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Bond Bankruptcy Report

Conversion Under Section 706(b): Involuntary Servitude?

There is a spectre haunting individual chapter 7 debtors with excess income – the spectre of involuntary conversion, pursuant to section 706(b), to a case under chapter 11 of the Bankruptcy Code.  Section 706(b) states that “[o]n 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.”

Recently the Bankruptcy Appellate Panel for the Eighth Circuit Court of Appeals (the “Eighth Circuit BAP”) had occasion to address this issue.  In In re Schlehuber, an unsecured creditor moved to have an individual’s chapter 7 case converted to chapter 11 under section 706(b), alleging that the debtor’s schedules showed a substantial monthly excess of income over expenses.  Following the motion, the debtor, whose debts were primarily non-consumer, amended his schedules, showing increased expenses and decreased income, which resulted in no monthly disposable income.  The Bankruptcy court examined the debtor’s earning statements and other documents, however, and found that a “significant monthly disposable income” did in fact exist, and converted the debtor’s case to a chapter 11.

The Eighth Circuit BAP reiterated its holding in previous decisions: the determination of whether to convert under section 706(b) is left to the discretion of the court, based on what will result in the greatest benefit to all parties in interest.  In making this determination, the court should consider anything that would further the goals of the Bankruptcy Code.

The heart of the Eighth Circuit BAP’s decision in In re Schlehuber is its holding that “[n]othing in § 706(b) suggests that a court may not focus on ability to pay….”  In fact, the court went so far as to hold that a chapter 7 debtor’s ability to pay was “logically a central consideration” under section 706(b), and that nothing in that section required that the debtor’s interests should prevail.

Consequently, the Eighth Circuit BAP affirmed the In re Schlehuber Bankruptcy and District Courts’ decisions converting the debtor’s case to one under chapter 11.

This reasoning appears to be in line with the overall changes to the Bankruptcy Code implemented by BAPCPA.  If a debtor can pay something to his creditors, he should pay something to his creditors.

However, a March, 2011 decision from the Bankruptcy Court for the District of New Mexico offers an illuminating, if subtle, contrast.  In In re Lobera, Bankruptcy Judge James S. Starzynski faced very similar facts: an individual debtor with primarily non-consumer debts, an unsecured creditor alleging excess income, and seeking a section 706(b) conversion to a chapter 11 case.   In re Lobera involved an even less sympathetic chapter 7 debtor than the one in In re Schlehuber.  The Lobera debtor was a wealthy physician whose initial bankruptcy petition failed to list even his full name, or to schedule, among other things, an Army pension, Microsoft stock, four vehicles and an $18,000 bonus.

Judge Starzynski, like the Eighth Circuit BAP, found that the decision of whether to convert under 706(b) was within the sound discretion of the court, based on what will most inure to the benefit of all parties in interest.  In making this determination, Judge Starzynski also found, as did the Eighth Circuit BAP, that the court should consider anything that would further the goals of the Bankruptcy Code.  The Lobera court then hinted at a slightly different approach to section 706(b) by quoting the United States Supreme Court’s decision in NLRB v. Bildisco for the proposition that “the policy of chapter 11 is to permit successful rehabilitation of debtors.”  Judge Starzynski found that, despite the debtor’s less than stellar record, conversion to chapter 11 would not further the interests of the debtor or his dependents.

The Lobera court’s analysis under section 706(b) reveals only a slightly different approach to the balancing of the interests of all parties, and the goals of the Bankruptcy Code.

However, the Lobera court went on to note two statutory ramifications of an individual 706(b) conversion to chapter 11 that the Eighth Circuit BAP in In re Schlehuber did not.  Only the first played a direct role in the Lobera court’s reasoning.  It involved section 1112(a)(3), which permits conversion from chapter 11 to chapter 7 “unless…the case was converted to [chapter 11] other than on the debtor’s request.”  Judge Starzynski opined that 1112(a)(3) would result in the debtor’s being “trapped” in a chapter 11 case that he didn’t need or want.  The Lobera court found that this was “not the fresh start that Congress envisioned.”   Even taking section 1112(a)(3) into account, and combining it with an emphasis on the debtor’s “fresh start,” still does not render Judge Starzynski’s approach significantly different from the Eighth Circuit BAP’s  in In re Schlehuber.

The second statutory ramification noted by Judge Starzynski, however, does mark a different approach, rendered no less significant by the fact that it was made in dictum, and relegated to a footnote in the Lobera decision.  The gist of the footnote is that there can be no such thing as an involuntary chapter 12 or 13 case.  This, of course, is because such a chapter 12 or 13 debtor, whose post-petition earnings are property of the estate, would, in effect, be compelled to work for the benefit of his creditors; that would be in contravention to the 13th Amendment’s prohibition against involuntary servitude.  Section 706(c) reflects this concern:

[t]he court may not convert a case under this chapter to a case under chapter 12 or 13 of this title unless the debtor requests or consents to the conversion.

11 U.S.C. § 706(c) (emphasis added).

At the time the Bankruptcy Code was drafted, this concern with involuntary servitude did not apply to chapter 11, because a chapter 11 debtor’s post-petition earnings were not property of the estate.  This changed, however, with BAPCPA’s implementation in 2005.  New section 1115(a)(2) of the Bankruptcy Code specifically defines a chapter 11 debtor’s post-petition earnings as property of the estate, making an individual debtor’s chapter 11 case similar, at least in one major respect, to a chapter 12 or 13 debtor’s.

Thus, an individual chapter 7 debtor whose case is converted without his consent to a chapter 11 case under section 706(b), is essentially in the same position as though his case were converted to a chapter 13.  And, as we know from section 706(c), this is prohibited.

The seeming paradox was noted by Judge Starzynski in his thought-provoking footnote, where he opined that “Congress may have created the setting for a constitutional challenge.”

And Judge Starzynski’s footnote does provoke some thoughts: why is it that this distinction did not entirely escape the attention of BAPCPA’s drafters? After all, section 707(b)(1), which applies only to individual consumer debtors, provides for dismissal or conversion of a chapter 7 case (before BAPCPA, it provided only for dismissal).  However, the drafters of BAPCPA added to section 707(b)(1) language (consistent with section 706(c)) that conversion to chapters 11 or 13 could take place under 707(b)(1) only “with the debtor’s consent.”  In fact, the very words “or consents to,” as they appear in section 706(c), were added by BAPCPA.

So, it is clear from their tinkering with the language of sections 706(c) and 707(b)(1) that BAPCPA’s drafters had “involuntary servitude,” or something very much like it, in mind.  Why was section 706(b) left unmodified?

We are also left to wonder about the ramifications of this paradox to section 303 of the Bankruptcy Code, which permits involuntary chapter 11 (but not chapter 13) petitions against individual alleged debtors.  Given the new, revised, chapter 11 for individuals, with post-petition earnings constituting property of the estate, should section 303 also be amended to preclude involuntary chapter 11 petitions against individuals?

For now, little more can be said than it is safer to be an individual non-consumer chapter 7 debtor with excess income in New Mexico, than in any district within the Eighth Circuit.  One might add, however: “individual chapter 7 debtors with excess income, uniteYou have nothing to lose but a good portion of your post-petition earnings for a period to be determined pursuant to the provisions of a court-approved chapter 11 plan.”