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CONVERSION OF A BANKRUPTCY FROM CHAPTER 11 TO CHAPTER 7

By:  John B. Newman

Business debtors under financial duress have two alternate remedies under the Bankruptcy Code.  If they believe that they can rehabilitate their affairs by proposing a plan of reorganization which can be confirmed by the court, they will generally file under Chapter 11.  Upon the filing, the debtor becomes a debtor-in-possession and retains control of the business, albeit under the watchful eyes of the United States Trustee and its creditors.  If a debtor does not believe that it has a likelihood of rehabilitation, then it can file for liquidation under Chapter 7 of the Bankruptcy Code.  In that case, a trustee is appointed to take control of the remaining business assets, liquidate them and distribute the proceeds in accordance with law.  Since the debtor loses control of its assets immediately upon filing a Chapter 7, most debtors with any prospect of rehabilitation (and some that do not) elect Chapter 11.

If a debtor files under Chapter 11, in most circumstances it can later convert its case to Chapter 7 and liquidate its assets.  In addition, the Bankruptcy Code has a special provision which permits any creditor to apply to have a case converted from Chapter 11 to Chapter 7 “for cause.”  A wily debtor who has frustrated a lender, often for years, and who believes he is going to retain control of his property in a Chapter 11 can be devastated by an involuntary conversion to a Chapter 7.  When the criteria for conversion are met, conversion by a creditor can be a spectacularly successful maneuver.  The court will consider whether or not there is a reasonable likelihood of rehabilitation and whether or not the estate is continuing to shrink due to losses or other causes.

Likelihood of Rehabilitation

Under this test, the court will look at the entire financial picture of the debtor, including its actual prospective income, its assets and the liens on those assets, and will determine whether or not after proceeding through the reorganization process a viable company is likely to emerge.  If the debtor has little income or the ability to generate income, there is little to rehabilitate.

The courts have held that where the purpose of the Chapter 11 filing was only to obtain time to either sell or refinance a parcel of real estate, then the case should be converted to Chapter 7.  The rationale is that debtors should not be allowed to “speculate at the expense of their creditors while remaining in possession of the property without having to pay rent, real estate taxes or insurance premiums.”  Absent income to meet these ordinary expenses, generally speaking, the debtor will have little reasonable likelihood of rehabilitation.

Estate Will Suffer Continuing Loss

Here, the court looks at the actual cash flow and potential depreciation of assets.  Post-petition negative cash flow is the principle evidence of continuing losses.  Likewise where the current cash flow is insufficient to service accruing interest, taxes, insurance, and other costs, the creditor’s position would weaken as a Chapter 11 continued.  Deferred maintenance is also evidence of continuing shrinkage of the estate.

Lack of Good Faith

While not required by the Bankruptcy Code in order to obtain a conversion, the courts have held that Chapter 11 is only for debtors who are motivated by a legitimate reorganization purpose and not principally by the desire to prevent foreclosure.  Thus, with a single-asset debtor which has little or no equity and which is facing a foreclosure, a court might very well find that a Chapter 11 filing is in bad faith.  Lack of good faith is, in and of itself, cause for converting a case to Chapter 7.

Strategy

Debtors use numerous ploys in the state courts to delay a lender’s realization upon collateral.  While most lenders dread a bankruptcy filing, it often can serve as an opportunity to improve a lender’s position.  An involuntary conversion to a Chapter 7 can be a rude shock to a debtor and may result in a lender being able to realize upon its collateral more quickly than it would have in state court.

This publication is intended for general information purposes only and does not constitute legal advice. The reader should consult legal counsel to determine how the law may apply to specific situations.