The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), analyzing a recent decision of interest:
The United States Bankruptcy Appellate Panel of the Tenth Circuit (the BAP) ruled that a bankruptcy court in New Mexico did not abuse its discretion when it denied an individual chapter 11 debtor’s motion to voluntarily convert his previously unconverted case to a chapter 7. The BAP concluded that under the Supreme Court’s ruling in Marrama v Citizens Bank of Massachusetts, 549 U.S. 365 (2007) a debtor did not have an absolute right to request conversion where he would be “ineligible” to be a chapter 7 debtor in light of the right to reconvert set forth in section 706(b). In re Kearney, 625 B.R. 83 (10th Cir. BAP 3/12/21).
To view the opinion, click here.
Debtor Victor Kearney (“the debtor” or Kearney) married Mary Abruzzo Kearney in 1988. Mary and her three brothers owned stock in a successful company, ARCO, which her brothers managed after their parents’ deaths. After marriage, Mary executed a will that placed her share of the stock in ARCO in two trusts and named the debtor as the life beneficiary of the two trusts. She died in 1997, which eventually resulted in hotly contested litigation regarding the trust terms between the debtor and the brothers (the Abruzzos) in New Mexico state court. In short, the debtor behaved badly in the state court litigation, which resulted in judgments against him, an award of attorney’s fees, and imposition of various sanctions. The state court found the debtor had “no allegiance to the truth,” had “little or no credibility”, and “exhibited bad faith non-compliance” with various obligations.
Just before a scheduled state court hearing on appointment of a trustee (to replace the debtor, who had resigned as a trustee of the trusts), the debtor filed a chapter 11 bankruptcy petition. An Unsecured Creditors Committee (UCC) was appointed immediately and after the debtor battled senselessly with it and the Abruzzos, the bankruptcy court let the debtor’s exclusivity to file a plan lapse. The UCC proposed a plan which involved the sale of ARCO stock back to the company and would eventually provide $3Million to the bankruptcy estate in exchange for releases of claims against the trusts and others. The state court had to approve trust modifications but before it could do so, the debtor removed that litigation to the district court and also filed new litigation against the trustees in Nevada District court. All those bad tactics quickly got unwound, with the New Mexico bankruptcy court finding the debtor engaged in questionable tactics.
Eventually the bankruptcy court confirmed the UCC’s plan, issuing a written opinion which was highly critical of the debtor and his tactics.
The debtor was indicted in federal court for conspiring to commit fraud on the IRS and filing false tax returns, based on a referral to the IRS made by the state court. Debtor filed a motion to employ a criminal defense attorney at the expense of the chapter 11 estate, which the bankruptcy court denied, saying the debtor should fund the employment from non-estate assets since his potential personal criminal liability was not an estate matter. Notwithstanding this denial, the proposed counsel entered her appearance in the criminal proceeding in early 2020 and remained attorney of record throughout this proceeding.
Debtor moved to convert his case to a chapter 7, asserting that he had an absolute right to do so under section 1112(a) and it was necessary for the case to be converted so that he could use his income to employ his criminal defense attorney since a debtor’s postpetition income in a chapter 7, unlike in a personal chapter 11, is the debtor’s, not the estate’s. The bankruptcy court denied the motion to convert, making a finding that the grounds for conversion were pretextual, since criminal counsel was already representing the debtor in court. The court also relied on Marrama to conclude that the conversion right was not absolute, especially since the case could be immediately reconverted to a chapter 11 under section 706(b), making the debtor “ineligible” for chapter 7 relief. The debtor appealed and the BAP affirmed.
The BAP looked first at the language contained in section 1112:
(a) the debtor may convert a case under this chapter to a case under chapter 7 of this title unless—
(1) the debtor is not a debtor in possession;
(2) the case originally was commenced as an involuntary case under this chapter; or
(3) the case was converted to a case under this chapter other than on the debtor’s request.
. . .
(f) 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.
The BAP found the debtor met the subsection (a) requirements but the BAP found an “out” subsection (f), language that was identical to the provisions of section 706 (c) on which the Marrama Court had relied when it denied a chapter 7 debtor the absolute right to convert to chapter 13. In both instances, the relief the debtor sought was conditioned on the debtor being eligible under the desired chapter. Because of the debtor’s bad faith tactics, the Court in Marrama found there would be a “procedural anomaly” if the bankruptcy court converted a chapter 7 to a chapter 13 only to thereafter immediately return it to chapter 7.
The BAP found this reasoning persuasive against Kearney. The confirmed plan was in the best interest of all parties, including the debtor as it would provide funds to pay nondischargeable tax debt. The debtor’s estate had the means to fund this beneficial plan since the state court had approved the trust modifications which would make the $3 million dollars available to the bankruptcy estate. This circumstance would inevitably lead to either the post-conversion chapter 7 trustee, the UCC, or the Abruzzos filing a motion to reconvert the case to chapter 11 under section 706(b), which the court would grant. Section 706(b) provides that “on the request of a party in interest and after notice and a hearing, the court may convert a case under this chapter  to a case under chapter 11 of this title at any time.” Just as the chapter 7 debtor in Marrama would end up back in a chapter 7 if the case were to be converted, making that debtor ineligible for chapter 13 due to his bad faith as found by the Supreme Court, Kearney would end up back in chapter 11, making him ineligible for chapter 7 relief because his estate could fund a chapter 11 plan in the best interest of all parties.
The debtor had argued that Law v Siegel, decided by the Supreme Court after Marrama, meant the court could not consider his bad faith tactics in denying him the relief which he requested. The BAP rejected that argument out of hand, as its analysis did not rely on the bad faith findings of the bankruptcy court, but rather the ineligibility to be a debtor in the face of a section 706(b) motion.
The Supreme Court in Marrama opened the door for this decision, especially in light of the identical language in sections 1112(f) and 706(c). We have all learned to live with Marrama, despite the seemingly mandatory right the statute accorded to a chapter 7 debtor to convert to a chapter 13. Since the Supreme Court spoke once that the mandatory language was not mandatory, it would do so again if confronted with the issue decided by the 10th Circuit BAP. I have no doubt the BAP got it right.
Of course, it helps that this was a despicable debtor. Despite the BAP’s non-reliance on the bad faith findings, what court faced with a section 706(b) motion to convert a chapter 7 to a chapter 11 would hesitate to do so if confronted with a debtor like Kearney and the chance to preserve the benefits of the confirmed plan.
This submission was authored by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), a member of the ad hoc group with editorial contributions by Adam A. Lewis, Senior counsel, Morrison & Foerster LLC, a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.