On a question where the circuits are split, the Ninth Circuit Bankruptcy Appellate Panel hewed to Ninth Circuit precedent by holding that a debtor’s bad faith in chapter 11 does not preclude the debtor from converting the case to chapter 7 under Section 1112(a). Even if the case already has been converted to chapter 7, the debtor’s conduct in the prior chapter 11 case does not allow dismissal of the chapter 7 case under Section 707.

To put the BAP’s rationale into a few words, chapter 7 has remedies like denial of discharge to account for a debtor’s bad faith. Consequently, the existence of a statutory remedy for bad faith does not allow bad faith to represent “cause” for dismissal under Section 707, especially since chapter 7 can benefit creditors generally.

The Debtor’s Misbehavior in Chapter 11

The individual debtor in chapter 11 had “failed to provide the type of complete disclosures contemplated by the Code,” the BAP said in a nonprecedential, per curiam opinion on April 8. Despite being “repeatedly warned . . . that his case was subject to dismissal,” the debtor persisted with “incomplete and conflicting disclosures.”

The bankruptcy court entered an order directing the debtor to show cause why his case should not be converted or dismissed. Before the hearing, the debtor filed a request for conversion to chapter 7.

The court converted the case to chapter 7, but the conversion order directed the debtor to show cause why the chapter 7 case should not be dismissed. At the ensuing hearing, the bankruptcy court dismissed the chapter 7 case under Section 707(a).

The debtor appealed to the BAP.

Prior Ninth Circuit Authority

In pertinent part, Section 707(a) provides that the “court may dismiss a case under this chapter only after notice and a hearing and only for cause, including — (1) unreasonable delay by the debtor that is prejudicial to creditors . . . .”

The BAP described the bankruptcy court as having dismissed on “two related grounds: (i) that Debtor’s conduct was an abuse of the bankruptcy process that qualified as ‘cause’ under § 707(a); and (ii) that Debtor’s conduct qualified as ‘unreasonable delay by the debtor that [was] prejudicial to creditors’ under § 707(a)(1).”

In view of the subsequent decision by the Supreme Court in Marrama v. Citizens Bank of Mass., 549 U.S. 365 (2007), the BAP was tasked with deciding whether it remained bound by two Ninth Circuit decisions, Neary v. Padilla (In re Padilla), 222 F.3d 1184 (9th Cir. 2000); and Sherman v. S.E.C. (In re Sherman), 491 F.3d 948 (9th Cir. 2007).

In Padilla, the Ninth Circuit held “that bad faith per se can properly constitute ‘cause’ for dismissal of a Chapter 11 or Chapter 13 petition but not of a Chapter 7 petition under § 707(a).” Padilla, supra, 222 F.3d at 1192-93.

In Padilla, the Ninth Circuit explained why bad faith was not available for dismissing a chapter 7 case: In chapters 11 and 13, the appeals court said that the debtor “retain[s] its assets [to] reorder its contractual obligations to its creditors. In return for these benefits, the debtor must approach its new relationship with the creditors in good faith.” Id. By contrast, the circuit court said that chapter 7 “requires no ongoing relationship between the debtor and its creditors and should be available to any debtor willing to surrender all of its nonexempt assets, regardless of whether the debtor's motive in seeking such a remedy was grounded in good faith . . . .” Id.

In Sherman, the chapter 7 debtor’s misconduct was misrepresentation of liabilities and expenses. The BAP characterized the circuit court as “holding that such misrepresentations did not provide ‘cause’ for dismissal under § 707(a)” because “§ 727(a)(4)(A) [denial of discharge for knowingly and fraudulently making a false oath] covered the specific conduct by the debtor.”

In Sherman, the BAP characterized the Ninth Circuit as having “held that the proper remedy was to deny the debtor a discharge under § 727(a)(4)(A), not dismiss the case under § 707(a).”

With six circuits having held to the contrary, the BAP admitted that “Padilla represents a minority view” and that those circuits decided that bad faith is grounds for dismissal under Section 707(a).

Marrama

Marrama “complicat[es] our analysis,” the BAP said. The panel described the Supreme Court in Marrama as having “held that the debtor’s bad faith conduct with respect to his chapter 7 filing precluded conversion to a chapter 13,” in part because bankruptcy is reserved for honest but unfortunate debtors.

Later, the Supreme Court handed down Law v. Siegel, 571 U.S. 415 (2014). There, the BAP described the Court as holding that Section 105(a) “does not authorize courts to take action in contravention of the Code.”

While there was no dispute that Section 707(a) controlled, the BAP said that “we must contend with Marrama” but decided “that we are bound by Padilla notwithstanding the Supreme Court’s decision in Marrama.”

To begin with, Marrama involved conversion from chapter 7 to chapter 13. The BAP mentioned how the Supreme Court “itself noted that allowing a chapter 7 debtor an absolute right to convert to a chapter 13 case would provide the debtor an opportunity to retake control of property of the estate and potentially ‘take actions that would impair the rights of creditors.’ Marrama, 549 U.S. at 375 n.13.”

Similarly, the BAP noted how the Ninth Circuit in Padilla mentioned that, “unlike chapter 7, chapters 11 and 13 allow debtors not only to retain assets but to continue their relationship with creditors . . . . And, while chapters 11 and 13 explicitly invoke good faith as a requirement to plan confirmation, chapter 7 is silent with respect to good or bad faith.”

Furthermore, there is a difference in the conversion statutes. The BAP said:

Unlike § 707(a), § 1112(b) and § 1307(c) allow for dismissal or conversion to a chapter 7 case for cause. While this difference may seem elementary, it is integral to why conversions to chapter 7 are different from conversions from chapter 7. [Emphasis in original.]

The BAP decided that “these distinctions place Padilla beyond the holding of Marrama,” because “a chapter 7 case is itself a remedy to bad faith conduct in a chapter 11 or chapter 13 case, and because of the different relationship a chapter 7 debtor has with the estate as compared to chapter 11 and chapter 13 debtors.” It was therefore “unlikely” that Marrama “overruled Padilla,” the BAP said. Indeed, the BAP said, “Law actually bolsters the holding in Padilla.”

Remaining bound by Padilla, the BAP saw “no meaningful distinction between the conduct at issue in this case and the conduct at issue in Sherman.” Likewise bound by Sherman, the BAP reversed the bankruptcy court’s holding that the debtor’s misconduct in chapter 11 amounted to “cause” for dismissal under Section 707(a).

Section 707(a)(1)

The bankruptcy court also based dismissal on “unreasonable delay” under Section 707(a)(1).

The BAP once again observed “that chapter 7 contains alternative remedies for courts and parties in interest to police abuse by debtors” and that “dismissal of a chapter 7 case is an extraordinary remedy.” Furthermore, “§ 707(a)(1) does not specify whether ‘delay’ includes preconversion delay of the case under a different chapter.”

The BAP held “that Congress likely intended § 707(a)(1) to apply only to conduct that delays a chapter 7 case.” In other words, “the court must analyze whether the delay caused by the debtor delayed the chapter 7 case, and whether such delay caused prejudice to creditors in the chapter 7 context.” [Emphasis in original.]

The BAP reversed and remanded for the bankruptcy court to determine “whether Debtor’s conduct caused unreasonable delay to the chapter 7 case.” [Emphasis in original.]