Tug of War: District Court Versus Bankruptcy Court Over the Heart of Subchapter V

Author’s Note

Appellate rulings in a California bankruptcy case have the potential to upend a bedrock principle of Subchapter V plans. After an apparel company filed for Chapter 11 under Subchapter V because of a judgment it could not pay, its plan to reorganize has bounced between bankruptcy court and the district court since 2020. While the bankruptcy court supports the debtor’s use of Subchapter V’s unique provisions favoring debtors and equity holders, the district court has taken a more creditor-centric view and blocked its plan twice. While thousands of Subchapter V cases have relied on a three to five-year plan time horizon, the California district court does not believe creditors should be so constrained. Now, it appears the 9th Circuit will need to opine on this critical principle.

Company Overview

Hologenix (also sometimes referred to as the ‘Company’ or ‘Debtor’), based in Los Angeles and founded in 2002, develops, manufactures, and licenses a wearable textile for leading clothing brands including Under Armour and Levi’s. The product, CELLIANT®, is a thermo-reactive mineral compound that converts body heat into infrared energy to improve health and performance. Hologenix made the Inc. 5000 list for 2020 with $5 million in revenue and 225% growth from 2017.

 

 

Lanham Act Litigation

Hologenix’s descent into bankruptcy stemmed from a dispute with a competitor about its advertising campaign. Specifically, the competitor alleged that the campaign gave consumers the impression that the FDA had approved CELLIANT®.

In early 2019, competitor Multiple Energy Technologies, LLC (MET) teamed up with litigation funder Legalist to launch a Lanham Act case against Hologenix in California. [See “Multiple Energy Technologies, LLC versus Hologenix, LLC”, Case No. CV 19-1483, United States District Court, Central District of California] MET alleged that Hologenix’s FDA statements had decimated its competing product, Redwave®. On the eve of the trial in March 2020, a settlement was reached where Hologenix agreed to pay $2.4 million and to a permanent injunction (PI) by which it was to cease its prior advertising campaign. Because Hologenix didn’t have the cash on hand and would need to raise the funds, the award was structured to be paid over time with the first $1.4 million due approximately six weeks later.

On March 9th, in a US District Court (DC) hearing [Docket 717, page 92] in California to approve the settlement, Judge Percy Anderson very wisely asked what would happen if a portion of the settlement payment was not made:

“MR. BUTLER (MET Attorney): Your Honor, the settlement that has been agreed includes a payout over a period of time. So the parties have agreed to a dismissal of the claims without prejudice subject to the case being restored should the economic terms —

THE COURT: Sir, that is not acceptable. If the terms — if the payments aren’t made, then you can sue on that settlement agreement. But either this case is settled or it’s not. You can seek to have the terms enforced if the payments aren’t made and judgment entered. But I’m not dismissing this case without prejudice so that in three weeks or a month or a year somebody can come back in here and restart all over again. So, I think you’re going to — you’re either going to have to try the case or make some alternative arrangements.”

Then later,

“MR. BUTLER: And that’s the reason why we’ve asked you to maintain that right should there be a default, which we’re hoping is theoretical. We’ve been assured that payment will be made.

THE COURT: Okay. Well, okay. I can’t help you with that. As far as I’m concerned, the case isn’t settled. And if you want to settle it, that’s fine; otherwise, I expect everybody here tomorrow morning prepared and ready to go to trial.”

As is clear above, the Judge would not give the parties the option to simply restart a trial if there was a settlement payment default. Judge Anderson sua sponte refused to accept the provision contained in §5(b)(3) of the proposed settlement agreement that would permit the trial to recommence — a development that was not and could not have been anticipated by the Debtor. [Docket 717 Casden Decl p. 6].  After a short recess, the parties agreed to a dismissal with prejudice. With MET’s claim thus liquidated, the case was closed. [i]

COVID Causes Chaos

What followed was a whipsaw of events including the COVID-19 pandemic, corporate and personal bankruptcies, two confirmed reorganization plans, each of which was subsequently blocked by reversals at the DC, and an appeal to the 9th Circuit.  After four years and nearly $5 million in attorney fees, we are no closer to a resolution.

Shortly after agreeing to the $2.4 million settlement and PI, things changed rapidly for the Company and the world. Hologenix had been in discussions to raise the capital necessary to make the initial $1.4 million payment to MET.  However, when the pandemic hit, lending activity stopped. In addition, Under Armour, which accounted for 60% of Hologenix’s sales, announced it would be delayed at least 90 days in paying a $650,000 receivable. Furthermore, Under Armour demanded indemnification for litigation threatened by MET for how it had marketed the Company’s product.

When it became clear that the Company would not be able to fund the initial payment, it filed for bankruptcy under Subchapter V of Chapter 11. The Company did this on April 22, 2020.

The chart below illustrates the significant relevant events of 2020:

Critical Election of Subchapter V

Subchapter V of Chapter 11 (Sub V) has several advantages over traditional Chapter 11 for debtors and equity holders, but it is decidedly worse for general unsecured creditors (GUCs). To qualify for Sub V, a debtor’s liquidated and non-contingent debts owed to non-insiders cannot exceed a particular dollar cap — a cap that has toggled between two different amounts since Sub V came into law in 2019.

The cap was $2.7 million until shortly before Hologenix filed Chapter 11. Serendipitously, however, to help battle the economic consequences of the pandemic, the CARES Act became law in March 2020, temporarily increasing the cap to $7.5 million just days before Hologenix faced the payment deadline. [ii]

Sub V provided a path for Hologenix that is unique in bankruptcy law. First, there is no absolute priority rule in Sub V. This means equity can be retained without paying creditors in full. Second, only the debtor, i.e., Hologenix, can file a plan, giving debtors more control over the process. Third, there is generally no committee of unsecured creditors, so creditors have to bear the cost of their own legal fees if they want to participate; this would not end up being a deterrent for MET. Fourth, and what would turn out to be most critical for this case, Sub V envisions a three to five-year plan horizon, which has its roots in Chapter 13. Evaluation of a plan’s fairness typically hinges on the debtor handing over all of its disposable income to creditors in this timeframe.

The three to five-year plan horizon implicates the absolute priority rule and cramdown. In a traditional Chapter 11, in order for equity to retain its ownership, the debtor must pay all unsecured classes 100%. Sub V removes this limitation.  That is not to say creditors have no protections. As one commentator explains:

“The Absolute Priority Rule simply doesn’t exist in subchapter V. To be more precise, to cramdown a subchapter V plan on a class of unsecured claims or interests, the plan still cannot discriminate unfairly, and must still be fair and equitable. The difference is that the definition of “fair and equitable” is different in subchapter V. No longer is it satisfied by members of the class being paid in full or, in the alternative, by classes junior to it getting nothing.

Instead, Bankruptcy Code § 1191(c)(2) provides that a Sub V plan is fair and equitable as to a class of unsecured creditors or to a class of interests if at least one of two things is true: either the plan applies all of its “projected disposable income” over three to five years to payments under the plan; or the value of the property to be distributed under the plan in that same timeframe is not less than the debtor’s projected disposable income.” [iii]

2020 Plan Terms

The Debtor’s first plan in June 2020 split creditors into three different classes.  Class 1 and 2 were comprised of insider secured claims, and Class 3 included MET and other third-party GUCs. In a long-term upside scenario, insiders and equity would fare much better than third-party unsecured claims. The Debtor also felt that this eventuality was squarely supported and provided for by Sub V. The Debtor proposed to pay all calculated disposable income to Class 3 over the three-year plan period. Unsurprisingly, Hologenix chose three years as opposed to four or five, equating to $300,000 (nothing in year one, $50,000 in year two, and $250,000 in year three). Please see the “Disposable Income Shenanigans section” that follows for more detail. Note this section can also be skipped with no loss of continuity.

As an added twist, the Debtor gave themselves the option to pay the present value of these cash flows within 90 days of confirmation at a 35% discount rate, equating to $121,000, or 2.5% of the face value of GUCs. As if that weren’t flexible enough, the Debtor offered a death trap of sorts by making available 25% of the interest that would have been paid to insiders if Class 3 voted in favor of the plan, which would add $135k to their recovery over the life of the plan.

Needless to say, MET was not pleased with these developments. They had been days away from receiving a $1.4 million down payment on a $2.4 million award, and now their recovery was pennies on the dollar. Judge Russell would sympathize with MET during the October 2020 confirmation hearing [Docket 236 p. 70]:

“But I really do understand. If I were in your position, I would be upset, too. You have this multimillion-dollar — you think you’re going to get it and you don’t.”

As would be expected, MET filed motions to dismiss the case for bad faith and later objected to all reorganization plans. They alleged that Hologenix knew it was going to file and was preparing for such an eventuality well in advance, including granting senior liens to insiders in February 2020.

Readers who don’t have an interest in the disposable income topic as it relates to Sub V plans, may skip the next section.

Disposable Income Shenanigans

While traditional Chapter 11 plans might call for a debtor to pay some percentage of excess cash flow to creditors in the future, which will vary based on financial performance, the methodology in Sub V is quite different. It calls for the application of ‘all’ disposable income as projected to be generated in the future for up to five years.

‘All’ is qualified here because the debtor is allowed to keep a certain amount of working capital on its balance sheet so as not to imperil the business.  Importantly, the quantum of cash flow is determined at the plan stage. Furthermore, the debtor gets to choose whether to contribute three, four, or five years of cash flow, depending on how much it needs in order to satisfy Bankruptcy Code § 1129(a)(7).

Calculation of disposable income necessarily requires formulation of projections.  Predicting the future is notoriously difficult. Each profit and loss (P&L) line item is also subject to the debtor’s wide latitude in judgment. Any number of decisions can lower projected disposable income and, by extension, the recovery to general unsecured creditors. Examples include:

• Choosing to invest more via capital expenditures or research and development (R&D)
• Paying higher salaries
• Lower sales
• Higher cost of goods sold

Post-confirmation, creditors do not benefit in the event the projections were conservative. They can only be negatively affected if the projections fall short. However, Congress did build in recourse for this eventuality. As the bankruptcy (BK) court noted:

“The Court finds and concludes that the Plan satisfies § 1191(c)(3)(B) because the Plan provides appropriate remedies to protect holders of claims or interests in the event that the payments are not made based on the evidence presented. The Plan provision “IV.D” is appropriate and satisfies § 1191(c)(3)(B), as [sic] standard provision in reorganization plans in the Central District of California.” [Docket 762, page 83]

The plan provision IV.D describes that if Debtor defaults on the plan, a creditor or other party in interest may bring a motion to convert or dismiss the case; Judge Russell also noted that the plan could be extended [Docket 236 p. 57]. Gregory Jones, Sub V Trustee, noted that this is not an ideal outcome for several reasons, including that it shifts costs to creditors who may not have enough at stake to justify the spend and that conversion to Chapter 7 or dismissal would likely eliminate any chance of recovery.

A Sub V Trustee is appointed in every Sub V case under Section 1183, and their role is akin to an impartial mediator whose goal is a consensual plan. Trustee Jones initially thought there was a good chance of a consensual resolution given the amount of the judgment and size of the Debtor. He was later surprised at the amount of vitriol between the parties. At different points, it was hard to tell what each party wanted: was it money or the cessation of the Debtor’s existence?  While economic offers were exchanged, no deal was ever reached.

Taking these powerful Sub V tools into account, the Debtor would go on to file three reorganization plans that proposed to pay MET and other GUCs only 6-12% of their claims, while allowing equity holders to retain their interests, and also preserving the right for millions of dollars of insider unsecured claims to possibly realize a full recovery after the plan term of three years. The BK  court would confirm each of these plans, but the DC would reverse for different reasons.

2020 Plan Confirmation and MET Objections

Judge Barry Russell held a confirmation hearing for the 2020 Plan in October 2020. Sub V Trustee Greg Jones generally supported the plan. He did not view the avoidance actions to be of significant value to non-insider GUCs due to the difficulty prevailing in litigation after administrative fees. He did, however, raise the conflict of interest issue, namely that Hologenix CEO Casden would be unlikely to initiate an avoidance action against himself or related parties and that derivative standing may be warranted. MET had lodged objections under a number of different theories, but Judge Russell overruled them all.

Notably, the PI had crystallized MET’s debt as a $2.4 million unsecured claim. If the PI had not been invoked at the time of the bankruptcy, it could have been seen as an executory contract. This could have potentially opened the door for MET to argue for a cure, or estimation of damages. However, the BK court would state that under the ‘Countryman Test,’ the settlement was not an executory contract because there was nothing left for MET to do other than receive money. [Docket 236 p. 38].

MET’s main arguments to reject the June 2020 plan were as follows:

Does Not Satisfy Best Interest of Creditors Under 1129(a)(7)

According to 11 USC 1129(a)(7) the ‘best interests of creditors’ test requires that non-consenting creditors “will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date.”

Debtors typically show that their plan satisfies this section by preparing a Chapter 7 liquidation analysis. Readers will generally see a table showing something like ‘Chapter 11 recovery: 10%, Chapter 7 recovery: 0%’ to prove that the plan satisfies 1129(a)(7); as a creditor, you’d prefer the plan to liquidation. Similar to projecting disposable income, a liquidation analysis contains multiple assumptions.

MET focused mainly on the concept of the Debtor’s secured debt. MET believed the senior liens could be avoided under Section 547 because (1) the debt was owed to insiders, (2) certain of the liens were only filed within 365 or 90 days of the bankruptcy, and (3) the debtor was insolvent when the liens were filed. In the 90 days leading up to the petition, there is a presumption of insolvency under Section 547(f). If this action were successful, MET pointed out that all $2.1 million would be available to GUCs (less certain fees) as opposed to $300,000-$435,000 under the 2020 Plan.

Is Not Fair and Equitable Under 1191(c) (Sub V Concept)

Under Sub V, the phrase ‘fair and equitable’ does not bear its plain meaning but rather refers to the requirement that the debtor contribute three to five years of disposable income to plan payments and demonstrate a reasonable likelihood that it will be capable of doing so. See 11 U.S.C. § 1191(c). [Docket 219 p. 4].

This is where MET shined a light on what they believed to be disposable income shenanigans. They noted that the executive salaries and bonuses were excessive and R&D was too high. They highlighted that while three years was the minimum, five years would be ideal.

They also discussed the effect of the PI.  In August 2020, the DC found Hologenix to be in violation of the PI. The Debtor had taken the position that statements pre-dating April 24, 2020 did not violate the PI, but the DC disagreed, noting that “Under this logic” the Debtor “would be able to completely circumvent the PI by posting statements that predate the PI.” [Docket 219 p. 2] Because the Debtor would be required to scrub its website and marketing materials for comments implying FDA approval, MET argued their projections would need to be adjusted downward and, therefore, they couldn’t comply with the plan.

Was Not filed in Good Faith Under 1129(a)(3)

MET pointed out that the 2020 Plan preserved the newly filed secured claims of Casden and other insiders, including his family members.  They noted that the Debtor agreed to a settlement with substantial benefits and escaped payment with a suspiciously-timed petition.

BK Court Reasoning

During the confirmation hearing in October 2020, both sides presented oral arguments. Judge Russell ruled from the bench. The table below summarizes the Judge’s comments with respect to the issues raised either in the hearing or the order [Docket 236 and Docket 247]:

Issue	Court Response
Fair And Equitable — found that only three years is required by statute.	“But that’s the way it is under the bankruptcy laws, and such as that you only have to do for three years. Sure, it would be nice, more. But that’s not required by the statute. And that’s just the way it is. We’re all bound by it. It would be — it might have been nice to have that in there, but it’s not. And I don’t intend to intentionally get reversed by doing something that I don’t have the power to do.” [Docket 236 p. 70] “The Plan’s treatment of the creditors in Class 3 is fair and equitable because as of the Effective Date, the Plan provides that all of the Debtor’s projected disposable income to be received in the three-year period…” [Docket 247 p. 10] “The Plan’s Net Present Value Discount of 35% is appropriate for the payment and treatment of Class 3…”[Docket 247 p. 10]
Fair And Equitable — projections complied with Debtor’s business judgment	“…all the various issues of the compensation, of the reserve, and all that. I think, given the circumstances, I’m satisfied that that was a reasonable business judgment of the Debtor.” And later: “So I understand that’s all to some — to a certain degree, any projection is speculative, but you have to do it” [Docket 236 p. 71]
Good Faith	“In determining that the Plan has been proposed in good faith, the Court has examined the totality of the circumstances surrounding the formulation of the Plan. Here, the Debtor filed the Plan in good faith and discussed its provisions at length with and to the satisfaction of the Subchapter V Trustee.” [Docket 247 p. 9]
Best Interest of Creditors	“Considering the uncertainty, risk, and expense of litigating the possible avoidance of liens and/or subordination of claims held by creditors in Class 1 and Class 2, and accounting for an appropriate discount in the success of any such speculative and uncertain litigation, the Plan satisfies Section 1129(a)(7) of the Bankruptcy Code.”[Docket 247 p. 10]
As it relates to Sub V	“So I think it’s a fabulous statute.” [Docket 236 p. 74]

MET properly appealed to the DC. In the 9th Circuit, appellants have a choice between the Bankruptcy Appellate Panel (BAP) or the DC. Both parties have to agree if BAP is chosen. There is some debate as to which is strategically better.  The prevailing wisdom is that if you win in BK court, you prefer a DC appeal. This is because DC are less familiar with bankruptcy matters and are more likely to defer to the BK court. On the other hand, the BAP, with BK court bankruptcy judges who evaluate complicated code questions every month, is more likely to have an opinion on the BK court’s findings.  Approximately one year later, in September 2021, the DC ruled in MET’s favor without oral argument.

DC Rejects 2020 Confirmed Plan

Obama appointee DC Judge Fernando Olguin heard the appeal. Judge Olguin was recently in the news for granting a motion to dismiss in favor of rock band Nirvana when they used an image of the plaintiff as a baby swimming naked in a pool. The table below summarizes Judge Olguin’s opinion [All page numbers refer to Docket 420]:

Issue	Court Response
Best Interest of Creditors	“Solvency was the cornerstone of Hologenix’s claim that hypothetical preference actions against Class 1 and Class 2 claims were unlikely to succeed…” [p. 9] “However, Hologenix’s claim of prepetition solvency is not supported by competent evidence.” [p. 9] “The Casden Reply Declaration contains no evidentiary facts to permit the fact finder to reach such a conclusion with respect to Hologenix’s solvency between October 2019 and February 2020.” [p. 9] “…the solvency and valuation analyses in Exhibits 1 and 2 have no evidentiary value because they calculate ‘enterprise value’ (based on Hologenix’s EBITDA) rather than liquidation value (based on the difference between its fairly valued assets and outstanding debts) as required by Title 11.” [p. 10]
Good Faith	“The Findings Order…contains no findings of fact on the issue of Hologenix’s good faith…” [p. 11] “the absence of affirmative findings of fact on the issue of good faith is fatal to the confirmation of the Plan.” [p. 14]

The DC also discussed the BK court’s suppression of one of MET’s declarations in support. Judge Olguin stated, “the record does not reflect that the Bankruptcy Court engaged in Rule 403’s requisite balancing inquiry before excluding” [Docket 420 p. 16] the offending declaration. Because MET was handicapped in its evidentiary support for its bad faith allegations, the DC felt it also weighed in favor of vacate and remand.

In short, the DC took issue with the underpinnings of the BK court’s orders relating to evidence and findings of fact. The DC was also obviously troubled by Casden’s status as a manager, fiduciary, secured creditor, unsecured creditor, and equity holder. The events leading up to the petition, such as the granting of liens within 90 days, weighed against the Debtor.

Back to the Drawing Board With the 2022 Plan

No doubt disheartened by the reaction of the DC, the Debtor went back to the drawing board to reformulate the plan. They filed two additional plans, first in January and then in June 2022. For brevity, this article will focus on the June 2022 Plan summarized below:

The Debtor made a concerted effort to narrow the potential issues, most importantly by waiving any liens and payments to insider claims. Class 2A and 4 (now the insider classes) would not receive any payments during the three-year term, but would retain their claims and could potentially realize a full recovery afterward, depending on financial performance. The distributable cash from operations went up significantly, from $300,000 to $500,000, as did the net present value (NPV) discount rate to 40%. Recovery to creditors like MET went up from 9% gross and 4% present value in 2020 to 12.5% gross and 6% present value.  Equity retained its interests as before.

Greg Jones, Sub V Trustee, did not fully support the 2022 Plan: “The Debtor, through counsel, continuously sought the Subchapter V Trustee’s input to address all of the Subchapter V Trustee’s concerns and make adjustments to its reorganization plan justifiable under the facts, law, and notions of good faith and equity but decided not to make changes to the Plan sufficient to obtain the Subchapter V Trustee’s support for the Plan.” [Docket 762 p. 24].  Mr. Jones’ main issue was the disparate treatment of Class 3. During the confirmation hearing, he said:

“This is a novel situation where you have one class getting all of the disposable income, but you have two other classes that, you know, in theory, aren’t getting anything. But post plan when it’s over, they could have the potential to get all of their claim. Now, I can see it’s a long way off. What’s the value of getting repayment of something in 2027? Is it worth — are they — is that better than what is being given to the class three creditors? I don’t know…” [Docket 735 p. 103]

During the confirmation hearing, Judge Russell would remark on the importance of dealing with the liens:

“I remember after I got the district court’s opinion…I pointed out, that you’re going to have to do something about these liens. I think that is a problem that was pointed — I pointed it out. Clearly, counsel was listening.” [Docket 735 p. 108]

He also expected to be appealed: “because I have no doubt either way, whatever I did would be appealed.” [Docket 735 p. 113] Notably, he did not fault the DC for reversing him the first time: “[I] believe the district court was quite correct on some of the things that I did and didn’t do and evidentiary rulings and so forth…”. [Docket 735 p. 113]  The Judge noted this case would be appropriate for an article: “as far as attorney-client privilege and — what is — how — what is confidential between the Chapter V Trustee and the Debtor and so forth. That whole concept might be interesting for an article at some time…” [Docket 735 p. 117]

There is a certain amount of deference that BK court judges give to DC judges. In the federal system and as Legislative Article I courts, BK courts are considered ‘special’ in a legal sense relative to Judicial Article III district courts as established by the Constitution. First, BK court judges are appointed by the DC. Second, their scope of judicial review is more limited and BK courts cannot enter final orders in non-core matters. Third, BK court judges are not appointed for life tenure. Finally, the relative status is reflected in BK judge salaries, which are roughly 90% of that of DC judges.

The following charts show the differences in revenue and distributable cash between the 2020 and 2022 Plans. Business had improved even though the Debtor had to comply with the PI, which presumably should have negatively affected revenue. However, the supply chain issues and negative effects of the pandemic had dissipated by 2022, allowing the Debtor’s financial performance to improve:

 

2022 Plan Confirmation and MET Objections

MET lodged objections under a number of different theories but Judge Russell overruled on all.  MET’s main arguments were as follows:

Does Not Satisfy Best Interest of Creditors Under 1129(a)(7)

Whereas in the 2020 Plan, MET had focused mainly on the concept of the Debtor’s secured debt, because the liens were now waived, MET did not attack 547 avoidance. Instead, MET focused on: (i) $250,000 of post-petition transfers that Casden would be required to return, (ii) inflated administration costs, and (iii) liquidation discount rates.

Is Not Fair and Equitable Under 1191(c) (Sub V Concept)

MET reiterated its prior arguments that the disposable income calculation was flawed. They noted that “compared to the [2020] Plan, every single category of operating disbursements has increased, in some instances dramatically…” [Docket 700 p. 15].

Was Not Filed in Good Faith Under 1129(a)(3)

MET focused on the disparate treatment between insider and non-insider claims.  They noted that Class 3 was limited to just three years or a discounted lump sum payment, while all other creditor classes could look to the rest of time for up to 100% payment.

MET’s Other Objections

MET objected on the basis of 1191(b), noting that the 2022 Plan “discriminates unfairly by separately segregating general unsecured creditors into three separate classes for no other purpose than to favor insiders over non-insiders. Non-insider general unsecured creditors in Class 3 will receive just 5.99% – 12.5%, while insider general unsecured creditors in Classes 2A and 4 will retain the right to be paid in full, possibly as soon as Hologenix pays a paltry $239,133.00 to Class 3 non-insiders…the so-called ‘subordination’ of the Class 4 claims is a farce.” [Docket 700 p. 13]

MET also lodged objections on the following grounds: (i) inappropriate NPV discount rate, (ii) excessive executive compensation, (iii) does not satisfy Section 1129(a)(1) feasibility because of balloon payments to Class 2, and (iv) does not satisfy section 1129(a)(2) or1129(a)(5).  In all, MET objected along seven main lines of reasoning.

BK Court Reasoning

During the confirmation hearing in August 2022, both sides presented oral arguments. The BK court again approved the plan over MET’s objections. The table below summarizes the court’s reasoning [All page numbers refer to Docket 762]:

Issue	Court Response
Good Faith 1129(a)(3)	“A plan not proposed in bad faith simply because the debtor does what the Bankruptcy Code permits it to do. In re Sisk, 962 F.3d 1133, 1150 (9th Cir. 2020).” [p. 42] “Almost all creditors will be frustrated by breathing space afforded a debtor by the filing of bankruptcy, but this rises to bad faith only when the Debtor has no prospect for reorganization.” [p. 44] “Delay to a creditor cannot itself be the indication of a bad faith filing, for ‘all debtors file for bankruptcy in order to delay creditor action.’ ” [p. 44]
Best Interest of Creditors	“The Court overrules MET’s objection because MET misapplies the requirements of 11 U.S.C. § 1125 to this subchapter V case where no such application has been required.” [p. 53] “MET’s Opposition and Mr. Pastore’s [MET expert] declaration in objecting to the best interest of creditors test is an unsatisfactory criticism of the Plan because MET and Mr. Pastore did not provide convincing evidence.” [p. 55] “Mr. Pastore testified that he was not hired to do anything of actual use in determining the hypothetical liquidation.” [p. 55] “Considering all of the foregoing, at best, the adjusted hypothetical chapter 7 liquidation analysis would still show only a 10.4% recovery for Class 3 creditors…” [p. 59]
	“Court finds and concludes that separate classification of Classes 3 and 4 such that all Disposable income be provided to non-insider Class 3 is a compromise and settlement integral to the Plan which is appropriate and proper pursuant to § 1123(b)(3).” [p. 28]
Burden of Proof	“MET treated its Opposition as if it were a complaint pleaded under Rule 8 of the Federal Rules of Civil Procedure, where all allegations would be taken as true to survive a challenge under Rule 12(b)(6) of the Federal Rules of Civil Procedure. But the Opposition is not a complaint, and MET’s allegations are not accepted as true.” [p. 29] “Mr. Pastore was apparently not hired to form an opinion, but simply to critique the Debtor and Mr. Grobstein. His expert testimony was unhelpful to the Court.” [p. 29]
1129(a)(1)	“The claims and interests placed in each class, where applicable, are substantially similar to other claims and interests in each such class. Valid business, factual, and legal reasons exist for separately classifying the various classes of claims created under the Plan.” [p. 32]
1129(a)(2)	“MET (and its expert) improperly and repeatedly applied disclosure statement requirements of § 1125 to the Debtor’s plan confirmation process in a failed attempt to allege that the Debtor had not carried its burden or otherwise justified various parts of the Plan. The plan need only include projections and a liquidation analysis, and no further explanation, disclosure, adequate information is required.” [p. 38] “MET advocates for an application of § 1129(a)(2), followed by a minority of courts, but otherwise viewed as improperly turning all of title 11 into a ‘minefield’ of plan denial, not supported in the Ninth Circuit.” [p. 39]
1191(b)	“The Court overrules MET’s objection that Class 3 is receiving worse treatment than Classes 2 and 4. ECF 700 (Opp.) at 17. MET (and the Subchapter V Trustee) are incorrect because in the context of SBRA and subchapter V where Congress has limited MET’s recovery to three years (and at most five years) of projected Disposable Income. See, 11 U.S.C. § 1191(c)(2). Against this backdrop, the Court finds and concludes that Class 3 is getting the most that is available under the Bankruptcy Code under §§ 1191(b), (c) and (d). Insider and noninsider claims in the Debtor’s case and Modified Plan are not similarly situated and therefore appropriate for different treatment, which is better – not worse – for Class 3 creditors.” [p. 62] “In this Case, the difference between insider and non-insider claims in the new subchapter V is profound because subchapter V eliminates numerous creditor protections in favor of the debtor: (1) only the Debtor can ever propose a plan; (2) plan confirmation can be achieved without any creditor consent at all; and (3) the absolute priority rule does not exist, and, instead, general unsecured creditors are limited to recovering only the capped Disposable Income.” [p. 62] “The Debtor has availed itself of the numerous advantages of subchapter V…The Debtor’s insiders will realize the ‘lush years’ through their equity and control.” [p. 63] “and show to the Court a fair deal by giving Class 3 all of the Disposable Income.” [p. 65] “With the ‘fair and equitable’ treatment statutorily capped at three-to-five years of Disposable Income, creditors cannot demand anything more.” [p. 68] “Congress has struck the balance in the statute with its plain language, and the courts are not at liberty to deviate and demand more than this specified period.” [p. 68]

MET timely appealed, and in March 2024 the DC ruled in MET’s favor — again without oral argument.

DC Rejects 2022 Confirmed Plan

This time, Judge Olguin’s opinion was most notable for what it didn’t address.  While MET raised seven issues on appeal, the DC did not address any of them.  Instead, the core of the reversal turned on one word: ‘includes.’  Judge Olguin started with the text of the Statute 1191(c), which reads: “(c) Rule of Construction. – For purposes of this section, the condition that a plan be fair and equitable with respect to each class of claims or interests includes the following requirements:”

Judge Olguin reasoned that “the use of the word ‘includes’ indicates that the list is not exhaustive – that is, a plan need not be limited to the provisions of that section.” [Docket 421 p. 4]. He also pointed out that because Classes 2 and 4 were going to receive payments after the five year cap, it means that Sub V plans are not really limited to five years. Furthermore, there is nothing that limits debtors from paying some amount less than all disposable income to creditors after the five-year cap. Finally, even though Sub V has its roots in Chapter 12 and Chapter 13, which envision a fixed timeframe, Chapter 11 does not contain the same five-year temporal limitation.

No doubt the ruling was a shock to everyone, though it was surely welcome to MET. The ruling demonstrates a fair amount of original thought, as it would have been much more typical to simply address each of the appellant’s arguments in turn as opposed to formulating a new theory.  As a consequence, there is no clarity on the seven issues MET raised.

Both parties filed a status report in late April 2024 with different perspectives. The Debtor points out that “much of the predictability of subchapter V with a limit of five years of projected disposable income has been destroyed” [Docket 956 p. 6] and requested mediation, further BK court briefing, or amending the Plan. MET observes that the Debtor had been “hoisted on its own petard” by so aggressively preferring insider creditors over regular GUCs and recommends conversion or dismissal. It is unclear whether conversion or dismissal would yield a better economic result than remaining in a Chapter 11 process.

Since the status report, the case has been appealed to the 9th Circuit.

CEO Suit

MET filed suit against Casden personally in February 2021 for Lantham Act and other violations similar to those in the corporate lawsuit. These were for violations that occurred after the March 2020 PI, as well as for interference with the PI caused by the bankruptcy. After a four-day trial, the jury found in favor of MET but only awarded nominal damages of $1. Unfortunately for Casden, seven months later DC Judge Wright issued a post-trial order reflecting that it considered the jury’s damage determinations as merely advisory and increased the award to $5.4 million. The amount included the PI payment of $2.5 million, plus triple damages for disgorgement of several years of Casden’s salary, totaling $2.9 million.  Needless to say, Casden strongly disagreed with the damages calculation, pointing out that salary is not synonymous with profits, and furthermore he paid taxes on them. [Casden Docket 98] MET also filed for $725,000 in attorney’s fees.

MET quickly moved to enforce which caused Casden to file for personal bankruptcy in October 2023. The personal bankruptcy is ongoing and has been contentious.  Sub V is not available to Casden as an individual, therefore METs claim is pari passu with his other GUCs in the latest plan.

MET was able to sue Casden personally because while Chapter 11 shields the debtor from both future and pending litigation, it does not shield officers. Importantly, the PI contained a release for directors and officers, but the suit was still allowed to proceed. This raises important questions about officer liability when acting for an enterprise and the effectiveness of releases.

Conclusion

After the Lantham Act case, a series of rapid-fire events brought us to where we are today. Were it not for the pandemic, the Company probably would have raised the funds to pay the judgment and soldiered on. But while the pandemic killed their financing, it opened a new door in the form of Sub V. The Debtor saw ​​a large loophole in Sub V.  Luckily, their insider debt was already distinct enough from GUCs to meet key thresholds; otherwise, they would have had to lump everyone into the same class.  But in a stroke of bad luck, MET was big enough, mad enough, and sufficiently funded to fight the plans. The vast majority of creditors, especially the kind you find in a Sub V case, would not have had the time, money, or inclination to fight this battle. And there is no UCC to fight for them.

While the Debtor’s motivations are straightforward, those of MET are more unclear.  On the one hand, MET is a competitor who might benefit from less competition. On the other hand, it won a $2.4 million money judgment that it would like to collect.  Behind the scenes, they have litigation funder Legalist, who presumably has solely financial interests. Millions of dollars have been spent by both sides, which seems disproportionate to the assets at stake. This could lead some to question whether MET’s goal was really to take out a competitor,  but that wouldn’t seem to help Legalist, who just wants a return on its investment.

Though hindsight is 20/20, it seems all parties would have been better served by a creative plan that would have been much more insulated from challenge. This would have saved everyone untold time, aggravation, and hard costs.  One way to do this would be to lump all $7.6 million GUCs into the same class. This would equate to a 6.5% total recovery over three years at $500,000. Casden is almost 90% of Class 2 and the majority of Class 4. Once the plan term was complete, it would clear the way for equity and insiders to realize the ‘lush’ years without it being tied specifically to pre-existing claims. In fact, Judge Russell alluded to this in his order confirming the 2022 Plan [Docket 762 p. 68]:

“The Court also notes as additional support for this result, the very argument that MET advanced in the similar context of executive compensation, where MET advocates: ‘… once the Debtor has completed its plan and creditors have received fair distribution on their claims… the Debtor can then pay Mr. Casden whatever increased salary might then be agreeable.’ ECF 700 (Opp.) at 27. The Court finds and concludes that the same logic applies for the treatment of the insider claims in Classes 2 and 4 as compared against the non-insider claims in Class 3. Congress enacted a structure where creditors like MET and Class 3 are entitled to nothing more than three-to-five years’ of projected Disposable Income. 11 U.S.C. § 1191(c). After that three-to-five-year period, the Debtor and its insiders can pay whatever they find agreeable.”

This certainly would have been confirmed by the BK court and quite likely by the DC because it would remove many of the sticking points that troubled the DC. It would have been a substantially similar economic result, but with much less fanfare. In any event, final resolution of the case will contain important implications for Sub V plans in the future.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Things to Consider Before You File
2. Defending Against Bankruptcy Avoidance Actions
3. Asset Sales in Receivership

This article was originally published on August 19, 2024.]

©2024. DailyDAC^TM, LLC. This article is subject to the disclaimers found here.

[i] Just prior to settlement, the Company improved certain creditors’ positions, including with respect to $2 million in convertible notes it had issued in 2019, of which its CEO, Seth Casden (“Casden”), held approximately 60%. And so, less than a year after issuance and just before settlement, the Company permitted the holders of the notes to file UCC-1’s to secure and place them ahead of any existing or future unsecured claims.  MET observed “Thus, it appears even while negotiating with MET, Hologenix was setting itself up for a bankruptcy filing and attempting to place insiders in an advantageous position in the event of such filing over MET.” [Docket 78 p. 7].

[ii] The cap decreased to $3,024,725 on June 21, 2024. See Lance P. Martin, It Just Got More Difficult to Qualify For Subchapter V Bankruptcy, THE NATIONAL LAW REVIEW, July 2, 2024 (Volume XIV, Number 184).

[iii] Friedland, et al. STRATEGIC ALTERNATIVES FOR AND AGAINST DISTRESSED BUSINESSES PRACTICE MANUAL § 5:13 (West, 2024); Friedland, et al. Subchapter V of Chapter 11: A User’s Guide, at § 9; see also Friedland, Rich Man, Poor Man . . . Hurry Up, Man: Wash Away Personal Guarantees Quickly.