Supreme Court Limits "Absolute" Right to Convert to Chapter 13

In the first bankruptcy opinion of the term, the Supreme Court held in a 5-4 decision that a misbehaving Chapter 7 debtor does not have an absolute right to convert his case to Chapter 13. Marrama v. Citizens Bank of Massachusetts, No. 05-996, 549 U.S. ___ (2007). The Supreme Court stated that a debtor whose case could be converted or dismissed for cause under 11 U.S.C. Sec. 1307(c) had forfeited the right to proceed under Chapter 13 and thus was not a person eligible to convert to Chapter 13.

According to Justice Stevens writing for the majority:

"An issue that has arisen with disturbing frequency is whether a debtor who acts in bad faith prior to, or in the course of, filing a Chapter 13 petition by, for example, fraudulently concealing significant assets, thereby forfeits his right to obtain Chapter 13 relief. The issue may arise at the outset of a Chapter 13 case in response to a motion by creditors or by the United States trustee either to dismiss the case or to convert it to Chapter 7, see Sec. 1307(c). It also may arise in a Chapter 7 case when a debtor files a motion under Sec. 706(a) to convert to Chapter 13. In the former context, despite the absence of any statutory provision specifically addressing the issue, the federal courts are virtually unanimous that prepetition bad faith conduct may cause a forfeiture of any right to proceed with a Chapter 13 case. In the latter context, however, some courts have suggested that even a bad-faith debtor has an absolute right to convert at least one Chapter 7 proceeding into a Chapter 13 case even though the case will thereafter be dismissed or immediately returned to Chapter 7."

The Supreme Court took the course of pragmatism, finding that the bankruptcy court could skip to the ultimate result and deny the conversion where the Debtor would not be able to maintain the Chapter 13 case. However, to do this, they had to get around some apparently clear statutory language.

Sec. 706(a) states 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. Any waiver of the right to convert a case under this subsection is unenforceable." This language seems pretty straightforward. The debtor may convert "at any time." The right to convert cannot be waived. Not so fast said the nimble Justice Stevens. Section 706(d) states 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." According to Justice Stevens, a person might not be eligible for Chapter 13 relief on one of two grounds. First, Sec. 109(e) might provide that the person was not eligible. Second, Sec. 1307(c) might allow the case to be dismissed for "cause." Since a case could possibly be dismissed for cause, a person committing an act constituting cause was never eligible to be a debtor under Chapter 13 and his request for conversion could be denied.

In a display of consistent dedication to text, Justice Alito, joined by Chief Justice Roberts and Justices Scalia and Thomas, dissented. They pointed out that the statutory language is "clear" and "unambiguously provides that a debtor who has filed a bankruptcy petition under Chapter 7 has a broad right to convert the case to another chapter." He also pointed out that the word "eligible" under Sec. 706(d) refers to eligibility under Sec. 109(e), which is appropriately titled "Who may be a debtor." Sec. 1307(c) is not an eligibility provision, but rather a device for weeding out eligible but deficient cases. "...Sec. 1307(c) plainly does not set out requirements that an individual must meet in order to 'be a debtor' under Chapter 13. Instead, Sec. 1307(c) sets out the standard ('cause') that a bankruptcy court must apply in deciding whether, in its discretion, an already filed Chapter 13 case should be dismissed or converted to Chapter 7."

The dissent also points out that the majority mistakenly decided that "following the literal terms of the Code would be pointless." Justice Alito pointed out that by denying the right to convert, the majority would deprive a debtor of the ability to propose a plan and convince the court that the plan was filed in good faith. He concluded that, "Today's opinion renders these questions academic, and little is left to guide what a bankruptcy court must consider, or may disregard in blocking a Sec. 706(a) conversion."

This is a case where the conservative justices, with their emphasis on following the text, have the better argument. In trying to simplify procedure in the specific circumstance before them, the majority has muddied the law in several important respects:

1. The court has confused eligibility to file a case with the ability to remain in that case once filed. An ineligible debtor has no right to file. However, a debtor who has committed acts which could rise to the level of cause is at least entitled to file his case and try to convince creditors and the court that he can do better for them in the current chapter. Whether "cause" exists will not be readily apparent until after the court examines the debtor's conduct in the current chapter, i.e., whether he is using chapter 13 for the good faith purpose of paying his creditors or as a continuation of his efforts to evade creditors. Because "cause" often cannot be determined at the outset of a case, it should not form the basis for eligibility to file or convert.

2. From a procedural point of view, the Supreme Court has required the "cause" determination to be made too early. If the court must determine whether "cause" to reconvert the case exists at the time of the original request for conversion, the court is making its decision based on a hypothetical set of facts. While the debtor may be able to talk about what he would do in a potential Chapter 13 case, the court would not have the benefit of seeing the actual plan proposed by the debtor or gaining the input of the Chapter 13 Trustee on that plan.

3. Finally, the Supreme Court blithely stated that federal courts are "virtually unanimous" that pre-petition bad faith conduct may forfeit the right to proceed in Chapter 13. This is not really very accurate. Indeed, some of the "virtually unanimous" cases cited by the Supreme Court dealing with pre-petition bad faith conduct do not actually support the proposition. For example, In re Alt, 305 F.3d 413 (6th Cir. 2002) relied upon a totality of the circumstances test and focused primarily upon the debtor's failure to schedule a known claim. Similarly In re Leavitt, 171 F.3d 1219 (9th Cir. 1999) relied upon a totality of the circumstances test and gave the most emphasis to the debtor's failure to schedule assets, overstated expenses and refusal to amend his plan. Most bad-faith cases rely on a combination of both pre-petition and post-petition conduct. It seems that the Supreme Court has confused general bad faith with pre-petition bad faith. This would be a huge mistake. While bankruptcy is generally designed to benefit the "honest but unfortunate" debtor, Chapter 13 has traditionally been a forum where the previously dishonest debtor may repent and amend his ways to the benefit of both himself and his creditors. Allowing Chapter 13 cases to be dismissed solely based upon pre-petition conduct would be a significant shift in bankruptcy policy.