By: Donald L Swanson

There are two bankruptcy court opinions—issued a week apart.  One converts a Chapter 11 case, involuntarily, to a case under Chapter 7.  The Chapter 11 Debtor in the other opinion survives a similar conversion effort—but just barely and due to unique circumstances.

A comparison and contrast of these two opinions is instructive on the types of circumstances that result in conversion vs. the types of circumstances that don’t.  Accordingly, what follows is a summary of the two opinions.

Converting Chapter 11 Case to Chapter 7

The conversion opinion is in the Subchapter V case of In re Gabbidon Builders, LLC, Case No. 20-30845, Western District of North Carolina Bankruptcy Court (issued May 14, 2021, Doc. 175).

A motion is filed to convert Debtor’s case to Chapter 7.

–Inadequate Plan Provisions

Debtor’s Plan proposes to sell a real estate lot and use the net proceeds to, (i) pay creditors $10,000 each (the remaining claim amounts are to be paid under the Plan), and (ii) use the rest of the net proceeds to purchase a second lot, upon which Debtor would build a 4,300 square foot house, then sell the house and use the profit to continue funding the Plan.

The Court is skeptical of such a proposal because “there is no evidence to support a conclusion that the sale of the Property is imminent.”  Instead, the Debtor’s history on sale of the lot is:

• Debtor’s first Motion for approval of sale raises objections and is withdrawn;
• Debtor’s second Motion for sale of the same lot also raises objections but is approved anyway at a price of $260,000;
• The approved sale falls through, but Debtor fails to inform anyone until the hearing on the conversion motion; and
• At the conversion hearing, Debtor’s representative “conveniently testified” about a new contract for sale at the same $265,000 price—but Debtor had not filed a motion for approval of the new sale and does not produce any supporting documentation in evidence.

The Court finds Debtor’s Plan to be unrealistic and unconfirmable because, for example:

• Debtor will use proceeds from sale of the lot to purchase another lot for $60,000—but the Court finds no reliable evidence of the existence of the additional vacant lot, or an ability to purchase it for that price, or an ability to construct a home on it at a profit;
• Debtor will pay $6,355 every month to creditors—an amount that cannot be supported by Debtor’s financial history;
• Debtor’s representative blames prior losses on the pandemic and declares that business is now “booming”– the Court finds such representations unreliable; and
• Debtor has commingled funds with non-debtor affiliates, ignored corporate formalities between affiliates, payed personal expenses with business funds, and been unable to properly project income and expenses.

–Motion to Convert

Motions to convert a Chapter 11 case to Chapter 7 are often granted, for “cause,” when (i) the debtor has no profitable core around which to reorganize, or (ii) debtor cannot or will not formulate a reasonable plan.

Also, “cause” for conversion includes gross mismanagement of the estate and substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation (§ 1112(b)(4)).

The Court finds and concludes that “cause” exists for conversion to Chapter 7 because:

1. Debtor has no profitable core around which to structure a reorganization;
2. Debtor’s cash position has always been precarious, causing any potential dividend to creditors to diminish;
3. Debtor’s repeated failures to account for expenses indicate Debtor is not equipped to become profitable or to safeguard the estate; and
4. Debtor’s failure to timely apprise the Court of critical information shows that Debtor does not exercise the diligence required of a Chapter 11 debtor.

In sum, Debtor has engaged in gross mismanagement, diminution of the estate exists, there is no reasonable likelihood of rehabilitation, and conversion is in the best interest of creditors so that a chapter 7 trustee can liquidate Debtor’s assets and distribute the proceeds to creditors.

Accordingly, the motion to convert the case to Chapter 7 is granted.

Denying Conversion of Chapter 11 Case to Chapter 7

The conversion-denial opinion is in the Subchapter V case of In re Neosho Concrete Products Co., Case No. 20-30314, Western District of Missouri Bankruptcy Court (issued May 6, 2021, Doc. 176).

The Bankruptcy Court is asked to convert the case to chapter 7 “for cause” under 11 U.S.C. § 1112(b).  

–Legal Standards for Conversion

Governing rules for a conversion motion include:

• The movant bears the burden of proof—if satisfied, the burden shifts to Debtor to produce rebuttal evidence; and
• dismissal or conversion to chapter 7, “whichever is in the best interest of creditors and the estate,” is required when the movant establishes “cause”—the court has broad discretion.

 “Cause” includes “substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation” (§ 1112(b)(4)(A)).  The purpose is to preserve estate assets by preventing a debtor from gambling on the enterprise, at creditors’ expense, when there is no hope of rehabilitation.

“Cause” of this type is explained further:

• Post-petition negative cash flow may be sufficient to establish loss or diminution—especially when debtor ceases business operations and liquidates its assets—because losses come straight from the pockets of creditors;
• A loss is “substantial” when sufficiently large to materially impact the bankruptcy estate and interests of creditors; and 
• A “continuing” loss exists when it is uninterrupted and persisting into the future.

–Conversion Argument and Ruling

The conversion argument in Neosho is based on continuing post-petition losses:

1. Debtor’s earned revenue comes exclusively from small-scale sales of inventory;
2. Debtor is incurring attorneys’ fees and costs to, (i) prosecute an adversary proceeding against Owens Corning, and (ii) continue in chapter 11; and
3. Debtor’s operating bank account balances continue to decline.

–Unique Circumstances

In response, the Bankruptcy Court opines:

• “Under other circumstances, the court might agree” that Debtor’s negative cash flow would establish grounds for conversion; but
• “the unique circumstances of this case compel a different conclusion.”

The unique circumstances in this case include:

• When Owens Corning terminated its supply agreement with Debtor before bankruptcy, Debtor (i) suddenly lost its primary source of revenue and could not fund operations, and (ii) had 20,470 tons of waste materials blighting its property—Debtor filed this bankruptcy case to ameliorate both problems; and
• In bankruptcy, Debtor tried to negotiate a new supply agreement with Owens Corning—reasonably believing it would be successful, thinking it actually had a new agreement, and filing an adversary to enforce the new agreement.

–No Substantial or Continuing Losses

The following circumstances prevent the court from characterizing Debtor’s ongoing administrative expenses as “substantial or continuing” losses:

1. Debtor’s ongoing administrative expenses are not substantial;
2. Due to the waste materials and its high cost of remediation, very little value would be available to unsecured creditors if the estate were liquidated;
3. Unless Debtor or a trustee creates value by litigating against Owens Corning or from avoidance actions, the estate and unsecured creditors have little to lose—and administrative claimants are bearing the primary risk of nonpayment;
4. A Chapter 7 trustee is likely to abandon any cause of action against Owens Corning, together with Debtor’s blighted premises, which would deprive unsecured creditors of any value and leave the premises blighted; and
5. In contrast, by remaining in chapter 11, Debtor proposes to generate value through ongoing operations and from an insider’s voluntary reimbursement of alleged preferential transfers, with the hope of resuming operations, remediating the waste, and paving the way for a successful reorganization.

–Reasonable Likelihood of Rehabilitation Exists

In evaluating whether “a reasonable likelihood of rehabilitation” exists, a court must weigh whether the debtor’s business prospects justify continuance of the reorganization effort: e.g., whether debtor’s continuing losses can be corrected and whether the necessary remediation can be performed.

In this case, the evidence shows only the status of Debtor’s negotiations with Owens Corning, which does not establish Debtor’s business prospects.  Debtor might be able to find an alternative path to reorganization—it is too early to determine otherwise.

Consequently, the court denies the motion to convert, without prejudice.

Conclusion

The two opinions summarized above present a comparison and contrast on differences between:

• a case that gets converted, involuntarily, from Chapter 11 to Chapter 7; and
• a case that survives a similar conversion effort, at least temporarily, because of unique circumstances.

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