By: Donald L Swanson
A recent Bankruptcy Court opinion grants an involuntary Debtor’s motion to convert its Chapter 7 case to Subchapter V—relying on a U.S. Supreme Court opinion.
This Bankruptcy Court opinion provides a path for others to follow. The opinion is In re Zarifian Enterprises LLC, Case No. 24 B 06598, Northern Illinois Bankruptcy Court (decided December 17, 2024, Doc. 46).
What follows is a summary of that opinion.
Procedural History
On May 2, 2024, four petitioning creditors file an involuntary petition in bankruptcy against Debtor.
On June 5, 2024, the Bankruptcy Court enters an Order for Relief under Chapter 7 against Debtor, and a Chapter 7 Trustee is appointed.
On July 10, 2024, Debtor files:
- its bankruptcy schedules and statement of financial affairs; and
- its Motion to convert the Chapter 7 case to Subchapter V of Chapter 11.
Then, the Chapter 7 Trustee files an Objection to Debtor’s conversion Motion, to which Debtor files a Reply.
Debtor’s Assets & Liabilities
Debtor’s Schedules list Debtor’s assets at a total value of $563,203.47, consisting of:
- $57,000 accounts receivable;
- $40,000 inventory;
- $16,300 office furniture, fixtures, and equipment; and
- $449,903.47 machinery, equipment, and vehicles.
Debtor’s Schedules also list a claim of “unknown” value against Debtor’s landlord, for damages from an alleged wrongful lockout from leased premises.
Debtor’s Schedule D lists the following claims against Debtor:
- $29,000 claim secured by a purchase money security interest in a box truck worth $25,000;
- $197,068 priority claims; and
- $2,192,266 general unsecured claims.
Debtor Stopped Operating but Intends to Liquidate under Subchapter V
The Debtor:
- no longer maintains its business operations as a carpentry and millwork business;
- no longer retains any employees and is unable to hire any employees, because Debtor has no cash to address the collective bargaining agreement of the carpenters’ union;
- does not intend to resume its carpentry and millwork operations; but
- maintains a bank account and intends:
- to actively engage in liquidating Debtor’s assets to pay creditors; and
- to pursue a voluntary liquidation via a Subchapter V plan, if its Motion to Convert is granted.
Statutory Right to Convert from Chapter 7 to Chapter 11
§ 706(a) of the Bankruptcy Code provides: “The debtor may convert a case under this chapter to a case under chapter 11, 12, or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable.”
But § 706(d) adds this limitation: “Notwithstanding any other provision of this section, a case may not be converted to a case under another chapter of this title unless the debtor may be a debtor under such chapter.”
U.S. Supreme Court Ruling on § 706(a)&(d), & Its Application Here
In Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365, 375 (2007), the U.S. Supreme Court addresses the meaning of the § 706(d) limitation by declaring:
- a motion to convert from Chapter 7 to Chapter 11 under § 706(a) “may be denied,” if the new chapter 11 case “would simply be reconverted to chapter 7 ‘for cause’ under 11 U.S.C. § 1112(b).”
Here’s how the In re Zarifian Bankruptcy Court applies such U.S. Supreme Court ruling to the Debtor’s Motion to convert:
- to determine whether the In re Zarifian cases “would simply be reconverted to chapter 7 ‘for cause,’” the Bankruptcy Court must apply the two-prong standard in § 1112(b)(4)(A) for conversion of a case from Chapter 11 to Chapter 7; and
- those two prongs are:
- substantial or continuing loss to or diminution of the estate; and
- the absence of a reasonable likelihood of rehabilitation;
Two-Prong Conversion Standard Applied
To satisfy the first prong, the loss must be substantial or continuing, but it need not be both. Continuing loss or diminution is established where the debtor has negative cash flow and no definite source of income.
The Trustee argues that Debtor will be unable to continue its carpentry and millwork operations because Debtor has no cash, no employees, no ability to hire new employees, no place of business to operate, and only one account receivable.
But such facts do not establish a negative cash flow or a diminution of assets. Debtor persuasively asserts:
- the voluntary liquidation of receivables, inventory, equipment and the lawsuit will generate revenue for the estate; and
- such liquidation revenues will be used to pay creditors.
And the Trustee’s evidence does not meet the burden of showing either a diminution of assets or a substantial or continual loss. So, the first prong is not satisfied.
The second prong (absence of a likelihood of rehabilitation) is met because “rehabilitation” for purposes of § 1112(b) does not include liquidation.
Nevertheless, since the first prong has not been met, Debtor’s Motion to convert will not be denied, based on § 1112(b).
Eligibility for Subchapter V
Trustee’s alternative argument is this: Debtor is not eligible for Subchapter V relief because Debtor is not “engaged in commercial or business activities,” as required by § 1182(1)(A).
Debtor answers in its Reply that Debtor satisfies the “engaged in commercial or business activities” standard of § 1182(1)(A) because:
- in other Subchapter V cases, the debtors were no longer actively operating a business and had filed a liquidating plan, and the courts still found the debtors to have “engaged in” eligibility for Subchapter V:
- in one such case, the debtor established “engaged in” eligibility by litigating a lawsuit, collecting on accounts receivable, maintaining its physical plant and vehicles, and filing reports and tax returns; and
- in another such case, the debtor established “engaged in” eligibility by having bank accounts and accounts receivable, analyzing and exploring counterclaims in a lawsuit, winding down its business, and taking reasonable steps to pay its creditors and realize value for its assets;
- here, Debtor maintains significant assets and a bank account, has a 4-year commercial lease, and asserts a claim against its landlord for wrongful lockout;
- Debtor would be liquidating its assets to pay its creditors, had the involuntary petition not been filed; and
- Debtor intends to file a Subchapter V plan of liquidation upon conversion.
Ruling
The Bankruptcy Court finds that Debtor:
- meets the § 1182(1)(A) definition of a Subchapter V Debtor; and
- is eligible for Subchapter V under § 706(d).
“For all of the reasons stated above, IT IS HEREBY ORDERED THAT [Debtor’s] Motion to Convert is GRANTED.”
Conclusion
Here’s a “Thank you” to the Northern Illinois Bankruptcy Court for this instructive In re Zazrifian opinion.
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