Even when the corporate debtor intends to liquidate, the debtor is entitled to convert an involuntary chapter 7 case to Subchapter V of chapter 11, for reasons explained by Bankruptcy Judge David D. Cleary of Chicago.

The bankruptcy court entered an order for relief after creditors filed an involuntary chapter 7 petition. Alongside its schedules and statement of affairs, the debtor filed a motion for conversion of the case to Subchapter V of chapter 11. For assets, the schedules listed accounts receivable, inventory and equipment, plus a claim against the landlord.

In his December 17 opinion, Judge Cleary said,

Debtor no longer maintains its core or historical business operations as a carpentry and millwork business . . . . Debtor states that it does not intend to resume its historical business operations as a carpentry and millwork, but to actively engage in liquidating its assets to pay its creditors.

The chapter 7 trustee objected to the conversion motion.

Marrama Allows Conversion to Sub V

The debtor’s ability to convert is governed by Section 706(a), which says that “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.”

Before 2007, Judge Cleary said that “courts did not agree on whether chapter 7 debtors had an absolute right to convert to a reorganization case.” That year, the Supreme Court decided Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365, 375 (2007).

Judge Cleary characterized Marrama as holding that a motion to convert may be denied “[i]f a chapter 11 case would simply be reconverted to chapter 7 ‘for cause’ under 11 U.S.C. § 1112(b).”

As required by Marrama, Judge Cleary examined Section 1112(b)(4)(A) to decide whether there would be cause for reconversion to chapter 7 if the case were converted to chapter 11 on the debtor’s motion. As cause for conversion, the subsection mentions “substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation.”

With regard to “substantial or continuing loss to or diminution of the estate,” Judge Cleary found “neither substantial or continual loss, nor diminution of the estate.” Although the debtor had neither cash nor employees nor an operating business, he said that the debtor had “receivables, inventory, a lawsuit, and the sale of equipment” to generate revenue “to pay creditors.”

Judge Cleary ruled that the trustee had not satisfied the first test, because the trustee had not shown “diminution of assets, or substantial or continual loss . . . .”

To convert, the second test in Section 1112(b)(4)(A) requires the court to find “the absence of a reasonable likelihood of rehabilitation.”

“Because the Debtor here intends to file a liquidating plan” and “conversion to chapter 11 Subchapter V cannot lead to rehabilitation,” Judge Cleary found that the second test had been satisfied. “Nevertheless,” he decided that he would not be required to reconvert the case to chapter 7 because “the first prong has not been met.”

An Operating Business Isn’t Required

While Section 1112(b) did not preclude reconversion to chapter 7, Judge Cleary said that Section 706(d) “puts a limitation on this nearly absolute right to convert.” The subsection provides that “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.”

The chapter 7 trustee contended that the debtor was not eligible for Subchapter V because Section 1182(1)(A) requires the debtor to be “a person engaged in commercial or business activities.”

As authority for the meaning of “commercial or business activities” required by Section 1182(1)(A), Judge Cleary cited In re Port Arthur Steam Energy, L.P., 629 B.R. 233 (Bankr. S.D. Texas 2021); and In re Offer Space, LLC, 629 B.R. 299 (Bankr. D. Utah 2021). To read ABI’s reports, click here and here.

In Port Arthur, Judge Cleary recounted how the court “found that the debtor engaged in commercial and business activities by litigating a lawsuit, seeking to collect on outstanding accounts receivable, maintaining its facility and vehicles, and filing reports and tax returns.” In Offer Space, he said that the debtor was “engaged in commercial and business activities” by having an active bank account and accounts receivable and by winding down the business.

Judge Cleary granted the debtor’s motion for conversion to Subchapter V because the debtor had “significant assets, a bank account, a 4-year commercial lease, and a claim against its landlord” and intended “to file a Subchapter V plan of liquidation upon conversion.”