April 9, 2007

Supreme Court Broadly Interprets Bankruptcy Courts’ General Powers

Holland & Knight Newsletter
Richard E. Lear

On February 21, 2007, the Supreme Court of the United States determined by a one-vote margin that a chapter 7 debtor who acts in bad faith does not have an absolute right to convert his case to a chapter 13 case. Marrama v. Citizens Bank of Massachusetts, 127 S.Ct. 1105 (2007) (5-4 decision). Although this holding resolves a dispute between the courts as to whether there is a “bad faith” exception to the ability of a debtor to convert his case pursuant to section 706(a)1 of the United States Bankruptcy Code, 11 U.S.C. §§ 101 et seq. (Bankruptcy Code), the more notable aspect of the decision is the broad interpretation given by the Court to section 105(a)2 of the Bankruptcy Code.

From the Supreme Court’s description of the facts, it would be difficult to argue that the debtor had not engaged in prepetition “bad faith” conduct. The Court described certain information provided by the debtor and his motive for making such statements as follows:

In verified schedules attached to his petition, Marrama made a number of statements about his principal asset, a house in Maine, that were misleading or inaccurate. For instance, while he disclosed that he was the sole beneficiary of the trust that owned the property, he listed its value as zero. He also denied that he had transferred any property other than in the ordinary course of business during the year preceding the filing of his petition. Neither statement was true. In fact, the Maine property had substantial value, and Marrama had transferred it into the newly created trust for no consideration seven months prior to filing his chapter 13 (sic) petition. Marrama later admitted that the purpose of the transfer was to protect the property from his creditors.

Marrama, 127 S.Ct. at 1108.

After the bankruptcy trustee’s examination of the debtor under oath at the first meeting of creditors, the trustee informed debtor’s counsel that the trustee intended to file an action to recover the Maine property as an asset of the bankruptcy estate to be administered for the benefit of creditors. Subsequently, debtor’s counsel filed a “Verified Notice of Conversion to Chapter 13.” Both the trustee and Citizens Bank of Massachusetts, described in the opinion as a “principal creditor”, filed objections to the conversion of the case, taking the position that the debtor made the request to convert in bad faith and that conversion of the case to chapter 13 would constitute an abuse of the bankruptcy process. At the hearing on the request to convert the case to chapter 13, the debtor explained through counsel3 that “his misstatements about the Maine property were attributable to ‘scrivener’s error’, that he had originally filed under Chapter 7 rather than Chapter 13 because he was then unemployed, and that he had recently become employed and was therefore eligible to proceed under Chapter 13.”4 The bankruptcy court denied the request to convert the case based on the debtor’s bad faith.

The debtor appealed the adverse decision to the Bankruptcy Appellate Panel for the First Circuit, principally taking the position that he had an absolute right to convert his case to a chapter 13 case under the plain language of section 706(a) of the Bankruptcy Code.5 The panel affirmed the opinion of the bankruptcy court, determining that section 706(a) created a right to convert a case from chapter 7 to chapter 13 “that is absolute only in the absence of extreme circumstances.”6 The First Circuit Court of Appeals affirmed the decision of the panel. In rejecting the argument that section 706(a) provided a chapter 7 debtor an “absolute right” to convert to chapter 13, the First Circuit emphasized that a bankruptcy court has the “unquestioned authority” to dismiss a chapter 13 case due to “bad faith” on the part of the debtor. Consequently, the First Circuit concluded that:

We can discern neither a theoretical nor a practical reason that Congress would have chosen to treat a first-time motion to convert a chapter 7 case to chapter 13 under section 706(a) differently from the filing of a chapter 13 petition in the first instance.

Marrama v. Citizens Bank of Massachusetts, et al. (In re Marrama), 430 F.3d 474, 479 (1st Cir. 2005).

The Supreme Court affirmed the First Circuit’s decision, concluding that section 706(d)7 of the Bankruptcy Code required the Court to consider whether cause existed to convert or dismiss a chapter 13 case as a component to the determination of whether an individual was qualified to be a debtor under chapter 13. By doing so, the Court took a practical approach utilizing section 105 of the Bankruptcy Code, effectively determining to avoid any “required” conversion of a chapter 7 case of a debtor proceeding in “bad faith” to a chapter 13 case based on an “absolute right” to convert the case, only to re-convert the chapter 13 case back to chapter 7 for “cause” pursuant to section 1307(c)8. This approach, however, was at the cost of abandoning the textual approach which the Court has admonished lower courts for not following.

The Court’s approach is inconsistent with a logical interpretation of section 706(d) which would lead one to conclude that section 706(d) refers to whether a debtor satisfies the requirements of section 109 of the Bankruptcy Code. Section 109, which is captioned “Who may be a debtor”, sets out the eligibility requirements as to who may be a debtor under chapter 13.9 Instead, the Court treats section 706(d) as if it were a separate source of eligibility requirements for proceeding under chapter 13, i.e., that the case would not be subject to dismissal or reconversion pursuant to section 1307(c).10 As the dissent noted, however, section 1307(c) “plainly does not set out the requirements that an individual must meet in order to ‘be a debtor’ under Chapter 13. Instead, § 1307(c) sets out the standard … 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.”11

Acknowledging that “[t]he class of honest but unfortunate debtors” has “an absolute right to convert their cases from Chapter 7 to Chapter 13”, the Court determined that such an absolute right does not exist “for the atypical litigant who has demonstrated that he is not entitled to the relief available to the typical debtor.”12 In rendering its decision, the Court cited to the “broad authority” granted to bankruptcy judges under section 105 and to the inherent equitable powers of the bankruptcy courts.13 While relying on such powers as the bases for its holding, the Court failed to acknowledge that neither authority may be invoked to contravene the provisions of the Bankruptcy Code.14

The reason why the Supreme Court chose to bypass fairly clear statutory language and to invoke section 105 was clearly based on the Court’s view that granting the debtor’s request to convert his case to a case under chapter 13 would necessarily lead to a reconversion of that case back to chapter 7 “for cause” based on the debtor’s prepetition “bad faith”, and the Court wished to avoid what it clearly felt was a pointless procedural formality and opted to “cut to the chase”.15 By relying on the general and equitable powers of the bankruptcy court to do so, the Court has given a broader interpretation to section 105 than any it has adopted previously. What is left to be determined is whether this broader interpretation is an anomaly or a harbinger of things to come from this Court.

1 Section 706(a) of the Bankruptcy Code states that:
(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.

11 U.S.C. § 706(a).

2 Section 105(a) of the Bankruptcy Code states that:

(a) The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.

3 Apparently, no actual testimony was taken by the bankruptcy court in the hearing on the debtor’s request to convert his case to a chapter 13 case. See Marrama v. Citizens Bank of Massachusetts, et al. (In re Marrama), 430 F.3d 474, 476 (1st Cir. 2005) (“Following a non-evidentiary hearing, the bankruptcy court refused to permit the conversion to chapter 13, on the ground that the deceptive statement of financial affairs demonstrated Marrama’s ‘bad faith’”) (emphasis added).

4 Marrama, 127 S.Ct. at 1108-09.

5 In support of his argument, debtor also pointed to the legislative history of section 706(a):

Subsection (a) of this section gives the debtor the one-time absolute right of conversion of a liquidation case to a reorganization or individual repayment plan case. If the case has already once been converted from chapter 11 or to chapter 7, then the debtor does not have that right. The policy of the provision is that the debtor should always be given the opportunity to repay his debts, and the waiver of the right to convert a case is unenforceable.

Id. at 1110, citing S. Rep. No. 95-989, p. 94 (1978).

6 In re Marrama, 313 B.R. 525, 531 (Bankr. 1st Cir. 2004).

7 Section 706(d) provides that a case may not be converted to a case in a different chapter of the Bankruptcy Code unless the debtor could be a debtor in such chapter.

8 Section 1307(c) provides that a chapter 13 case may be dismissed or converted to a chapter 7 case “for cause” and includes a non-exhaustive list of 10 examples of cause. 11 U.S.C. § 1307(c). The Supreme Court stated that bankruptcy courts “routinely” treat dismissal of a case for pre-petition bad faith as “being implicitly authorized by the words ‘for cause.’” Marrama, 127 S.Ct. at 1110-1111.

9 11 U.S.C. § 109(e); see Marrama v. Citizens Bank of Massachusetts, et al. (In re Marrama), 430 F.3d at 478-79 n.3 (section 706(d) provides that a debtor’s conversion right is conditioned upon satisfying certain requirements, including eligibility requirements to be a chapter 13 debtor under section 109(e)).

10 Marrama, 127 S.Ct. at 1110-11.

11 Id. at 1114-15 (Alito, J., dissenting).

12 Id. at 1111.

13 Id. at 1111-12.

14 See, e.g., Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988) (a bankruptcy court’s general and equitable powers “must and can only be exercised within the confines of the Bankruptcy Code”).

15 See Marrama, 127 S.Ct. at 1111-12 (Section 105(a) “is surely adequate to authorize an immediate denial of a motion to convert filed under § 706 in lieu of a conversion order that merely postpones the allowance of equivalent relief and may provide a debtor with an opportunity to take prejudicial action prejudicial to creditors”). Whether the conversion of a debtor’s case to a case under chapter 13 actually would be pointless is subject to debate. Id. at 1115 (Alito, J., dissenting) (The court’s decision eliminates the ability of a “bad faith” debtor to rehabilitate himself by filing a chapter 13 plan which “must be filed in good faith and which must demonstrate that creditors will receive no less than they would” in chapter 7).

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