Cases Demonstrate Multiple Ways to Leave Chapter 7

Paul Simon once said that there must be fifty ways to leave your lover.   Two recent cases show that as with failed romances, there are multiple ways to leave chapter 7.     In Torres v. Krueger (Matter of Krueger), No. 14-11135 (5^th Cir. 1/19/16), the Fifth Circuit dismissed a chapter 7 case for “cause” under 11 U.S.C. §707(a), while in In re Karlinger-Smith, No. 15-10214 (Bankr. W.D. Tex. 1/26/16), Judge Tony Davis found that he could have involuntarily converted an individual debtor to chapter 11 but declined to do so. These cases illustrate the variety of ways in which a case filed under chapter 7 can leave that chapter. The opinions can be found here and here.

The Path Out of Chapter 7

Sections 706 and 707 set out the pathway out of chapter 7.   Section 706 governs conversion, while section 707 controls dismissal.

Section 706 contains two options for conversion.    Under 11 U.S.C. §706(a), the debtor may voluntarily convert to chapter 11, 12 or 13 as a matter of right so long as the case has not been previously converted from one of those chapters to chapter 7.  Section 706(b) allows a case to be converted from chapter 7 to chapter 11 on request of a party in interest.    Section 706(c) confirms that a case cannot be converted from chapter 7 to chapter 12 or 13 over the debtor’s objection.   Finally, section 706(d) provides that a debtor may only be converted to a chapter that he is eligible for.    Thus, an individual debtor has the sole decision on whether to convert to chapter 12 or 13 but may be involuntarily placed in a chapter 11 proceeding.

Section 707 contains two ways to dismiss a chapter 7 case.   A consumer debtor’s case may be dismissed under section 707(b) for “abuse” based on the means test with certain exceptions for disabled veterans and other persons serving or who have served in the military.     While section 707(b) is limited to debtors with primarily consumer debts, any debtor may have their case dismissed for “cause” under section 707(a).     The examples of cause given include unreasonable delay, failure to pay the filing fee and failure to file the information required under section 521.   Thus, the examples given involve failure to perform.   However, the statute provides that cause “includes” these examples.

Torres v. Krueger:   The Exit of a Bad Debtor

Torres v. Krueger shows how section 707(a) can work as a backstop when other sections of the Code prove inadequate.    An obviously offended Judge Edith Jones opened the opinion with a reference to the arrogance it took to even bring the appeal.

This appeal of a bankruptcy court decision dismissing a chapter 7 case “for cause” can only be described as an exercise in chutzpah. The debtor flagrantly and repeatedly abused bankruptcy and court processes to retain assets for himself and defeat the legitimate claims of his business partners. The bankruptcy and district courts finally had enough of his manipulation and rightly dismissed pursuant to 11 U.S.C. § 707(a) for the debtor’s bad faith conduct constituting “cause” for dismissal.

Opinion, p. 1.

Krueger and Torres were shareholders in Cru Energy.  After Krueger initiated litigation against Torres, the State District Court entered temporary restraining orders and a temporary injunction barring Krueger from taking any action to affect the business.   Ignoring the injunction, Krueger withdrew over $300,000 from the company’s accounts and formed a new company, Kru Energy.   Faced with an order to show cause why he should not be held in contempt, he filed chapter 7 bankruptcy.

Cru Energy filed a dischargeability complaint and objection to discharge against Krueger.   However, Krueger voted his stock (which was property of the estate) to oust management and fire the lawyers suing him.  Because the company did not have a lawyer, the complaint was dismissed.    With the time to file a complaint having expired, it looked as though Krueger would get away with his scheme.   Torres then moved to dismiss the case under section 707(a).     After an extensive hearing, the Bankruptcy Court dismissed the case with prejudice to refile for two years.

On appeal, Krueger argued that bad faith did not constitute “cause” to dismiss a case under section 707(a).    The Fifth Circuit disagreed.

This circuit joins those courts that have held a debtor’s bad faith in the bankruptcy process can serve as the basis of a dismissal “for cause,” even if the bad faith conduct is arguably encompassed by other provisions of the Code. This is no more than acknowledgement in the chapter 7 context of what has long been recognized: “Every bankruptcy statute since 1898 has incorporated literally, or by judicial interpretation, a standard of good faith for the commencement, prosecution, and confirmation of bankruptcy proceedings.”

Opinion, p. 8.   The Court went on to elaborate what “cause” meant.

Courts have broad authority to determine what is cause for dismissal under § 707(a): “[C]ause is any reason cognizable to the equity power and conscience of the court as constituting an abuse of the bankruptcy process.” (citation omitted). This can include “prepetition bad-faith conduct,” (citation omitted), postpetition bad faith conduct, or petitions that simply serve no legitimate bankruptcy purpose, (citations omitted).

This broad reading of “cause” is faithful to the dictionary meaning of that term, (citation omitted), the customary judicial understanding of that term, and the flexibility traditionally afforded to bankruptcy courts.  (citations omitted)).

 Opinion, pp. 8-9.   

 

The Court had no difficulty finding that cause was present:

Krueger’s case is paradigmatic of the need for cause to include bad faith before, within, and throughout the case. Krueger’s attempt to recast his conduct as a few isolated, questionable acts is unconvincing.6 Krueger’s actions formed a concerted scheme to use the bankruptcy process as both a shield from legitimate state court actions and a sword to retake control of Cru.

***

There is no clear error in the bankruptcy court’s findings. Instead, the record is replete with evidence that Krueger filed bankruptcy for illegitimate purposes, misled the court and other parties, and engaged in bare-knuckle litigation practices, including lying under oath and threatening witnesses. (citation omitted). Krueger offered little evidence besides his own testimony to contravene the strong evidence of his machinations and the bankruptcy court explicitly found he lacked credibility. Even a cold record supports this finding.

***

Under a flexible, totality of the circumstances approach, the court found that Krueger filed chapter 7 because of a criminal contempt proceeding pending against him, because his state court litigation had taken a turn for the worse, and to provide him the cover to retake control of Cru. These “non-economic motives” are “unworthy of bankruptcy protection.” (citation omitted). Once his chapter 7 case commenced, Krueger engaged in conduct designed to manipulate the proceedings to his own ends, including false filings, false testimony, and witness intimidation. His duplicitous behavior is exactly the sort of conduct contemplated by most courts as giving cause for dismissal under § 707(a). Finally, the bankruptcy court weighed the costs of dismissal to creditors and was able to mitigate them through appropriate orders. In light of the court’s balancing inquiry and findings, it cannot be said that the bankruptcy court abused its discretion in dismissing this case.

Opinion, pp. 14, 14-15 and 17.

By embracing the good faith concept in a chapter 7 case, the Court provided another tool for dealing with abusive filings.    The court could have simply ruled that Krueger’s actions in voting the stock violated the automatic stay and were voidable.   That would have solved the initial problem of the disappearing dischargeability action.   However, it seems clear that the Bankruptcy Court and the reviewing courts believed merely undoing Krueger’s actions was not enough.   They appear to have concluded that he was a bad person and they did not want him in their court.

Karlinger-Smith:   Good Faith Debtor Stays in Chapter 7

The court’s findings with regard to the Debtor’s good faith prevented a high income debtor from being involuntarily converted to chapter 11 in In re Karlinger-Smith.

Ms. Karlinger-Smith had a failed veterinary practice.   Over the course of seven years, she managed to pay off all of the creditors from the clinic except for one.     When the U.S. Trustee filed a motion to convert the case to chapter 11, the court stated that while this was possible in theory, he would not do so in the particular case.  

The Court wrote:

Can wage-earners who have sought refuge from creditors, and a fresh start, by filing a chapter 7 liquidation be forced into a chapter 11 reorganization, and be compelled to repay creditors in a five-year plan? In general, yes. But not here, where the Debtors have made extensive and diligent efforts—over a period of seven years—to repay creditors prior to bankruptcy, only to run into one implacable creditor, and where the Debtors have timely paid their taxes and secured creditors.

Opinion, p. 1.

In most circumstances, the case of a doctor with substantial disposable income who was sending her children to an expensive private school might have drawn some skepticism from the Court.   However, in this case, it is clear from the opinion that the debtor made a favorable impression on the court.  

Like many new businesses, the veterinary hospital ultimately failed. Shortly after opening in 2003, the hospital was unable to generate enough cash flow to make timely payments on its outstanding debts.  For a time, though, the business (or the Debtors) continued to make at least some payments to its various creditors. The Debtors also continued to pay their consumer debts while Dr. Karlinger-Smith drew minimal income in her efforts to steady the hospital’s finances. In 2008, however, the Debtors closed the business, and Dr. Karlinger-Smith went to work for a more established veterinary hospital.

But the Debtors did not cut and run on the business debts. Using the services of a credit counseling group, they continued to pay these creditors, and did so at some sacrifice. Indeed, after using their disposable income to pay their creditors “there was usually nothing left at the end of the month.” Although the record is not clear regarding the total amount of business debt the Debtors satisfied after closing the hospital, only the Well Fargo debt now remains.

Opinion,, p. 4 (emphasis added).      Although the debtors attempted to work with their one remaining creditor, they did not reach an agreement.   Just as limitations was about to expire, the creditor filed suit, prompting the bankruptcy.

The United States Trustee filed a Motion to Convert the case to chapter 11.   The Court summarized the parties' positions as follows:

The U.S. Trustee asserts that conversion is appropriate as the debtors have the ability to pay a substantial dividend to their creditors based on their significant disposable income. Further, the U.S. Trustee claims that the debtors are enjoying luxuries that most chapter 7 debtors cannot afford: private school tuition and extracurricular activities for their two children. If these expenses were eliminated, as might be required if the case was converted to chapter 11, the Debtors would be able to pay even more to creditors through a chapter 11 plan. The Debtors contend that the private school tuition, which is paid to Saint Dominic Savio Catholic High School, a school affiliated with the Roman Catholic Diocese of Austin, is a reflection of their deeply held religious beliefs, and therefore not a luxury expense.

 Opinion, p. 6.

After a hearing and subsequent briefing (including an amicus brief from a local debtor's attorney), the Court released its opinion.      The Court noted that section 706(b) was one of several potential remedies.

The US Trustee does not seek dismissal for abuse under section 707(b), which is not available because the Debtors do not have primarily consumer debts.32 Nor does the US Trustee seek dismissal for cause under section 707(a). Instead, the U.S. Trustee seeks conversion under section 706(b) because the Debtors have disposable income. Section 706(b) allows the Court to convert a chapter 7 case to a chapter 11 case “[o]n request of a party in interest . . . .”

Opinion, p7.    The Court then pondered which standard to apply.

Unlike the detailed requirements for dismissal under section 707(b), and unlike dismissal under section 707(a), which at least requires “cause,” there are no statutory standards for conversion under section 706. Only two limitations are provided: the court cannot convert to chapter 12 or 13 without the debtor’s consent, and the debtor must qualify to be a debtor under the chapter to which the case is being converted.33 Nearly 30 years ago, interpreting identical language and citing legislative history, the Fifth Circuit stated that in considering a decision to convert from chapter 7 to chapter 11, over the debtor’s objection, the bankruptcy court should exercise its discretion “based on [a] determination of what will most inure to the benefit of all parties in interest.”

The Fifth Circuit’s directive to examine the “benefit to all parties in interest” suggests not an inquiry solely into the best interests of the creditors, or even the best interests of the estate, but rather a broader inquiry into what will collectively benefit the debtor, the creditors, and any other parties with a stake in the case.  Thus, the decision should not be made based on the interests of any one party or class of parties.

 Opinion, pp. 7-8.

Having explained the "benefits to all parties in interest" standard, the Court rejected cases holding that section 706(b) could not be used to involuntarily convert an individual debtor with primarily business debts into chapter 11.

First, section 706 contains no reference to, and is therefore not expressly limited by, section 707(b). Second, section 706 already has two express limits: the debtor must be eligible to be a debtor in the chapter to which conversion is sought, and no debtor can be forced into a chapter 12 or 13 case. The latter of these express limits is most instructive—it suggests that Congress considered whether limits should apply to forced conversion of individual debtors, and put a limit—debtor consent—on conversion to chapter 12 or 13, but did not limit conversion to chapter 11.  

Nor is there any inconsistency between granting conversion under section 706(b) and refusing to dismiss under section 707(b). One governs involuntary conversion of any chapter 7 case to a chapter 11 case; the other governs dismissal of a chapter 7 case involving primarily consumer debt. Although Congress placed additional limits on the availability of chapter 7 relief to debtors with primarily consumer debts through the BAFJA and BAPCPA amendments to 707(b), neither act changed the language of section 706(b) or purported to expand or contract the eligibility of non-consumer debtors for chapter 7 relief.   This is not to suggest that the elements of section 707(b) are not relevant to the court’s exercise of discretion under section 706. For example, the Debtors’ income and ability to pay are highly relevant in determining whether conversion would benefit all parties.

Opinion, pp. 10-11.    Thus, the Court held that it is possible to force a debtor to choose between proposing a plan under chapter 11 or foregoing bankruptcy relief.    However, in the current case, the court found that there was no net benefit to conversion.   On the one hand, the payment of income from the debtors to their creditors was a zero-sum transfer.  However, the cost of the chapter 11 process would mean that the cost to the debtors would be greater than the benefit to their creditors.   Further, the court doubted whether the debtors would be incentivized to work for the benefit of their creditors for five years.

But here there is no evidence of any benefit to the Debtors or a net benefit to parties in interest considered as a whole. All the Court would accomplish by converting this case is the zero-sum transfer of some portion of the Debtors’ future income to creditors, at the cost of the chapter 11 process. Taken as a whole, the parties in interest will be worse off. And absent some benefit to the Debtors, however small or intangible, it is difficult to see how the Debtors will be incented to work as productively as they are now for five years, when all their disposable income is being directed to creditors against their will. This is by no means a determinative factor, but it is significant. Veterinarians and teachers, like most wage-earners, work hard at their jobs and they do so to support their families and provide for their futures. This is part of the reason wage earners cannot be forced into chapter 13. And while wage-earners can be forced into chapter 11, it would be a poor exercise of discretion not to take a lack of benefit to the debtor—and concomitant lack of incentive—into consideration.

Opinion, p. 12.    The Court also found that another factor weighing against conversion to chapter 11 was the debtor's failed negotiations with Wells Fargo.   The court found that "it therefore seems likely that Wells Fargo will be an active player in any chapter 11 case" and might object to the debtor's expenses.     The Court dismissed Wells Fargo's representations that would not object to the Debtors' current budget and would vote for a plan that complied with the Bankruptcy Code, stating that "that only begs the question of what the Bankruptcy Code requires in individual chapter 11 cases."    

In conclusion, the Court stated:

These Debtors responsibly, diligently, and successfully paid much of their business debt
outside bankruptcy, and at no small personal sacrifice. The Debtors paid their taxes on time and in full. Of all their business creditors, only Wells Fargo remained unsatisfied by the Debtors’ efforts, and only Wells Fargo resorted to the prepetition lawsuit that pushed the Debtors into bankruptcy. And yet, Wells Fargo did not join the U.S. Trustee’s motion and offered no evidence in support of that motion. Under these unusual circumstances, the Court is unable to find the requisite benefit inuring to all parties in interest that would support conversion to chapter 11.

Opinion, p. 15.

While some of the Court's reasoning is quite interesting, it is important to note that the Court appeared to be quite impressed with the debtors' character and work ethic.   This is in stark contrast to the Debtor in Krueger v. Torres who the Fifth Circuit found to possess many negative and unredeeming traits.    These outcomes are not surprising.   Because neither section 707(a) nor section706(b) contain a definite standard, they entail an equitable balancing.   In this balancing, the character of the debtor is likely to tip the scale.   

Disclosure:   In Karlinger-Smith, my firm represented the creditor and I assisted with the briefing.