The Ninth Circuit recently wrote a checklist identifying the questions a bankruptcy court must answer when deciding whether to grant a motion for dismissal or conversion of a chapter 11 case to chapter 7.
The circuit’s June 8 opinion also laid out the analysis for deciding whether assets that reverted to the debtor on confirmation of a chapter 11 plan would end up in the chapter 7 estate on conversion.
The chapter 11 debtor was an individual who owned several parcels of real property subject to mortgages. Disputing the validity of the mortgages, the debtor confirmed a plan requiring her to place rental income from the collateral into an escrow fund pending resolution of the objections.
If the objections were overruled, the plan required the debtor to turn over the escrowed funds to the lender and to pay the lender going forward.
About five years after confirmation, the bankruptcy court ruled in favor of the debtor, but she refused to turn the escrow over to the lender. Six months later, the lender filed a motion for conversion to chapter 7.
Bankruptcy Judge Martin R. Barash converted the case and directed the debtor to turn the escrowed funds over to the lender. The district court affirmed.
The debtor appealed to the Ninth Circuit, contending that the bankruptcy court should not have converted and that the escrowed funds did not become part of the chapter 7 estate earmarked for the lender. In an opinion on June 8, Circuit Judge Danielle J. Forrest affirmed.
Conversion or Dismissal
Judge Forrest first adopted the holding of the Ninth Circuit Bankruptcy Appellate Panel by ruling that the creditor carries the initial burden of demonstrating “cause” for conversion or dismissal.
On the merits, Section 1112(b)(1) provides:
[T]he court shall convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause unless the court determines that the appointment under section 1104(a) of a trustee or an examiner is in the best interests of creditors and the estate.
In turn, “cause” is defined in Section 1112(b)(4)(N) to include a “material default” under the plan. However, the Code does not define “material default.”
To determine whether the failure to pay the lender was a material default, Judge Forrest noted that an individual chapter 11 debtor does not receive a discharge until all payments are made under the plan. She agreed with her circuit’s BAP that “failing to make required plan payments can be a material default of the plan, even if the debtor has made payments for an extended period before the default or taken other significant steps to perform the plan.”
Still, Judge Forrest said, every missed payment is not a material default if the amount of the payment or the period of the default was “minimal.” To judge materiality, she said the court should consider the number of missed payments, the number of creditors who were not paid and how long the default occurred.
In the case on appeal, the amount of the default was at least $200,000 and included five years of payments. Even if the debtor had not defaulted under other provisions of the plan, Judge Forrest upheld the bankruptcy court’s finding of “cause.”
Although there may be “cause,” Judge Forrest said the court must next decide whether conversion is in the best interests of all creditors. Furthermore, she said that the court must address subsection (b)(2), which says:
The court may not convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter if the court finds and specifically identifies unusual circumstances establishing that converting or dismissing the case is not in the best interests of creditors and the estate . . . .
The debtor claimed there were unusual circumstances to avoid conversion by invoking subsection (b)(2). On that point, Judge Forrest adopted the holding of her BAP that “unusual circumstances” are not common conditions in a chapter 11 case. In other words, “unusual circumstances” must be something more than “inherent financial pressures” on a debtor and “adversarial differences.” Furthermore, the ability to cure a default is not an “unusual circumstance.”
“Conversely,” Judge Forrest said, an unusual circumstance could be a case where remaining in chapter 11 would yield a larger dividend for creditors.
In the case on appeal, the lender said it was willing to take a chance with a chapter 7 trustee, and no creditor objected to conversion. In addition, the bankruptcy judge found that conversion would conclude the case more quickly.
Judge Forrest found no abuse of discretion and upheld conversion to chapter 7.
Asset Turnover
The debtor argued that she should not have been required to turn the escrowed funds over to the chapter 7 trustee. Alluding to Section 1141(b), the debtor contended all assets of the estate revested in her on confirmation. Indeed, the section says that confirmation “vests all of the property of the estate in the debtor.”
Judge Forrest said that the “Bankruptcy Code is silent as to what constitutes the bankruptcy estate when a Chapter 11 case is converted to Chapter 7 after plan confirmation.”
Although “courts have varied in their approach to what happens with the bankruptcy estate upon conversion from Chapter 11 to Chapter 7,” Judge Forrest found an answer in the Ninth Circuit’s own caselaw. She held that the “bankruptcy court should undertake a holistic analysis of the plan to determine whether its provisions deviate from the default vesting rule in 11 U.S.C. § 1141(b).”
In the case on appeal, the plan had no “express provision” saying where estate property would go on conversion. However, Judge Forrest noted that the plan required the debtor to make payments into the escrow fund if her objection to the secured claim proved unsuccessful.
Judge Forrest said that the plan did not give estate property back to the debtor on confirmation free and clear of creditors’ claims and interests. She upheld the direction to turn the escrow fund over to the trustee, because revesting the assets in the debtor “upon conversion to Chapter 7 would frustrate the intent of the Plan and is contrary to many of its provisions.”
The Ninth Circuit recently wrote a checklist identifying the questions a bankruptcy court must answer when deciding whether to grant a motion for dismissal or conversion of a chapter 11 case to chapter 7.
The circuit’s June 8 opinion also laid out the analysis for deciding whether assets that reverted to the debtor on confirmation of a chapter 11 plan would end up in the chapter 7 estate on conversion.
The chapter 11 debtor was an individual who owned several parcels of real property subject to mortgages. Disputing the validity of the mortgages, the debtor confirmed a plan requiring her to place rental income from the collateral into an escrow fund pending resolution of the objections.
If the objections were overruled, the plan required the debtor to turn over the escrowed funds to the lender and to pay the lender going forward.
About five years after confirmation, the bankruptcy court ruled in favor of the debtor, but she refused to turn the escrow over to the lender. Six months later, the lender filed a motion for conversion to chapter 7.
Bankruptcy Judge Martin R. Barash converted the case and directed the debtor to turn the escrowed funds over to the lender. The district court affirmed.
The debtor appealed to the Ninth Circuit, contending that the bankruptcy court should not have converted and that the escrowed funds did not become part of the chapter 7 estate earmarked for the lender. In an opinion on June 8, Circuit Judge Danielle J. Forrest affirmed.