Tuesday, November 11, 2008

The Now-Limited Right to Convert from Chapter 7 to 13, & from Chapter 13 to 7: the U.S. Supreme Court's Marrama and the 9th Circuit's Rosson Opinions

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys, Andy@BLSforAttorneys.com

Marrama v. Citizens Bank of Massachusetts
127 S.Ct. 1105
Decided February 21, 2007

In a Bulletin on this website in September entitled There's An Absolute Right for a Debtor to Dismiss a Chapter 13 Case, Right? NO, the Ninth Circuit Said on 9/24/08, I summarized the Ninth Circuit opinion Rosson v. Fitzgerald (In re Rosson),---- F. 3d ----, 2008 WL 4330558 (9th Cir 2008), which addressed conversion of a Chapter 13 case to a Chapter 7 one. In that opinion the Ninth Circuit expressly overturned a long-standing Ninth Circuit BAP opinion, based on the authority of the 2007 U.S. Supreme Court Marrama opinion cited above. Marrama dealt with conversion of a Chapter 7 case to Chapter 13, while Rosson dealt with conversion from Chapter 13 to 7. Because of its differences from and broader application than Rosson, and simply because it is one of the relatively rare Supreme Court bankruptcy opinions, Marrama is definitely worth knowing well.

Supreme Court Holding
Marrama involved the right of a debtor to convert a Chapter 7 case to Chapter 13 under § 706(a). The Supreme Court held "that the right to convert to Chapter 13 was impliedly limited by the bankruptcy court’s power to take any action necessary to prevent bad-faith conduct or abuse of the bankruptcy process."

The Facts and Procedural Context
This opinion provides a vague standard for determining when debtors have a right to convert to Chapter 13, but its very vagueness demands that it be well understood in order to be able to counsel clients on this issue. So knowing the facts in this opinion--the specific "bad-faith conduct or abuse of the bankruptcy process" which confronted the Supreme Court here--is critical.

The debtor filed a Chapter 7 case showing that he was the sole beneficiary of a trust that owned a residence with no value as to him personally. He also stated in his documents or at the Meeting of Creditors that he had not transferred any assets in the year before filing, had no tax refunds pending, and no debts owed to him. In fact, the residence "had substantial value, and Marrama had transferred it into the newly created trust for no consideration seven months prior to filing his Chapter 13 petition," with the intent of protecting it from his creditors. And months before the case was filed, he had submitted to the IRS an amended tax return showing a refund, which ended up being more than $8,700. Mr. Marrama was clearly not a forthright debtor.

Yet he sought to convert to Chapter 13 on the basis that he became employed in the meantime, with the primary argument that he had an absolute right to convert under the plain language of §706(a) of the Code. The bankruptcy court disagreed and denied his motion to convert, holding that debtor's concealment of assets constituted bad faith. The BAP affirmed, as did the First Circuit Court of Appeals. And yet in spite of all this unanimity in the lower courts, this was a 5-4 decision at the Supreme Court, with the more "liberal" and "centrist" members of the Court--Stevens, Kennedy, Souter, Ginsburg, and Breyer, siding in favor of the trustee and a creditor against the debtor, while the "conservative" members--Alito, Roberts, Scalia, and Thomas--sided with the debtor.

The Statute
In essence this was a dispute about statutory construction. The pertinent statutes are subsections (a) and (d) of §706, which provide:
(a) 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.
(d) Notwithstanding any other provision of this section, 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.
The Majority's Rationale
Justice Stevens' majority opinion acknowledged that the legislative history of §706 states that "[s]ubsection (a) gives the debtor the one-time absolute right to conversion of a liquidation case to a reorganization or individual repayments plan case." But Stevens' asserts that the direct "reference to an 'absolute right' of conversion is more equivocal that petitioner suggests." His opinion focuses on subsection (d) allowing conversion only if the debtor "may be a debtor" in Chapter 13, and from there argues that conversion to Chapter 13 is not appropriate if the debtor runs afoul of § 1307(c), the provision which governs dismissals and conversions of Chapter 13's "for cause."

§ 1307(c) "includes a nonexclusive list of 10 causes justifying" dismissal or conversion, none of which "mentions prepetition bad-faith conduct."

Bankruptcy courts nevertheless routinely treat dismissal for prepetition bad-faith conduct as implicitly authorized by the words 'for cause.' In practical effect, a ruling that an individual's Chapter 13 case should be dismissed or converted to Chapter 7 because of prepetition bad-faith conduct, including fraudulent acts committed in an earlier Chapter 7 proceeding, is tantamount to a ruling that the individual does not qualify as a debtor under Chapter 13. . . . . The text of §706(d) therefore provides adequate authority for the denial of his motion to convert.
The Court's Dissatisfactory Ambiguity
So what guidance does the majority opinion give to distinguish what Chapter 7 debtors may convert to 13 from those whose "bad-faith" provides "cause" disallow conversion? The answer is intentionally ambiguous: "The class of honest but unfortunate debtors who do possess an absolute right to convert their cases from Chapter 7 to Chapter 13 includes the vast majority of the hundreds of thousands of individuals who file Chapter 7 petitions each year." At that point the Court inserts this footnote: "We have no occasion here to articulate with precision what conduct qualifies as 'bad faith' sufficient to permit a bankruptcy judge to dismiss a Chapter 13 case or to deny conversion from Chapter 7. It suffices to emphasize that the debtor's conduct must, in fact, be atypical." So the Court reiterates "an absolute right to convert . . . to Chapter 13" if the debtor is of the "class of honest but unfortunate debtors," but not if the debtor is "atypical"!

This Bulletin cannot focus nearly as much attention on Justice Alito's dissenting opinion, although it was nearly as long as the majority opinion and arguably better reasoned.

Briefly, the dissent read § 706(a) and (d) plainly to state that a Chapter 7 debtor may convert to Chapter 13 as long as she meets the two "--and only two--" stated conditions: that 1) there have been no prior conversions to Chapter 7 and 2) the debtor meets the necessary conditions to "be a debtor under such chapter [13]." "By contrast, the Code pointedly does not give the bankruptcy courts the authority to deny conversion based on a finding of 'bad faith.' There is no justification for disregarding the Code's scheme."

The dissent asserted that "§706(d)'s requirement that a debtor may convert only if 'the debtor may be a debtor under such chapter' " "obviously refers to the chapter-specific requirements of §109" (which is entitled "Who may be a debtor"). For example, to qualify to be a debtor under Chapter 13, §109(e) refers to the familiar jurisdictional "noncontingent, liquidated" secured and unsecured debt limits for "an individual with regular income" to be able to file a Chapter 13 case. The dissent strongly disagreed with the majority's contrary focus on §1307(c) as a basis for restricting conversion to Chapter 13:

§1307(c) plainly does not set out requirements that an individual must meet in order to 'be a debtor' under Chapter 13. Instead, §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. Thus, the Court's holding in this case finds no support in the terms of the Bankruptcy Code.

by: Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

Please note that this writer is not licensed to practice law in Oregon. This means that he is not legally permitted to give any legal advice or provide and legal services. This Bulletin and the entire contents of this website is written only for attorneys. and is not intended for the public. If any non-attorney is reading this, you must consult an attorney about ANYTHING you read here. Nothing in this website is intended to be nor should be read as being legal advice to anyone.
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