Is a Debtors Right to Convert Under 706(a) Really Absolute
This article addresses the issue of whether the right to convert under §706(a) is actually absolute. In other words, is the right to convert an "absolute right," such that a bankruptcy court must allow a conversion to take place even in light of evidence that a debtor has acted in bad faith? The courts are split in their interpretation of this provision. Some decisions hold that to prevent an abuse of the bankruptcy system, a court may use its equitable power to deny a motion to convert, while others have held that a bankruptcy court cannot prevent the conversion from taking place, even if there is evidence that a debtor has acted in bad faith.
Not Always an Absolute Right
The language in the legislative history to §706(a) has not prevented some courts from denying motions by debtors to convert from chapter 7 to other chapters under the Bankruptcy Code, or from at least recognizing that under certain circumstances such motions may be denied. See In re Jeffrey, 176 B.R. 4, 5 (Bankr. D. Mass. 1994) (holding that right of conversion bestowed in §706(a) is not unlimited); In re Spencer, 137 B.R. 506, 510-14 (Bankr. N.D. Okla. 1992) (recognizing that conversion will be allowed absent extreme circumstances amounting to bad faith, imposition on the court’s jurisdiction, abuse of process or other gross inequity); In re Thornton, 203 B.R.648, 649 (Bankr. S.D. Ohio 1996) (holding that debtor does not have absolute right to convert when sufficient evidence exists of debtor’s lack of good faith).
Two decisions are frequently cited for the proposition that a court may rely upon its §105(a) equitable powers to deny a debtor’s motion to convert his case under §706(a) despite the fact that the legislative history provides for an "absolute right" to convert. See In re Calder, 93 B.R. 739, 740 (Bankr. D. Utah 1988) and Finney v. Smith (In re Finney) 992 F. 2d 43 (4th Cir. 1993). As will be shown below, however, the current viability of these decisions is unclear.
...in jurisdictions where the courts apply a literal interpretation, an injured party must wait until the case is converted and file a motion to reconvert unless the court reconverts the matter sua sponte.
In Calder, the bankruptcy court invoked its equitable powers under §105(a) to prevent a debtor from converting his chapter 7 case to a chapter 13, based on these facts: The debtor was an attorney familiar with chapter 13 bankruptcy law; he had been a debtor in three prior cases under chapter 13, two of which had been dismissed on grounds of bad faith; the motion to convert the case had been filed after the debtor had been denied discharge; and the debtor had made minimal efforts to repay creditors during the years he had been before the court. The court determined in these circumstances that the allowance of the motion to convert would constitute an abuse of the bankruptcy system. In re Calder, 93 B.R. at 740. The viability of the Calder decision, however, has been challenged in at least one decision, Stegall v. Adams, 1992 W.L. 698764 (N.D. Okla.). In Stegall, the district court stated that the Tenth Circuit decision in Calder v. Job (In re Calder), 973 F.2d 862 (10th Cir. 1992), did not support the bankruptcy court’s conclusions that it had discretion to prevent a debtor from converting a chapter 7 to chapter 11 because the Tenth Circuit, although addressing different issues and facts than the earlier Calder decision, held that the bankruptcy rules could not override the absolute statutory right to convert to another chapter of the Bankruptcy Code under §706(a).
In In re Finney, the Fourth Circuit Court of Appeals reviewed on appeal the decisions of the bankruptcy court and district court below. While the bankruptcy court, relying on its §105(a) powers, had denied the debtor’s motion to convert its case due to his misconduct during the chapter 7 proceeding, the district court, realizing that the Fourth Circuit requires cautious exercise of §105(a) authority, held that the debtor’s subjective bad faith standing alone was insufficient to abrogate the unqualified §706(a) right of conversion. See In re Finney, 992 F.2d at 44-45. The Fourth Circuit Court of Appeals agreed with the district court that the debtor’s conduct was insufficiently "egregious" to warrant denial of the debtor’s "unqualified" right of conversion and refused to express an opinion on what circumstances, if any, would justify invocation of §105(a) to deny a §706(a) motion outright. Id. at 45.
Perhaps the bankruptcy decision taking the strongest stance against the literal translation of the legislative history to §706(a) is In re Starkey, 170 B.R. 687, 693, (Bankr. N.D. Okla. 1995). The Starkey court, in reaching its decision that all courts have an inherent power and duty to prevent abuse of their jurisdiction, compared the actual language of §706(a) with that of §706(b). Section 706(a) provides that a debtor may convert a case under this chapter to a case under chapter 11, 12 or 13 of this title at any time, while §706(b) provides that on request of a party in interest and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 11 of this title at any time. Id. at 692. The Starkey court noted that the words "at any time" in §706(b) surely could not mean that the bankruptcy court can force a debtor into chapter 11 whenever the judge feels like it "regardless of circumstances." If the court does not have discretion to force the debtor into chapter 11 under §706(b), then the Starkey court reasoned that under §706(a) the debtor cannot force himself into chapter 11 or 13 whenever he feels like it. Thus, the Starkey court concluded that the phrase "at any time" does not mean "regardless of circumstances" but rather means "at any stage." Id. The Starkey court stated that the "absolute right" language used in the legislative history to §706 was never meant to be taken literally and that, at best, the legislative history is a clue to the meaning of the statute and not the only clue, or even the single most-important clue; and its summary, non-technical character must always be kept in mind." Id.
The Debtor’s Absolute Right to Convert
Unlike the Starkey decision discussed above, the majority of decisions take the legislative history to §706(a) literally. Courts generally grant a debtor a one-time absolute right to convert, even when the debtor has been recalcitrant or acted fraudulently. See In re Bowman, 181 B.R. 836 (Bankr D. Md. 1995). (Citing In re Finney, 992 F.2d at 45; In re Kleber, 81 B.R. 726,727 (Bankr. M.D.Ga. 1987) and In re Jennings, 31 B.R. 378, 380 (Bankr. S.D. Ohio 1983)). In at least one decision, a bankruptcy court implied that the bankruptcy court has no power to deny a motion to convert even under §105(a). See Stegall v. Adams, 1992 W.L. 698764 (N.D. Okla.) (holding that argument that §105(a) gives the bankruptcy court power to deny a motion to convert is without merit). Likewise, in In re Porras, 188 B.R. 375, 378 (Bankr. W.D. Tex. 1995), the bankruptcy court held that the Bankruptcy Code and Rules confer on a chapter 7 debtor the absolute right to convert his or her case to chapter 11 or 13 and that "any judge-made exception that operates to place a gloss on statutory language as implacable as that found in §706(a) poses a significant danger of judicial legislation."
Remedies for When a Court Grants a Motion to Convert
Although a bankruptcy court may read the legislative history to §706(a) literally and grant a motion to convert despite allegations of bad faith, parties injured by the conversion are not without redress. As the Fourth Circuit in In re Finney noted, although a debtor may have the right to convert his case from chapter 7, he does not necessarily have the subsequent right to remain in chapter 11. See In re Finney, 992 F. 2d at 45. See, also, In re McNallen, 197 B.R. 215, 219 (Bankr. E.D. Va. 1995), and In re Porras, 188 B.R. 375, 379 (Bankr. W.D. Tex. 1995). Specifically, if the debtor’s motion to convert to chapter 11 was in bad faith, an injured party in interest may move immediately upon conversion for the reconversion of the case to chapter 7 as authorized by §1112(b). Id. In determining whether reconversion from chapter 11 to chapter 7 is proper, courts generally apply a two-pronged test. Specifically, the party moving for reconversion must show subjective bad faith on the part of the debtor as well as objective futility as to reorganization. See In re Finney, 992 F. 2d at 45; In re McNallen, 197 B.R. at 220. If a debtor’s motion to convert to chapter 13 was in bad faith, then the injured party in interest may move to reconvert under §1307(c). See 11 U.S.C. §1307(c).
From a review of the authorities cited above, it is clear that there is not a bright line between cases that find an absolute right to convert and those that recognize the court’s authority to deny a motion to convert. The only real difference is that in jurisdictions where the courts apply a literal interpretation, an injured party must wait until the case is converted and file a motion to reconvert unless the court reconverts the matter sua sponte. As one bankruptcy court has noted, "to permit a conversion from chapter 7 to chapter 11 in circumstances where cause existed to immediately reconvert to chapter 7 or dismiss would be a futile and wasted act." See In re Wallace, 191 B.R. 925, 927 (Bankr. M.D.Fla. 1995). Be that as it may, until Congress acts to clarify the meaning of §706(a), many courts will continue to apply a literal interpretation to the legislative history.