Bankruptcy, rule 1019(2)(B)(i) (time to object to exemption was not reopened); and Taylor v. Freeland & Kronz, 503 U.S. 638 (1992) ("if no one files a timely objection, an exemption claim is valid even if it had no 'colorable basis' in the law.").
In this case, the debtors had claimed an exemption in the "full market value" of the home, which was wording that the Supreme Court had looked at in Schwab v. Reilly, 560 U.S. 770 (2010). The BAP described the case as holding that a debtor may claim "100% of FMV" to put parties in interest on notice that the debtor intends to claim the full value of the property as exempt, at the time of the petition or later at the time of sale.
The trustee argued that under the established "snapshot rule," the exemption was limited to the value of the property at the time of the filing of the petition and did not include postpetition appreciation. As explained by the BAP:
The snapshot rule fixes the point in time that defines the exemptions that a debtor is entitled to take. It says nothing about what happens when a debtor claims an exemption in postpetition appreciation to which the debtor is not entitled and no one timely objects. [Emphasis in original.]
To have the benefit of the snapshot rule, the BAP said, "a trustee or party in interest must object to an exemption claim that contradicts that rule." The BAP reversed the bankruptcy court's order that had limited the exemption to the statutory maximum of $45,950 and remanded for the bankruptcy court to determine how to enforce the exemption "and what other remedies, if any, are appropriate."
Finally, on appeal, the...
