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the code states

(2)A discharge under this chapter does not discharge a debtor who is an individual from any debt excepted from discharge under section 523 of this title. (3)The confirmation of a plan does not discharge a debtor if— (A)the plan provides for the liquidation of all or substantially all of the property of the estate; (B)the debtor does not engage in business after consummation of the plan; and (C)the debtor would be denied a discharge under section 727(a) of this title if the case were a case under chapter 7 of this title.

My question is: Say a debtor's plan provides for liquidation of all or substantially all of the property of the estate BUT they also engage in business after consummation of the plan. Since they are engaging in business but the plan provides for liquidation of all or substantially all of the property of the estate, would the confirmation of the plan discharge a debtor since they are engaging in business?

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Executive Summary

This is allowed because it allows an exception to a bankruptcy rule, that is designed to prevent trafficking in the tax losses of shell companies with no active businesses, in cases where an active business of a debtor continues to operate.

The way it gets there, however, is rather convoluted.

Background regarding discharging debts in Chapter 7

There are two ways that a debtor who files for bankruptcy under Chapter 7 can be prevented from discharging their debts.

One is a determination on 11 U.S.C. § 523 that a particular debt is not discharged.

The other is a determination that none of the debts of the debtor may be discharged under 11 U.S.C. § 727(a) for one of several reasons:

Section 727(a)(1) provides that entities can't have their debts discharged in a Chapter 7 bankruptcy. This prohibition exists mostly to prevent a market in shell entities with tax losses that have been liquidated and ceased to be going concern from being sold to people with unrelated viable businesses as a tax loophole.

Section 727(a)(2)-(7) and (11)-(12) prevent people who file for bankruptcy under Chapter 7 from having their debts discharged if they engage in serious misconduct in the bankruptcy court process.

Section 727(a)(8)-(9) prevent people who file repeated bankruptcies close in time to each other from having their debts discharged.

Section 727(a)(10) prevents people from having their debts discharged when a court approves a written waiver of that benefit of the bankruptcy process by the debtor. This provision basically allows a debtor who is accused of misconduct to settle a case where misconduct in the bankruptcy process is alleged by giving up the fight in the equivalent of a "no contest" plea, rather than having to go through the process of admitting wrongdoing or having hearings in which a court finds on the merits that the debtor engaged in misconduct.

Section 1141

11 U.S.C. § 1141(d)(2) and (d)(3) quoted above are designed to prevent someone who would be prevented from discharging a debt in a Chapter 7 bankruptcy from filing for bankruptcy under Chapter 11 and adopting a plan that is effectively indistinguishable from a Chapter 7 bankruptcy as a loophole that evades the limitations that apply to Chapter 7 bankruptcies.

The conditions of 11 U.S.C. § 1141(d)(3)(A)-(B) attempt to distinguish plans that are Chapter 7 liquidation bankruptcies in all but name from plans that are genuinely Chapter 11 reorganizations.

My question is: Say a debtors plan provides for a liquidation for all or substantially all of the property of the estate BUT they also engage in business after consummation of the plan. Since they are engaging in business but the plan provides for liquidation of all or substantially all of the property of the estate, would the confirmation of the plan discharge a debtor since they are engaging in business?

The short answer is yes.

The fact pattern in which 11 U.S.C. § 1141(d)(3)(A)-(B) seeks to continue to allow a discharge of debts is predominantly one in which the debtor has a business that is not asset intense, but has business debts, and wants to continue to be able to do business by discharging those debts.

An example:

Suppose that ohwilleke, PC is a law firm, which has few assets other than $1,000 of office equipment and supplies and $50 in a bank account, but is an entity that has been approved by the bar association for the conduct of law and has malpractice insurance as required by law, but incurred a $100,000 debt under the penalty clause of a lease when it failed to pay rent (because it lost a contingency case it was sure it would win and thus didn't have the money it planned to use to pay the rent) and was evicted. This is the firm's only debt.

The bankruptcy code allows ohwilleke, PC to continue to operate a law firm by reorganizing under Chapter 11 in bankruptcy, by discharging this $100,000 debt in a plan in which the owner of ohwilleke, PC personally pays $1,050 to the sole creditor of the firm and the rest of the debt to the landlord is discharged. This leaves the creditor in the same position it would be in if ohwilleke, PC had filed a Chapter 7 bankruptcy and ceased to do business.

The law firm does this, rather than simply liquidating the firm and starting over, however, because ohwilleke, PC has lots of net operating losses from losing a contingency fee case that it would like to apply to offset future income from the firm.

This would not be allowed in a Chapter 7 liquidation bankruptcy because ohwilleke, PC is an entity.

But because the Chapter 11 bankruptcy plan in the ohwilleke, PC bankruptcy continues the existing law firm business of ohwilleke, PC, discharging its debts does not offend the goal of preventing trafficking in tax losses to unrelated businesses.

What prevents evasion of the ban on discharge for misconduct?

Superficially, this would seem to allow debtors who engage in misconduct in the bankruptcy process to get their debts discharged anyway in Chapter 11 by continuing to operate a low or no asset business. But, this apparent problem is solved by another part of the bankruptcy code which allows the bankruptcy court to convert a Chapter 11 bankruptcy to a Chapter 7 bankruptcy when a debtor engaged in serious misconduct in the bankruptcy process.

Another reason to allow this in cases of debtor misconduct is to allow a reorganizations when the main point of the Chapter 11 reorganization is to reorganize a basically sound and honest business that is run by a corrupt and fraudulent management team that the plan replaces with a new management team that is not corrupt and fraudulent, so that the underlying business venture can survive.

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  • does this also apply to chapter 11 liquidation that calls for liquidation of substantially all of the property of the estate?
    – YXDV
    Commented Jan 27, 2023 at 15:00
  • The 11 U.S.C. § 1141(d)(3) prohibition on discharge only applies when the Chapter 11 plan calls for liquidation of substantially all of the property of the estate and for the business to cease operating as a going concern.
    – ohwilleke
    Commented Jan 27, 2023 at 15:27

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