United States: Are Unmatured Lease Obligations Considered Noncontingent Debt For Purposes Of Calculating Eligibility To File A Subchapter v Bankruptcy?

Congress passed the Small Business Reorganization Act of 2019 (the "SBRA") to benefit small businesses. The SBRA established a new framework within Chapter 11 of the Bankruptcy Code, known as subchapter V, which streamlines and simplifies the bankruptcy process for small businesses to allow them to restructure and exit bankruptcy in an expedited timeframe.

Section 1182 of the Bankruptcy Code sets forth specific definitions that apply to subchapter V. For the definition of "debtor," section 1182 currently provides that debtors are persons (which includes legal entities) engaged in commercial or business activities that have "aggregate noncontingent liquidated secured and unsecured debts as of the date of filing ... in an amount not more than $7,500,000." Accordingly, entities with more than $7.5 million in debt do not qualify for the protections and streamlined processes Congress provided for in the SBRA.

Recent cases out of the Eastern District of Virginia and the Southern District of New York have reached different conclusions as to whether the Bankruptcy Court should include the lease obligations of a debtor in its calculation of noncontingent and liquidated debts to consider subchapter V eligibility. Which approach a Bankruptcy Court follows could determine whether a small business debtor can proceed with a subchapter V case. A detailed discussion of the two approaches follows.

Eastern District of Virginia

In the case of In re Macedon Consulting, Inc., 652 B.R. 480 (Bankr. E.D. Va. 2023), certain lessors to debtor Macedon Consulting Inc. ("Macedon") filed a motion to dismiss Macedon's petition for relief. Lessors primarily argued that the bankruptcy had been filed in bad faith. However, they also asked the court to revoke Macedon's designation as a small business debtor under subchapter V. Macedon, an information technology solutions provider, filed for bankruptcy after experiencing considerable loss of business due to the COVID-19 pandemic and owed considerable sums under two lease agreements. As part of Macedon's initial filings, it had also asked the court to allow it to reject its leases with these two lessors. The aggregate amount owed by Macedon under these lease agreements was approximately $14.4 million —about $4.8 million and $9.6 million from each lease, respectively. As to Macedon's designation as a small business, the lessors argued that Macedon did not qualify for subchapter V because of the debt owed under these lease agreements.

The lessors' argument centered on the contention that Macedon was not eligible for subchapter V because its noncontingent liquidated liabilities included the debts due under the leases, and those debts exceeded the $7.5 million limit in subchapter V. The issue for the court was whether lease rejection claims should be considered contingent or noncontingent debts. Taking instruction from In re Parking Mgmt., 620 B.R. 544 (Bankr. D. Md. 2020), the court held that the leases Macedon wanted to reject were noncontingent debts. The court in In re Parking Mgmt. reasoned that PPP loan liability was contingent because PPP loans, which were created under the CARES Act, "allowed for complete forgiveness if the borrower met certain conditions," which means liability for the debt depends on a future event that may or may not occur.

The court in In re Macedon applied the logic from In re Parking Mgmt. and determined that the debt at issue, liability under leases, is noncontingent and liquidated because lease agreements simply establish the timing of lease payments. There is no question about a future event that may or may not occur, as was the case for the PPP loans in In re Parking Mgmt. In this court's opinion, the liability for the lease payments arose on the date the leases were executed. The Court reasoned that a tenant vacating a property before the expiration of the lease realizes that it must still pay rent though the remaining term of the lease, absent an agreement to the contrary. The Court held that fixing the timing of future lease payments does not make the lessee's obligation contingent or dependent on any future event.

Because lease agreements were held to create noncontingent debt, the court granted the lessors' motion to revoke Macedon's subchapter V designation. Macedon was, under this ruling, carrying more noncontingent debt in the form of payments due under its lease agreements ($14.4 million) than is allowed by the SBRA ($7.5 million) for small business reorganizations, so the court revoked the subchapter V election and converted Macedon's case to a regular chapter 11 case.

Southern District of New York

Several months later, Bankruptcy Judge Bentley of the Southern District of New York disagreed with the Eastern District of Virginia's In re Macedon holding as it relates to calculating noncontingent debt over unpaid rent obligations. In In re Zhang Medical P.C. d/b/a New Hope Fertility Clinic, 2023 Bankr. LEXIS 2847 (Bankr. S.D.N.Y. Nov. 30, 2023), debtor Zhang Medical P.C. ("Zhang") filed for bankruptcy under subchapter V. Zhang's landlord objected to that filing, arguing that Zhang's scheduled debts exceeded $7.5 million and, in the alternative, even if those scheduled debts did not exceed $7.5 million, Zhang had noncontingent debts amounting to more than $7.5 million under the parties' lease agreement. For the latter argument, the landlord relied on In re Macedon.

Judge Bentley first considered what it means for debt to be noncontingent and liquidated. Relying on a Second Circuit decision in Mazzeo v. United States, 131 F.3d 295 (2d Cir. 1997), the court determined that noncontingent debt is debt where all of the events giving rise to liability occur before filing for bankruptcy. In the context of taxpayer's duties, for example, a taxpayer's duty to pay taxes arises when the taxes come due. Separately, liquidated debt is debt that has a value that is easy to ascertain or where "the claim is determinable by reference to an agreement or by a simple computation." (quoting 2 L. King, Collier on Bankruptcy ¶ 109.06[2][c] (15th ed. rev. 1997)).

Judge Bentley ruled for the landlord on the first issue in dispute, finding that Zhang's noncontingent debts were well over the $7.5 million debt limit without even considering the unpaid lease payments. Though this obviated the need to address the landlord's arguments made in reliance on In re Macedon, Judge Bentley focused on the In re Macedon holding and noted, in dicta, that he did not agree with the conclusion that future payments owed under unexpired leases and executory contracts should count towards the subchapter V debt limit. Judge Bentley wrote that future payment obligations under unexpired leases and executory contracts should "rarely, if ever, be counted toward the subchapter V debt cap."

After providing a brief factual summary of In re Macedon, Judge Bentley explained that the In re Macedon decision relies on "essentially the same" definition of noncontingent debt as utilized in Mazzeo and that the Macedon court found future lease obligations to be noncontingent because the liability arises on the date of execution. However, Judge Bentley noted, "[i]f this ruling were followed, it would greatly restrict subchapter V eligibility." Furthermore, if more courts were to apply the In re Macedon holding, many debtors who otherwise would qualify under the SBRA as small businesses would be disqualified because of their unpaid lease obligations.

Judge Bentley found that In re Macedon overlooked the differences between a debtor's obligations under executory contracts or unexpired leases and other debtor obligations. Executory contracts and unexpired leases are effectively both an asset and a liability because they create both a right to performance and an obligation to perform. Essentially, executory contracts and leases are reciprocal agreements that the Bankruptcy Code allows debtors to either assume or reject.

Until the debtor decides whether to assume or reject an executory contract or unexpired lease, "the amount and nature of its obligations under that contract or lease are contingent and unliquidated." Assuming an agreement will force the debtor to pay the obligation in full, but rejection will mean the obligation to pay is much smaller. The amount of the debt depends on an uncertain future event (whether the debtor assumes or rejects the contract or lease), which means that any eventual debt is both contingent and unliquidated. Judge Bentley conceded that if a debtor were to reject a contract or lease on the petition date, an argument could be made that the rejection damages liability is a noncontingent debt that may count against the $7.5 million cap under the SBRA. However, that circumstance is "relatively rare," and the debtor may still have "strong arguments that its rejection liability is contingent and/or unliquidated."

Conclusion

How a court interprets the definition of "noncontingent liquidated" debt could substantially impact small business debtors. If, for example, a court applies the definition from Macedon Consulting, substantial outstanding debts under lease agreements could prevent small businesses from enjoying the SBRA benefits of subchapter V. Under the Zhang interpretation, however, debtors with outstanding debts on lease agreements are more likely to qualify for small business protections contained in the SBRA because their unpaid lease obligations would not be counted against the $7.5 million debt limit. Debtors intending to file for reorganization under subchapter V should be aware of the current split between various bankruptcy courts on this issue when evaluating a venue for their reorganization.

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