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Subchapter V and the Condominium

On Behalf of | Apr 25, 2023 | Firm News |

Association – A Not So Perfect Fit

Richard R. Thames
Thames | Markey
Jacksonville, Florida

April 24, 2023

The Small Business Reorganization Act of 2019 (the “SBRA”), codified at 11 U.S.C. § 1181-1195, created a new subchapter of reorganizations, known as “subchapter V,” to streamline the bankruptcy process by which small business debtors reorganize and rehabilitate their financial affairs. 1 Among the many advantages of subchapter V is the ability to confirm a plan of reorganization without an accepting class or application of the absolute priority rule. It also permits a debtor to of creditors devote projected disposable income towards funding a plan of reorganization over a three or five year period. 2 One might be tempted therefore to believe that subchapter V is the perfect solution for dealing with large judgments or liability claims against condominium associations. As the noted sportscaster Lee Corso would say, however: “Not so fast, my friend.”

A typical condominium association is usually set up as a non-profit corporation responsible for maintaining the common areas of the condominium property. Those common areas are either owned by the association itself, or as is required by statute in Florida, by the individual unit owners as tenants in common. Management is vested in a board of directors whose duties are derived from Declarations of Condominium (“Declarations”) running with the land. Expenses are paid through assessments against individual unit owners. Budgets are usually set on an annual basis, with directors maintaining the right to make special assessments for extraordinary expenses with the consent of a designated percentage of the individual unit owners.

For the most part, condominium associations pay their bills in a timely fashion and, as a consequence, will usually not have debts beyond those necessary to fund capital improvements. On occasion, however, the condominium association may face exposure for personal injury claims, unexpected repair bills, or attorney fees for various forms of litigation.

With the relaxed confirmation standards of subchapter V, one might be tempted to think subchapter V is the perfect solution for dealing with such issues, particularly the ability to confirm a plan over the objection of a judgment creditor. Unfortunately, the path is not that easy.

1 H.R. Rep. No. 116-71, at 1.

2 11 U.S.C. § 1191(c)(2).

a. The issue of retained collection rights.

The most difficult hurdle for a condominium association debtor to overcome may be the best interest of creditor test embodied in 11 U.S.C. § 1129(a)(7), made applicable to subchapter V cases by virtue of § 1191(a). It reads as follows:

(7) With respect to each impaired class of claims or interests—

(A) each holder of a claim or interest of such class—

(i) has accepted the plan; or

(ii) 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; or . . .

11 U.S.C. § 1129(a)(7) (emphasis added).

In the typical reorganization case, the best interest test is met by simply establishing the value of the debtor’s assets, then deducting administrative expenses, secured claims and the costs of liquidation to derive the potential amount distributable to creditors.

A condominium association is a different animal, however, established by Declarations running with the land that will continue to exist until terminated in accordance with state law. Because there is no discharge available to a corporate debtor, the question arises as to whether a creditor’s retained post-chapter 7 collection rights must be included in the best interest of creditors analysis.

A strong argument can be made that they must. The analysis begins with a comparison of § 1129(a)(7) to the best interest tests found in §§ 1325, 1225 and 1173. Under § 1325(a)(4), the chapter 13 best interest test limits the court’s analysis to the value to be distributed from a liquidation of “the estate of the debtor.” Section 1225(a)(4) employs the same terminology. Subchapter IV, Railroad Reorganizations, also contain a best interest of creditors test which, like the chapter 12 and 13 tests, focuses on the value to be received following a liquidation of the railroad lines and “the other property of the estate.” 11 U.S.C. § 1173(a)(2). Because Congress chose not to reference “property of the estate” in § 1129(a)(7) when it expressly did so in §§ 1325(a)(4), 1225(a)(4) and 1173(a)(2), it is presumed that the omission was intentional:

[W]hen Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.

Barnhart v. Sigmon Coal Co., Inc. 534 U.S. 438, 452, 122 S.Ct. 941, 951 (2002) (internal quotations omitted).

The courts must also interpret statutes in a manner which gives meaning to every term contained within the statute. Arguably, any interpretation of § 1129(a)(7) which fails to account for the value of the creditor’s retained rights would render the retention language contained within the statute superfluous.

Surprisingly, few courts have tackled this issue in the context of a condominium association. In re Oak Park Calabasas Condo. Association, 302 B.R. 665 (Bankr. C.D. Cal. 2003), appears, however, to be directly on point. There, the creditor objected to a plan of reorganization which did not provide for full payment of its claims, arguing that since the association would continue to exist following a chapter 7 proceeding, the claim would eventually be paid in full from future assessments. The court agreed:

In general, chapter 7 results in the liquidation of non-individual debtors since there are no exemptions to allow them to maintain assets or other property. In most cases this means that no debtor entity would remain from which ECC could collect. But a homeowner association is unique, since California law requires that it continue to exist and collect monies from the homeowners and that only a portion of those amounts are exempt from execution. Therefore a homeowner association would survive chapter 7 and so would its liabilities . . .

[fn 35] Since the HOA cannot be liquidated and it or its alter ego must continue to operate, there will be a source of repayment for creditors even after the trustee administers and distributes all assets of the estate.

Id., 302 B.R. at 673.

In analyzing § 1129(a)(7)(A)(2), the Calabasas court held that the “retained” right of the judgment creditor to levy on future assessments be included in the analysis:

Section 1129(a)(7)(A) requires that a holder of a claim who has not accepted the plan must (1) receive or retain property under the plan, which has a value on the effective date (2) which is at least as much as the holder would receive or retain if the debtor were liquidated under chapter 7 on the plan’s effective date . . . [B]ecause 11 U.S.C. § 102(5) states that ‘or’ is not exclusive, I need to determine not only the amount that ECC would receive through the Plan or from a chapter 7 trustee, but the present value as of the effective date of any remaining right to execute on its judgment.

Id., 302 B.R. at 667 (emphasis added).

Calabasas is consistent with other decisions focusing on the retention language of § 1129(a)(7), including In re Quigley Company, Inc., 437 B.R. 102 (Bankr. S.D. N.Y. 2010)(rights of non-settling defendants to pursue derivative claims against third parties must be considered under the best interest test); and In re Ditech Holding Corp., 606 B.R. 544 (S.D. N.Y. 2019)(the valuation of creditors’ successor liability claims against third parties was a necessary component of the best interest test).

Section 1129(a)(7) may therefore prove to be an insurmountable hurdle for achieving plan confirmation for a condominium association absent payment of creditor claims in full.

b. The issue of a chapter 7 trustee’s assessment rights.

An entirely different result may arise however in a jurisdiction which does not include “retained” post-chapter 7 collection rights in the best interest analysis. A creditor might be tempted to argue that the chapter 7 trustee can step into the shoes of the directors to assess the unit owners directly to satisfy claims against the estate. That is not necessarily the case.

A chapter 7 trustee derives his authority from § 704 of the Bankruptcy Code, which requires the trustee to, among other things, “collect and reduce to money the property of the estate which such trustee serves . . .” While property of the estate is generally construed broadly, in the condominium association context, property of the estate includes only those receivables and assessments owed as of the petition date, or in the hypothetical liquidation scenario, on the conversion date. Future assessments are not property of the estate and the trustee has no right to assess or collect same.

A case on point is In re Westwood Community Two Association, Inc., 266 B.R. 223 (Bankr. S.D. Fla. 2001). There, the chapter 7 trustee assessed the members for the amounts needed to satisfy the claims against the estate. A committee of condominium owners objected, arguing that the trustee did not have the authority to make the assessment. The bankruptcy court disagreed, finding further that the committee members did not have standing to challenge the assessment.

On appeal, the Eleventh Circuit found that, as aggrieved persons, the committee of owners did in fact have standing to challenge the assessment. In re Westwood Community Two Association, Inc., 293 F.3d 1332 (11th Cir. 2002). The bankruptcy court’s decision was thus reversed and remanded back for further proceedings. Id. at 1338. At that point, the bankruptcy court reversed itself and found that the trustee had no authority to make the assessment. The committee of unit owners then filed an action against the chapter 7 Trustee and his professionals to require disgorgement of the funds collected under the illegal assessment. The bankruptcy court sided with the committee and required disgorgement. On subsequent appeal, the Eleventh Circuit determined that the disgorgement was proper because the unit owner’s funds were not property of the estate and could not therefore be administered by the chapter 7 trustee:

. . . The question we must consider is whether the district court correctly affirmed the bankruptcy court’s denial of fees sought and disgorgement of interim fees paid to Dzikowski & Walsh, P.A. (“DZ Firm”). The district court’s order affirming the bankruptcy court’s ruling was based on a finding that the Trustee did not have the power to levy a special assessment against the property of non-debtor third-party homeowners to satisfy general unsecured claims against Westwood Community Two Association, Inc. (“Debtor”). The DZ Firm was paid with funds derived from the special assessment that were neither property of the Debtor’s estate nor the proceeds thereof and, therefore, as a professional retained by the Debtor, the district court held that the DZ Firm had no right to be paid from such fund.

* * *

. . . [W]e affirm the district court’s order affirming the bankruptcy court’s disgorgement of fees because the DZ Firm had no right to keep the interim fees it received which it derived from funds that were not property of the estate, but instead were the proceeds of an improper assessment against non-debtor property. . . .

In re Westwood Community Two Association, Inc., 2006 WL 940647, at *1 (11th Cir. 2006)(emphasis added).

Note, however, that same rule does not apply to state court receivership proceedings. A creditor has a right to pursue the appointment of a receiver to collect a judgment against a condominium association by means of assessment, as state court receivers are not bound by the “property of the estate” limitation of § 704. The inclusion or exclusion of a creditor’s retained collection rights in the § 1129(a)(7) best interest analysis will thus have a huge impact on the creditor’s treatment under a subchapter V plan.

c. The duty of assessment.

Another issue yet to be addressed in the subchapter V context is whether a condominium association debtor can meet the “good faith” requirements of § 1129(a)(3) without assessing its members to pay creditor claims in full, as the directors are still charged as fiduciaries with maximizing the value of the bankruptcy estate:

In a bankruptcy case, it is “Bankruptcy 101” that a debtor and its board of directors owe fiduciary duties to the debtor’s creditors to maximize the value of the estate . . .

In re Innkeepers USA Trust, 442 B.R. 227, 235 (Bankr. S.D. N.Y. 2010).

This duty was not eliminated upon enactment of subchapter V. See e.g., In re SRAK Corp., Case No. 22-40931, 2023 WL 2589252, *3 (Bankr. N.D. Tex. March 21, 2023) (A subchapter V plan should be “proposed with the legitimate and honest purpose of effectively reorganizing the Debtor and maximizing the recovery to creditors in accordance with the priorities set forth in the Bankruptcy Code”).

At least one court has held, pre-SBRA, that directors of a condominium association cannot simply avoid their statutory, common law and contractual duties to assess the unit owners to pay the association’s bills because of any perceived hardship on the owners:

Without support in law or logic, the bankruptcy court imports and applies “the business judgment rule” to free the Association from the fundamental obligations required by statute and memorialized in the Declaration. But the business judgment rule is no license for a condominium association to break with impunity from an obligation that in the moment displeases the association. If the Association can exploit the business judgment rule to escape paying for repair of the common elements, the Association may use the business judgment rule to escape honoring any purportedly binding document or contract, and each agreement the Association enters is entirely illusory because only in effect so long as the Association benefits. This reasoning, like the conclusion that the unit owners may vote to rescind a binding obligation, is untenable.

In re Colony Beach & Tennis Club Association, Inc., 456 B.R. 545, 558-59 (M.D. Fla. 2011).

There is no reason to believe that this principle has changed in the subchapter V context.

d. Conclusion.

Though subchapter V is a game changer for many small businesses, it is in fact no sure path for eliminating large judgments or claims against a condominium association. Practitioners must therefore be leery of promising elimination of extraordinary debts through the subchapter V process. Still, the prospects of paying problematic claims over a three to five year period may justify subchapter V relief even if the desired “haircut” is unavailable.

Richard R. Thames
Thames | Markey
Jacksonville, Florida