The following is a case update written by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLC, analyzing a recent decision of interest:
In two recent cases, bankruptcy courts came to differing conclusions about whether a debtor could transform a Chapter 11 case to a subchapter V (“Sub V”) case under Chapter 11. At bottom, the cases appeared to turn on the court’s view of the debtor’s integrity, along with a sensitivity to the remedial purposes of Sub V, finding plenty of purchase in the uncertainties created by the relevant statutes to reach the result they felt warranted. The cases are In re Easter, ___ B.R. ___, 2020 WL 6009201, 2020 Bankr. LEXIS 2830 (Bank. N.D. Miss. 2020) (“Easter”) and In re Wetter, ___ B.R. ___, 2020 Bankr. LEXIS 2860 (Bankr. W.D. Va. 2020) (“Wetter”).
In re Easter
The debtors, who owned a trucking company as a sole proprietorship, filed a joint Chapter 11 petition in May of 2019. They amended the petition to a small business case that July. Under Bankruptcy Code (the “Code”) section 1129(e), a small business debtor must file a plan within certain deadlines and confirm the plan within 45 days of filing it. In January of 2019, they filed a plan and disclosure statement, with the court subsequently conditionally approving the latter. The Small Business Reorganization Act of 2019 (the “SBRA”), provisions of which are at the heart of Easter, became effective in mid-February 2020 (the “Effective Date”). The United States Trustee and various creditors objected to confirmation, and only one creditor voted for the plan. Shortly thereafter, the debtors amended their petition to proceed under Sub V (Bankruptcy Rule 1019(a) allows a debtor to amend a petition of right). Their express rationale for converting to Sub V was that it was clear they could not confirm a plan otherwise because they would not have any objecting class voting for the plan and could not retain any property because they could not satisfy the absolute priority rule (which prevents debtors from confirming a plan under which they retain property if it does not pay creditors in full. Sub V does not require any creditor approval and allows debtors to confirm a partial payment plan while retaining property.
The UST and several creditors objected, advancing various arguments. The objections boiled down to certain main points. One was that the law disfavors retroactive application of statutes, so that only cases filed after the Effective Date of Sub V could proceed as Sub V cases. Another was that because Sub V sets various deadlines keyed off the petition date of the case (e.g., holding a status conference, filing a plan) that could not possibly be satisfied given how long ago the petition was filed, the case would have to be converted to Chapter 7 right away. A related argument was that trying to correct the deadlines issue would create procedural chaos. Next, in a more refined iteration of the retroactive argument, certain creditors argued that allowing the amendment to the petition would strip them of various vested property rights such as benefit of the very absolute priority rule the debtors wanted to outflank. Finally, some creditors contended that allowing the conversion would reward the debtors for their alleged bad faith in failing to provide the creditors with information about their collateral. The court rejected all the arguments.
In essence, the court saw the overall issue as a question of whether conversion to Sub V for cases filed before the Effective Date is permissible. It summarily rejected the naked argument that the law disfavors retroactivity. In part it reasoned that as a remedial statute designed to improve the prospects of reorganization of small businesses that otherwise would suffocate in a normal Chapter 11, the SBRA and Sub V overcame any theoretical aversion to retroactivity. On that score, the court also explained that no vested rights were being sacrificed because the absolute priority rule is a creature of bankruptcy law, not a property right a creditor already has when a case is filed. The same is true of any other purported examples of property rights that are being yanked from creditors by the conversion. As for the effect of the conversion to Sub V on deadlines and related procedures already governing the pre-conversion case, the court saw no reason that it could not set new deadlines consistent with the intent of Sub V. That might create some inconveniences, but nothing that rises to the level of an intolerable burden. The court also rejected the claim that the debtors were acting in bad faith. There was nothing wrong with their trying to take advantage of Sub V’s repeal of the absolute priority rule in order to try to confirm a plan on terms Sub V permits. Finally, although the court agreed that bad faith was a proper factor in assessing whether to permit retroactive conversion, the friction between the debtors and creditors over the status and value of collateral was attributable to anything more than changing circumstances and faulty records.
In re Wetter
The debtor, a dentist, ceased practice after selling his successful practice for a substantial monthly payment by the buyer. Later, the practice collapsed and filed a bankruptcy, exposing the debtor to large guarantee claims. Therefore, in July 2019, he filed his own Chapter 7 case, purporting to exempt his most valuable asset. After the Effective Date of SRBA, with its Sub V provisions, the debtor moved to convert the case to Chapter 11 expressly for the purpose of then being able to amend his petition to proceed under Sub V. The Chapter 7 trustee and several creditors opposed the motion, and after a two-day evidentiary trial, the court denied it (note that had the case already been in Chapter 11, subject to certain limitations Bankruptcy Rule 1019 would have permitted conversion to Sub V of right). At the trial, there was substantial evidence – some of it developed in earlier proceedings in the case – that the debtor knowingly materially misrepresented his assets in his schedules and made related intentional misrepresentations to the trustee and the UST.
The court began by explaining that although nominally under Code section 706(a) a Chapter 7 debtor has the absolute right to convert to another chapter, because Code section 706(d) limits conversion to a chapter under which the debtor can qualify as a debtor, a debtor cannot exercise that right if the case as converted would be subject to immediate dismissal or reconversion for any reason, including the prior bad faith of the debtor. Marrama v. Citizens Bank of Mass., 549 U.S. 365 (2007).
Rejecting the argument against conversion that the converted case would have to be reconverted or dismissed because it could not possibly satisfy the Sub V deadlines of Code section 1188, the court noted that the statute requires the court to set and meet the deadlines (except a deadline the debtor can meet only if the court first sets the deadlines in its control). Since the debtor cannot fairly be penalized for what the court cannot do in time, the 1188 issue is not a bar to conversion. The situation is a bit different for the requirement of Code section 1189(a) that the debtor must file a plan within 90 days of the order for relief. Like the section 1188 deadlines, the court is permitted to grant the debtor an extension of a deadline if the debtor cannot be held “justly accountable” for missing the deadline. See 11 U.S.C. §§ 1188(b), 1189(b). The court then described the tests developed by two courts for what “justly accountable” means. In one case, that court adopted a “circumstances beyond the debtor’s control” test and in the other the standard whether the debtor is “‘fairly responsible’” for the missed date. While in the former case the court found the debtor disqualified because the debtor elected Sub V after the deadline expired (note this was a case in which the debtor filed bankruptcy after the Effective Date), the latter case recognized that the setting of the deadlines was beyond the debtor’s control, in part because the debtor could not file a plan while in Chapter 7, and in part because the debtor could not choose Sub V until at least the Effective Date. The Wetter court chose the latter court’s analysis as being more consistent with the language of the statute.
But this narrow evaluation did not end the matter. Looking at the good faith issues lurking in every case and also at the best interests of creditors test for confirmation of a plan, the court concluded that the debtor’s evasiveness about his assets and his attempt to confirm a plan without any contribution to payment of creditors from his most valuable asset because he insisted on exempting all of it were fatal to the fate of any Chapter 11 case, whether the standard Chapter 11 or a Sub V.
These two cases illustrate the wide variety of procedural issues and paths to their resolution in cases seeking conversion to Sub V of Chapter 11 (either from another chapter or from a standard Chapter 11) in a case already pending on the Effective Date of Sub V. This trove of issues effectively gives courts considerable “discretion” in finding a way to a result they think is appropriate in the specific case before them. And good faith and honesty, along with the remedial purpose of Sub V, probably often will be among the issues that are decisive in any case. But the discussion of issues in the two cases and the cases upon which they rely probably will have implications for cases filed after the Effective date. In a way, that prospect is more important than the pre-Effective Date cases because the latter bundle will eventually flame out, whereas the former will continue to arise, if less frequently because most of the time new cases will start as Sub Vs.
One further note. It can be argued that the debtors in Easter were not so innocent of bad faith because they only reverted to Sub V when they couldn’t cram a plan down in their traditional Chapter 11. Such a view strikes a false note. Other than involving some more time and revised procedures, their switch to Sub V is little different than proposing another plan or two after a plan they have pursued proves unconfirmable. Such successive plans normally draw opprobrium only when multiple plans fail, reflecting either a hopeless situation or repeated attempts by the debtor to fleece its creditors for his own benefit.
These materials were authored by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLC, a member of the ad hoc group, with editorial assistance by Meredith Jury, (bankruptcy judge, C.D. Cal. (Ret.)), 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.