Somewhere in our rough memories of high school science, we should recall the general principle that a gas will always expand to fill a given void.  Although the Bankruptcy Code diverges markedly from scientific principles, newly enacted provisions in Subchapter V of Chapter 11 of the Bankruptcy Code suggest some similarity.  In In re Dani Transport Service, Inc., the United States Bankruptcy Court for the Central District of California found that Sections 1183 and 1185 of the Bankruptcy Code can be read together to remove a Subchapter V debtor’s misbehaving management and expand the Subchapter V trustee’s management duties to fill the void.  Aside from an example of these provisions in action, the case offers insight into the circumstances under which parties and the bankruptcy court may find management substitution preferable to chapter 7.

The Debtor’s Principals Fraudulently Apply for and Mismanage PPP Loan Proceeds

Dani Transport Service, Inc. (the “Debtor”) was a family business owned and operated by Abraham and Daniela Gutierrez that transports cars from manufacturers and delivers them to dealerships throughout California.  The Debtor expanded its services in mid-2019, but soon found that the contracts yielded substantially lower profit that did not offset the company’s costs of expansion.  On February 19, 2020, the Debtor filed a voluntary petition under Subchapter V.

In a sign of the times, two months after the Petition Date, the Debtor submitted a borrower application to the Small Business Administration for a loan (a “PPP Loan”) under the Paycheck Protection Program.  However, the Debtor’s principals did not disclose the bankruptcy case in the PPP Loan application where required, and did not disclose the PPP loan application to the Bankruptcy Court.

On April 30, 2020, the SBA approved the application and authorized the lender to disburse $170,000 to the Debtor.  The Debtor’s principals deposited $169,500 of the proceeds into a prepetition bank account and then transferred the funds to their son’s separate business account.  Ultimately, the Debtor’s principals used $100,000 of the funds to repay personal expenses and could not account for the remaining $70,000.

The Bankruptcy Court Removes Management and Expands the Subchapter V Trustee’s Duties

The scheme unraveled in February 2021, when the United States Trustee, Subchapter V trustee, and Debtor’s counsel learned of the PPP Loan from a filing in the bankruptcy case.  Although the Debtor’s principals agreed to repay the PPP Loan proceeds, the United States Trustee filed a motion to remove the principals from management of the Debtor and expand the responsibilities of the Subchapter V Trustee to fill management.

The United States Trustee’s motion relied on two sections of the newly enacted Subchapter V—11 U.S.C. §§ 1183 and 1185.  Section 1185(a) provides:

On request of a party in interest, and after notice and a hearing, the court shall order that the debtor shall not be a debtor in possession for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor, either before or after the date of commencement of the case, or for failure to perform the obligations of the debtor under a plan confirmed under this subchapter.

Section 1183(b)(1) sets forth the initial duties of a Subchapter V Trustee.  However, following the request of a party in interest, the court can expand of those duties “for cause,” under § 1183(b)(2).  The Bankruptcy Code specifically provides that, if the debtor ceases to be a debtor in possession, the Bankruptcy Court can order that a Subchapter V Trustee

perform the duties specified in section 704(a)(8) and paragraphs (1), (2), and (6) of section 1106(a) of this title, including operating the business of the debtor[.]

11 U.S.C. § 1183(b)(5).  The United States Trustee argued that the principals’ dishonesty and misconduct—fraudulently applying for the PPP Loan, diverting the PPP Loan proceeds, and failing to disclose the PPP Loan to the Bankruptcy Court by motion or in monthly operating reports—demonstrated sufficient cause to remove the principals from management and expand the scope of the Subchapter V trustee’s duties under these provisions.

For its part, the Debtor joined in the United States Trustee’s motion and offered insight into the rationale against conversion to chapter 7.  The Debtor had filed a disclosure statement and reorganization plan in December 2020.  The Debtor contended that plan confirmation would provide a 27% return to holders of allowed unsecured claims, which could not be achieved in a chapter 7 case.

On February 23, 2021, the Bankruptcy Court granted the motion, removed the principals from management of the Debtor, and expanded the Subchapter V trustee’s duties to include management under Section 1183(b)(2) of the Bankruptcy Code.  The Bankruptcy Court separately continued upcoming hearings on approval of the disclosure statement and related matters “to give the trustee additional time to evaluate the case.”

The Upshot

Subchapter V cases contemplate a unique and balanced relationship—similar to chapter 12 cases—between the Subchapter V trustee and the debtor in possession.  Section 1112, governing conversion or dismissal, still applies in Subchapter V cases, but Sections 1183 and 1185 offer parties in interest a more nuanced approach to misbehaving management by simply expanding the Subchapter V Trustee’s role.  Dani Transport sheds some light on at least one circumstance, a pending plan with purported benefit to unsecured creditors, in which the United States Trustee and Bankruptcy Court may prefer application of Sections 1183 and 1185 to maintain the debtor’s operations.