Dear constituency list members of the Insolvency Law Committee the following is a case update written by Patrick M. Costello, a principal of Vectis Law, analyzing a recent case of interest:
In an unpublished decision, the Ninth Circuit Bankruptcy Appellate Panel (the “BAP”) addressed the standard for challenging a dismissal of a chapter 11 case when it affirmed dismissal of the debtor’s voluntary chapter 11 petition. In re Sammy Ciling, BAP No. CC-22-1151-TLF, 2023 WL 166827 (9th Cir. BAP 2023) (the “BAP Decision”).
To view the opinion, click here.
The Debtors – husband and wife – filed a chapter 11 petition. Their principal scheduled assets were an over-encumbered home and 100% ownership of two corporations (the “Corporations”). Their principal scheduled debt was a $2.9 million judgment relating to the sale of an interest in the Corporations (the “Equity Related Claim”). Within two weeks of filing their chapter 11 petition, the Debtors moved to dismiss the case citing their need to move to Turkey to care for an ailing father.
The Appellant, an unsecured creditor—whose claim was against the Corporations but for which the Appellant alleged the Debtors were personally liable as alter egos—opposed dismissal on the theory that the Equity Related Claim was subject to subordination under Bankruptcy Code section 510 and that subordination might not exist outside of bankruptcy. As a result, dismissal of the chapter 11 case and the alleged loss of the ability to subordinate the Equity Related Claim constituted “plain legal prejudice.”
The bankruptcy court exercised its discretion to dismiss the chapter 11 case, leaving the parties to their nonbankruptcy remedies while imposing restrictions on the Debtors’ ability to file for further relief. In doing so, the bankruptcy court raised serious questions as to how the alleged subordination action would actually benefit unsecured creditors and as to how the litigation might be funded.
Appellant appealed, arguing that the case should have been converted to chapter 7 and that dismissal operated to Appellant’s “plain legal prejudice” in contravention of the dismissal requirements under Bankruptcy Code section 1112. The Ninth Circuit BAP affirmed the dismissal.
Bankruptcy Code section 1112(b) authorizes the court to dismiss or convert the case to one under chapter 7, whichever the court determines to be in the “best interests of creditors and the estate, for cause.” The BAP held that the bankruptcy court’s dismissal was not an abuse of discretion.
The BAP determined that a bankruptcy court is not required to find that there was no “plain legal prejudice” to creditors before dismissing the chapter 11 case. While “plain legal prejudice” to creditors is a factor which the bankruptcy court may weigh, it is not a shibboleth and legal prejudice to one creditor does not require the conclusion that dismissal is contrary to the best interests of all creditors.
While the bankruptcy court may have technically erred in rejecting out of hand conversion as an option, that error was harmless given that conversion was not a viable option. The BAP reasoned that a chapter 7 trustee would have little ability to compel Debtors to act while they were out of the country, and it would be futile to force a trustee to administer an estate that was administratively insolvent on its face.
The BAP accordingly concluded there was no basis to overturn the bankruptcy court’s exercise of its discretion to dismiss rather than convert to a chapter 7 case.
The key takeaway here is that a bankruptcy court’s decision whether to dismiss or convert a chapter 11 case is reviewed under an abuse of discretion standard, and the bankruptcy court’s analysis is by no means limited to a single factor such a “legal prejudice” to an individual creditor. Of course, certain variation in the facts—including the credibility of the Debtors, whether additional creditors opposed dismissal, the ability to administer the estate by a trustee, and whether the Debtors were available in the United States—might have resulted in a conversion rather than dismissal. What the BAP evidently rejected was the creditor’s “gotcha” argument: that once a debtor files for chapter 11 relief it is inextricably locked into bankruptcy, including conversion to chapter 7. A chapter 11 debtor, once it has submitted to bankruptcy jurisdiction and taken advantage of its protections, may indeed have a high hurdle to justify dismissal as consistent with the best interests of creditors, but a single creditor arguing that it might fare better in a chapter 7 case because it would be legally prejudiced by dismissal is not dispositive.
These materials were written by Patrick M. Costello, of Vectis Law, in San Mateo, California (firstname.lastname@example.org). Editorial contributions were provided by Joseph Boufadel of Salvato Boufadel, LLP in Los Angeles, California (email@example.com).