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The Final Say: Conversion from Chapter 11 to Chapter 7 is Not a Given

It is well-settled that if you are a debtor in chapter 11, you do not have the unfettered right to convert the case to a chapter 7 liquidation.  A recent 10th Circuit decision shows why. Kearney v. Unsecured Creditors Committee et al., BAP No. 20-33, 2021 WL 941435 (B.A.P. 10th Cir. Mar. 12, 2021).

The debtor had married into a family that owned real estate assets in New Mexico, Colorado and Arizona and lived off income from two spendthrift trusts formed by his late wife.  The debtor and his two brothers-in-law served as co-trustees of both trusts.  Despite receiving annual distributions from the trusts of approximately $800,000, Kearney sued his co-trustees in 2013, asserting improper management of the trusts.

In 2017, the debtor filed chapter 11, following years of ultimately unsuccessful litigation stemming, in part, from the co-trustees’ meritorious countersuit.  In February 2019, Judge David T. Thuma of the U.S. Bankruptcy Court for the District of New Mexico confirmed a plan that had been proposed by the unsecured creditors' committee.

A few months later, the debtor was indicted on charges of conspiracy to commit tax fraud.  The debtor hired a criminal defense attorney, but the bankruptcy court denied the debtor’s application to retain defense counsel.

In February 2020, the debtor moved to convert his case to chapter 7, alleging that he had insufficient funds to independently pay his defense attorney.  Judge Thuma denied that motion, deciding that the debtor’s request was pretextual.  In Judge Thuma’s view, the real purpose of the request was to void the previously confirmed plan.

The debtor argued that he had an absolute right to convert the chapter 11 to a chapter 7.  But his position was contrary to U.S. Supreme Court precedent set forth in Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365 (2007).  There, the Supreme Court noted that bankruptcy judges have wide discretion to prevent an abuse of the bankruptcy process and held that Bankruptcy Code section 706(d) provides adequate authority to allow the denial of a motion to convert “in lieu of a conversion order that merely postpones the allowance of equivalent relief [that] may provide a debtor with an opportunity to take action prejudicial to creditors.”  Id. at 366.

Conversions of chapter 11 cases are governed by Bankruptcy Code section 1112.  Since section 1112(f) contains a conversion restriction that mirrors section 706(d), Judge Thuma held that Marrama controlled.

Judge Thuma ruled that a conversion from chapter 11 to chapter 7 would be futile because the matter would immediately be reconverted to chapter 11 under Bankruptcy Code section 706(d).  The reason for that ruling was straightforward: the chapter 11 case under the creditors' confirmed plan would provide a superior outcome for all parties when compared to a chapter 7 liquidation.

Ultimately, the 10th Circuit affirmed the bankruptcy court’s ruling and held, “the Bankruptcy Court did not abuse its discretion in concluding it would immediately reconvert Debtor's case....” Kearney at 100. This case serves as a reminder that debtors lack the volition to freely convert their chapter 11 filings without court approval.