§ 146.2     Strategic Considerations: Costs and Benefits of Conversion to Chapter 11
Cite as:    Keith M. Lundin, Lundin On Chapter 13, § 146.2, at ¶ ____, LundinOnChapter13.com (last visited __________).
[1]

For debtors, the main attractions of Chapter 11 have been the ability to handle more debt and the power to modify the rights of secured claim holders in ways that were not possible in a Chapter 13 case. These attractions were stronger prior to the Bankruptcy Reform Act of 1994.

[2]

In 1994, Congress increased the debt limitations for Chapter 13 and provided for (modest) automatic increases on April 1, 1998, and every three years thereafter.1 The increased debt limits will make some individual debtors eligible for Chapter 13 who could only reorganize in a Chapter 11 case under prior law.

[3]

Before the 1994 Act, there was no restriction in Chapter 11 like § 1322(b)(2) to prohibit modification of a claim secured only by a security interest in the debtor’s principal residence.2 In cases filed before October 22, 1994, a Chapter 13 debtor could avoid the prohibition on modification in § 1322(b)(2) and avoid the Supreme Court’s interpretation of § 1322(b)(2) in Nobelman v. American Savings Bank3 by converting to Chapter 11. After conversion, the debtor could bifurcate and strip down an undersecured mortgage notwithstanding that the lienholder would be protected from that modification in a Chapter 13 case.4 The Bankruptcy Reform Act of 1994 amended § 1123(b)(5) to impose the same restriction on modification of claims secured only by real property that is the debtor’s principal residence that always existed in Chapter 13 cases under § 1322(b)(2).5 In Chapter 13 cases filed after October 22, 1994, conversion to Chapter 11 will not enable the debtor to modify a home mortgage that was protected from modification in the Chapter 13 case.

[4]

Incentive to convert from Chapter 13 to Chapter 11 remains after the 1994 amendments for the debtor with a large secured claim other than a home mortgage that cannot be paid within the five-year maximum duration of a Chapter 13 plan.6 The debtor with a large secured claim that is not protected from modification by § 1123(b)(5) can manage that claim in a Chapter 11 case over a period of years longer than the five-year maximum permitted under a Chapter 13 plan.

[5]

The 1994 amendments to § 348 of the Code apply at conversion from Chapter 13 to Chapter 11. As detailed above,7 at conversion in good faith of a Chapter 13 case filed after October 22, 1994, § 348(f)(1)(A) redefines the estate in the converted case as “property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”8 Valuations of property and of allowed secured claims in the Chapter 13 case “shall apply in the converted case, with allowed secured claims reduced to the extent that they have been paid in accordance with the Chapter 13 plan.”9 If conversion was “in bad faith,” then the estate in the converted case “shall consist of the property of the estate as of the date of conversion.”10 The legislative history indicates that § 348(f)(1)(A) and (f)(2) were intended to clarify fractured case law with respect to the content of the estate at conversion from Chapter 13 to Chapter 7.11 However, as written, the 1994 amendments to § 348(f) also affect property of the estate, valuations of property and the allowed amount of secured claims at conversion from Chapter 13 to Chapter 11.

[6]

The effects may be less dramatic because a Chapter 13 case can be converted to Chapter 11 only “before confirmation.”12 However, if conversion occurs after the Chapter 13 court has valued collateral or allowed secured claims, § 348(f) will apply those determinations in the Chapter 11 case. The passage of time during the Chapter 13 case may change the content of the Chapter 11 estate because of the redefinition of the estate at conversion under § 348(f)(1)(A) and (2).13 Strategic conversion to Chapter 11 might attract an aggressive Chapter 13 debtor who acquires an asset during the Chapter 13 case that would escape inclusion in property of the Chapter 11 estate at conversion under § 348(f)(1)(A).14

[7]

Individual debtors not engaged in business will no longer encounter the problem that many courts were reluctant to allow Chapter 11 cases that did not involve the reorganization of a business.15 The debtor will face the expense and complication of a disclosure statement and plan, noticing all creditors and voting. If the Chapter 11 plan deals with a large secured claim and absent the agreement of the claim holder, the debtor will have to satisfy the “fair and equitable” standard for cramdown under § 1129(b)(2). Some of the same limitations on curing default and rehabilitating long-term debts that apply in Chapter 13 cases have been applied in Chapter 11 after conversion from Chapter 13.16

[8]

The Bankruptcy Reform Act of 1994 defined the outer limits of a Chapter 13 debtor’s power to cure mortgage defaults under § 1322(b)(3) or (b)(5) as “until such residence is sold at a foreclosure sale that is conducted in accordance with applicable nonbankruptcy law.”17 This new boundary is applicable in Chapter 13 cases filed after October 22, 1994. There was no analogous amendment of Chapter 11 in the 1994 Act. It is conceivable that courts will limit the power of a Chapter 11 debtor to cure default with respect to home mortgages in ways that are more or less restrictive than the rule for Chapter 13 cases in § 1322(c)(1). The 1994 amendment to § 1322(e) that addressed the problem of “interest on interest” in Chapter 13 cases after Rake v. Wade18 does have a Chapter 11 analogue—the 1994 Act also amended 11 U.S.C. § 1123(d) to define the amount necessary to cure default in a Chapter 11 case in the same terms as in § 1322(e).19

[9]

Chapter 11 has some advantages from the standpoint of creditors. It is possible to cause the appointment of a trustee who will manage the debtor’s assets or operate the debtor’s business in a Chapter 11 case.20 When the Chapter 13 debtor is engaged in business and there is evidence of mismanagement, a creditor’s motion to convert to Chapter 11 faces the debtor with the choice of dismissing and dealing with creditors outside bankruptcy or risking loss of control of management of the business.

[10]

Once the debtor is in Chapter 11, the case cannot be voluntarily dismissed without a fight;21 a Chapter 13 case can be voluntarily dismissed by the debtor at any time.22 Thus, it is possible to “trap” the debtor in a Chapter 11 case by conversion from Chapter 13, then dispossess the debtor through the appointment of a trustee. All of this is theoretically possible—the debtor is likely to see it coming and move to dismiss the Chapter 13 case before conversion to Chapter 11 can be accomplished.23 Also, even if the creditor is successful in a motion to convert to Chapter 11, all creditors then face an involuntary Chapter 11 debtor. The cost of appointment of a trustee in the Chapter 11 case, proposing a creditor’s plan and so forth is likely to exceed the stakes, given the jurisdictional limits on the original Chapter 13 case.

[11]

Another advantage for creditors is that there are more exceptions to the dischargeability of debts in Chapter 11 than in Chapter 13.24 The holder of a claim that would be nondischargeable in a Chapter 11 case may gain some strategic advantages by moving to convert the Chapter 13 case—the threat itself may prompt the debtor to propose a greater percentage of repayment in the Chapter 13 case.

[12]

Conversion from Chapter 13 to Chapter 11 does not empower the debtor to manage a business or make payments to creditors in a manner that is different than during the Chapter 13 case. For example, the bankruptcy court in In re Lively25 held that after conversion from Chapter 13 to Chapter 11, the debtors could not pay prepetition installment debts except to provide court-ordered adequate protection to a lienholder. On the other hand, after conversion from Chapter 13 to Chapter 11, the debtor is clothed with all of the powers of a trustee under Chapters 3 and 5 of the Bankruptcy Code—a substantially broader menu of authority to avoid transfers, recover property and borrow money than is available to a Chapter 13 debtor.26

[13]

Conversion from Chapter 13 to Chapter 11 does not constitute the filing of a “petition” for purposes of the automatic stay in § 362. Conversion from Chapter 13 to Chapter 11 after relief from the stay does not impose or “reimpose” the stay in the Chapter 11 case.27 Because there is no codebtor stay like § 1301 in a Chapter 11 case,28 after conversion from Chapter 13 to Chapter 11, a creditor does not need relief from the stay to proceed against a codebtor or the codebtor’s property.29

[14]

Consistent with the majority of cases discussing conversion from Chapter 13 to Chapter 7,30 conversion from Chapter 13 to Chapter 11 does not entitle creditors to a new 30-day period within which to object to exemptions.31

[15]

Conversion from Chapter 13 to Chapter 11 can create some problems for debtor’s counsel. No provision of the Bankruptcy Code requires court approval to hire debtor’s counsel during the Chapter 13 case. After conversion to Chapter 11, § 327(a) requires court approval of the debtor’s employment of an attorney.32 To be eligible as debtor’s counsel in the Chapter 11 case, the attorney must be a “disinterested person.”33 It has been held that, after conversion to Chapter 11, debtor’s attorney is not a disinterested person if there are unpaid attorney’s fees from the Chapter 13 case.34

[16]

One especially controversial bankruptcy case from the U.S. Court of Appeals for the Ninth Circuit involved conversion of a Chapter 13 case to Chapter 11. In Gruntz v. County of Los Angeles (In re Gruntz),35 the debtor, a lawyer, filed a Chapter 13 case that included delinquent child support. The debtor converted to Chapter 11. The district attorney then prosecuted the debtor for criminal nonsupport. The debtor argued that the automatic stay prohibited the prosecution because the district attorney’s office had offered a suspended sentence if he pleaded guilty and paid the back child support. A California state court rejected the debtor’s automatic stay argument, and a jury found the debtor guilty. The debtor twice brought adversary proceedings in the bankruptcy court trying to stop the state court prosecution.

[17]

The bankruptcy court held that the state court determination that the criminal prosecution did not violate the automatic stay precluded the debtor’s adversary proceeding. The district court dismissed the debtor’s complaint on the basis of the Rooker-Feldman doctrine. The Ninth Circuit, en banc, held that the state court was without jurisdiction altogether to determine whether the automatic stay applied. In the process, the Ninth Circuit overruled its earlier decision in In re Hucke,36 which was often cited for the proposition that a criminal prosecution is subject to the automatic stay if the purpose of the prosecution was collection of debt.

[18]

Gruntz is sure to get much attention for its provocative holding with respect to the jurisdiction of state courts and the automatic stay. The case began as an (ordinary?) Chapter 13 case that converted to Chapter 11 and, some would say, spiraled out of control from there.


 

1  See § 11.1 [ Dollar Amounts ] § 14.1  Dollar Amounts.

 

2  See § 118.1 [ Most Home Mortgages Cannot Be Modified: § 1322(b)(2) and Nobelman ] § 79.1  Most Home Mortgages Cannot Be Modified: § 1322(b)(2) and Nobelman. Compare 11 U.S.C. § 1123 (prior to amendment in 1994).

 

3  508 U.S. 324, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993).

 

4  See Wade v. Bradford (In re Bradford), 39 F.3d 1126 (10th Cir. 1994).

 

5  11 U.S.C. § 1123(b)(5), as amended by the Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 206, 108 Stat. 4106 (1994), provides that a Chapter 11 plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence.”

 

6  See discussion beginning at § 112.1  General Rule: Three Years, More or Less.

 

7  See § 143.2  In Cases Filed after October 22, 1994, § 144.1  Exemptions at Conversion§ 145.2  In Cases Filed after October 22, 1994 and § 145.3  Lienholders’ Rights at Conversion under § 348(f) after BAPCPA.

 

8  11 U.S.C. § 348(f)(1)(A). See § 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

9  11 U.S.C. § 348(f)(1)(B). See § 145.2  In Cases Filed after October 22, 1994 and § 145.3  Lienholders’ Rights at Conversion under § 348(f) after BAPCPA.

 

10  11 U.S.C. § 348(f)(2). See § 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

11  See §§ 315.1 [ In Cases Filed before October 22, 1994 ] § 143.1  In Cases Filed before October 22, 1994 and 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

12  11 U.S.C. § 1307(d). See § 321.1 [ Standing, Procedure and Grounds for Conversion to Chapter 11 ] § 146.1  Standing, Procedure and Grounds for Conversion to Chapter 11.

 

13  See § 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

14  An opportunistic conversion might be “in bad faith,” which would invoke the alternative definition of property of the estate in the converted case under § 348(f)(2). See § 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

15  See Toibb v. Radloff, 501 U.S. 157, 111 S. Ct. 2197, 115 L. Ed. 2d 145 (1991) (Individual not engaged in business is eligible for Chapter 11.). Compare Wamsganz v. Boatmen’s Bank of DeSoto, 804 F.2d 503 (8th Cir. 1986); In re Winshall Settlor’s Trust, 758 F.2d 1136 (6th Cir. 1985); In re Dolton Lodge Trust No. 35188, 22 B.R. 918 (Bankr. N.D. Ill. 1982); In re Ponn Realty Trust, 4 B.R. 226 (Bankr. D. Mass. 1980).

 

16  See, e.g., In re Marshall, 54 B.R. 309 (Bankr. W.D. Mich. 1985) (Conversion from Chapter 13 to Chapter 11 does not enhance the debtor’s ability to cure default and reinstate a home mortgage. The rule announced in Federal Land Bank of Louisville v. Glenn (In re Glenn), 760 F.2d 1428 (6th Cir.), cert. denied, 474 U.S. 849, 106 S. Ct. 144, 88 L. Ed. 2d 119 (1985), applies in both chapters.).

 

17  11 U.S.C. § 1322(c)(1), as amended by Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 301, 108 Stat. 4106 (1994). See § 130.1 [ Prepetition Defaults ] § 82.1  Prepetition Defaults—When is Property “Sold” at Foreclosure?.

 

18  508 U.S. 464, 113 S. Ct. 2187, 124 L. Ed. 2d 424 (1993). See §§ 134.1 [ In General: Rake and Contracts before October 22, 1994 ] § 83.1  In General: Rake and Contracts before October 22, 1994 and 135.1 [ Section 1322(e): Contracts after October 22, 1994 ] § 83.2  Section 1322(e): Contracts after October 22, 1994.

 

19  See Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 305, 108 Stat. 4106 (1994), discussed in § 135.1 [ Section 1322(e): Contracts after October 22, 1994 ] § 83.2  Section 1322(e): Contracts after October 22, 1994.

 

20  See 11 U.S.C. § 1104. See, e.g., In re Kaziz, 256 B.R. 242, 244–45 (Bankr. D. Mass. 2000) (Court sua sponte converts Chapter 13 case to Chapter 11 and appoints a trustee. Debtor was in the fur sales and storage business. Chapter 13 case was pending from June 1999 to September 2000 without confirmation, and debtor did not pay sales or payroll taxes. On the Chapter 13 trustee’s motion to dismiss, court converts to Chapter 11: “no party, including the Chapter 13 Trustee, requested conversion of the case. . . . Section 105(a) . . . gives the Court discretion in the implementation of the meaning and spirit of the entire Bankruptcy Code, including Section 1307(d). . . . [T]he more the Court heard about the case at bar, the more convinced the Court became of the need for conversion so that the Debtor’s desire that his business continue to operate would be accommodated while the creditors would be protected, at least to some extent, by the watchful eye of a Chapter 11 Trustee.”). See also In re Snell, 227 B.R. 127 (Bankr. S.D. Ohio 1998) (That the court would be obligated to immediately appoint a trustee if the case were converted to Chapter 11 is one reason given for denying the debtor’s oral motion to convert to Chapter 11 and granting the Chapter 13 trustee’s written motion for conversion to Chapter 7.).

 

21  See 11 U.S.C. § 1112(b).

 

22  See discussion beginning at § 151.1  Procedure, Timing and Form.

 

23  See § 330.1 [ Absolute Right of Debtor? ] § 151.2  Absolute Right of Debtor?.

 

24  Compare 11 U.S.C. § 1141(d)(2), with 11 U.S.C. § 1328(a)(2).

 

25  266 B.R. 209 (Bankr. N.D. Okla. 1998).

 

26  Compare 11 U.S.C. § 1107(a) (“A debtor-in-possession shall have all the rights . . . and powers. . . of a trustee serving in a case under this chapter.”), with 11 U.S.C. § 1303 (“The debtor shall have . . . the rights and powers of a trustee under §§ 363(b), 363(d), 363(e), 363(f), and 363(l), of this title.”). See also § 8.5  Other Chapters Too Expensive, Too Complicated or Unfriendly for further discussion of differences between Chapter 11 and Chapter 13 cases.

 

27  See Ramirez v. Whelan (In re Ramirez), 188 B.R. 413 (B.A.P. 9th Cir. 1995).

 

28  See discussion beginning at § 65.1  Cosigners and Joint Obligors Are Protected for discussion of the codebtor stay.

 

29  See, e.g., In re Lennington, 286 B.R. 672 (Bankr. C.D. Ill. 2001) (Conversion from Chapter 13 to Chapter 11 eliminated argument that § 1301 prohibited a bank from foreclosing on a certificate of deposit pledged by in-laws to secure a loan to the debtors.).

 

30  See § 317.1 [ Exemptions at Conversion ] § 144.1  Exemptions at Conversion.

 

31  See In re Page, 240 B.R. 548, 549 (Bankr. W.D. Mich. 1999) (“Although the cases are not unanimous, the better reasoned decisions hold that the 30-day period for objecting to exemptions commences at the conclusion of the ‘first’ first meeting of creditors, and not at the conclusion of any subsequent meetings that may be held as a consequence of a conversion of the case from one chapter to another.”).

 

32  11 U.S.C. § 327(a) provides: “The trustee, with the court’s approval, may employ one or more attorneys.”

 

33  11 U.S.C. § 327(a).

 

34  In re Dugger, No. 97-30410, 1999 WL 33486706 (Bankr. D. Idaho Mar. 5, 1999) (unpublished).

 

35  166 F.3d 1020 (9th Cir.), as amended, 177 F.3d 728 (9th Cir.), withdrawn and reh’g granted, 177 F.3d 729 (9th Cir. 1999), after reh’g en banc, 202 F.3d 1074 (9th Cir. 2000). See also § 76.1 [ What Court? ] § 62.2  What Court?.

 

36  992 F.2d 950 (9th Cir. 1993).