On November 7, 2015, Eric P. Israel participated as a panelist in the 41st Annual Family Law Symposium at the Intercontinental Hotel in Century City, California, sponsored by the Family Law Section of the Beverly Hills Bar Association. Mr. Israel was one of three panelists on the one-hour program on “The Intersection Between Bankruptcy and Family Law,” which included Bankruptcy Judge Neil Bason and Brian Lipak, an expert in family law.
In Grego v. U.S. Trustee (In re Grego), 2015 WL 3451559 (9th Cir. BAP May 29, 2015), the Bankruptcy Appellate Panel for the Ninth Circuit reversed the conversion of a debtor’s case from chapter 11 to chapter 7 because the bankruptcy court did not expressly consider whether dismissal was in the best interests of creditors and the estate.
Glenn Grego owned a 50% interest in certain real property; the other 50% was owned by a trust formed by his father, of which Grego was the trustee. Grego caused the trust to file for bankruptcy. The U.S. Trustee filed a motion to dismiss that case, and a foreclosure sale was scheduled to take place one hour after the hearing. Rather than oppose dismissal of the trust’s bankruptcy case, Grego personally filed for chapter 11 to delay the foreclosure sale.
A few days after Grego filed his personal case, the bankruptcy court issued a routine order setting a case status conference. A few days before the hearing, the court issued a tentative ruling that, among other things, detailed significant omissions and obvious inaccuracies in Grego’s schedules and statement of financial affairs, and noted the fact that the debtor’s stated income was woefully inadequate to pay his stated living expenses. The tentative ruling stated that the court was inclined to continue the status conference, but was “not likely to permit [Grego] to delay the prosecution of this chapter 11 case for any significant length of time.” Grego filed amended schedules and a statement of financial affairs after issuance of the tentative ruling (but allegedly not in response to the tentative ruling), listing many assets and debts not included in his original schedules.
At the status conference, the bankruptcy court reiterated many of its concerns. The court also pointed out that Grego’s schedules failed to disclose a bankruptcy case filed by him three years earlier (in which Grego received a discharge only four months before commencing his newest case). The court found that Grego’s petition was either filed in bad faith or as a result of gross incompetence, and “conclude[d] that there is absolutely sufficient cause to either appoint . . . a chapter 11 trustee or convert the case to Chapter 7.”
The bankruptcy court asked the U.S. Trustee’s counsel whether creditors would be better served by the appointment of a chapter 11 trustee or conversion of the case to chapter 7. The U.S. Trustee’s counsel opined that conversion was the better option. The bankruptcy court agreed, and converted the case to chapter 7. Grego appealed.
While his appeal was pending, the BAP issued its published decision in Sullivan v. Harnisch (In re Sullivan), 522 B.R. 604 (9th Cir. BAP 2014). In that case, the BAP ruled that the bankruptcy court abused its discretion by dismissing a chapter 11 case without considering whether conversion or dismissal would be in the best interests of all creditors and the estate. The BAP held in Sullivan that
if a bankruptcy court determines that there is cause to convert or dismiss, it must also: (1) decide whether dismissal, conversion, or the appointment of a trustee or examiner is in the best interests of creditors and the estate; and (2) identify whether there are unusual circumstances that establish that dismissal or conversion is not in the best interests of creditors and the estate.
As in Sullivan, the BAP concluded that the Grego court failed to adequately consider the merits of each remedy available under section 1112(b). According to the BAP, “the bankruptcy court apparently did not consider the option of dismissing the case even though there did not appear to be much in the way of unencumbered nonexempt assets to administer under either set of schedules.” The BAP therefore reversed and remanded to the bankruptcy court to consider whether dismissal would better serve the interests of creditors.
First, the BAP questioned whether the bankruptcy court’s finding of “gross incompetence” constituted “cause” to convert the case. The BAP rejected the U.S. Trustee’s argument that the bankruptcy court meant to find that cause existed under section 1112(b)(4)(F) (“unexcused failure to satisfy timely any filing or reporting requirement established by this title or by any rule applicable to a case under this chapter”). Instead, the BAP felt that the bankruptcy court meant to invoke section 1112(b)(4)(B) (“gross mismanagement of the estate”), but concluded that the facts did not support such a finding because there was no evidence in the record regarding Grego’s postpetition management of the estate.
Second, the BAP analyzed the bankruptcy court’s finding that Grego filed his petition in bad faith. Such a finding is appropriate when, based on an amalgam of factors, the “debtor is attempting to unreasonably deter and harass creditors” as opposed to “attempting to effect a speedy, efficient reorganization on a feasible basis.” The BAP affirmed the bankruptcy court’s finding of bad faith because of the existence of a number of the typical bad faith factors.
Third, the BAP rejected Grego’s argument that the bankruptcy court violated his due process rights by converting the case sua sponte at the status conference. Bankruptcy courts have authority under section 105(a) to consider dismissal or conversion sua sponte, and if Grego believed that he needed a better opportunity to respond to the bankruptcy court’s concerns, he should have asked for additional time to do so. Also, any due process error was harmless because there was nothing in the record to suggest that the factors pertinent to the bad faith determination could or would materially change.
Finally, although the issue was not raised by the appellant, the BAP ruled that the bankruptcy court erred by not considering whether dismissal, instead of conversion, was in the best interests of creditors. The BAP was troubled by this for three reasons: (1) Grego had one or more secured creditors, who might have preferred dismissal so they could proceed with their remedies under state law; (2) secured creditors received no notice that the court would consider conversion and/or dismissal at the status conference, and thus were deprived of any meaningful opportunity to appear and be heard on the issue; and (3) the record suggested that Grego had almost no unsecured creditors and almost no unencumbered nonexempt assets to be administered by a chapter 7 trustee.
Under the circumstances, and in light of Sullivan, the BAP vacated the conversion order and remanded for consideration as to whether conversion or dismissal was in the best interests of creditors, and whether there existed any unusual circumstances militating against both conversion and dismissal.
1. It is unclear why the BAP felt the need to squeeze the bankruptcy court’s finding of “gross incompetence” into one of the sixteen nonexclusive grounds that constitute “cause” for dismissal or conversion under section 1112(b). The bad faith filing of a bankruptcy petition is not an enumerated ground, yet it is “cause” for dismissal or conversion. By focusing on whether the facts supported a finding of gross mismanagement of the estate (section 1112(b)(4)(B)), the BAP did not directly address whether “gross incompetence” of a debtor or his or her representatives may constitute “cause” under section 1112(b).
2. Practitioners should note that this is at least the fourth decision since August 2014 in which the BAP has emphasized that, after finding that “cause” exists under sections 1112(b) or 1307(c), a bankruptcy court has an independent obligation to consider whether conversion or dismissal is in the best interests of creditors. The other three cases: Kenny G. Enters., LLC v. Casey (In re Kenny G Enters., LLC), CC-13-1527-KiTaPa (9th Cir. BAP Aug. 20, 2014); Sullivan (Dec. 22, 2014); and Phillips v. Leavitt (In re Phillips), CC-14-1359-JuKuD (9th Cir. BAP May 8, 2015).
3. Practitioners (and bankruptcy judges) also should note that, in three of the four cases, the BAP raised and addressed the issue on its own. It was squarely before the BAP in Sullivan, where one of the issues identified in the appellant’s brief was “[w]hether the bankruptcy court abused its discretion in dismissing the case instead of converting the case to a case under Chapter 7 of the bankruptcy code.” However, the issue was not raised by the appellants in Kenny G and Phillips. In each of those cases, after briefly raising and discussing the issue, the BAP properly ruled that the appellant had forfeited any argument regarding the bankruptcy court’s failure to consider the alternative remedy. Kenny G at 26 (citing O’Guinn v. Lovelock Corr. Ctr., 502 F.3d 1056, 1063 n.3 (9th Cir. 2007) (arguments not raised before the trial court are waived)); Phillips at 8 (citing U.S. v. Ullah, 976 F.2d 509, 514 (9th Cir. 1992) (“We will not ordinarily consider matters on appeal that are not specifically and distinctly argued in appellant’s opening brief.”)).
However, in Grego the BAP not only raised this non-jurisdictional issue on its own, it vacated the conversion order solely because the bankruptcy court did not appear to have considered dismissal as an alternative remedy. The BAP did this because of its published decision in Sullivan:
While we recently stated in an unpublished decision that the debtor may forfeit this issue by not raising it either in the bankruptcy court or on appeal, [Kenny G], we also have stated recently, in a published opinion:[R]egardless of the parties’ arguments, the bankruptcy court [has] an independent obligation under [section] 1112 to consider what would happen to all creditors on dismissal and, in light of its analysis, whether dismissal or conversion would be in the best interest of all creditors . . . .
In re Sullivan, 522 B.R. at 612-13.
The BAP’s view that it was obligated to not only raise but also decide this non-jurisdictional question despite its waiver by the appellant is troubling. Any secured creditor or other party in interest that preferred dismissal over conversion could have sought reconsideration before the bankruptcy court, or even joined in the appeal. There is nothing in the decision to suggest that any creditor ever expressed a preference for dismissal; the BAP simply speculated that such a creditor might exist.
The BAP’s decision to rule on this waived issue is also impossible to reconcile with Phillips, which was also decided after Sullivan (and only three weeks beforeGrego). Bankruptcy judges and parties should at least be aware of the risk that the BAP will raise – and issue a ruling on – this issue regardless of whether a party raises the issue on appeal.
4. Had the issue of dismissal versus conversion actually been raised by the debtor in the appeal, the U.S. Trustee presumably would have alerted the BAP to the fact that, subsequent to filing the appeal, Grego filed a motion to dismiss the chapter 7 case on the alleged grounds that there were no nonexempt assets to be administered and no unsecured creditors to be paid. An unsecured creditor opposed the motion, alleging that the estate had both nonexempt assets and unsecured debts; the creditor specifically argued that dismissal was not in the best interests of creditors. The bankruptcy court denied Grego’s motion to dismiss in November 2014, and Grego did not appeal. Thus, not only was the question of dismissal versus conversion not raised before the BAP, by the time of oral argument the bankruptcy court had already decided that dismissal was inappropriate.
5. In essence, the BAP vacated the conversion order because the bankruptcy court did not expressly state, on the record, that it had considered dismissal and concluded that conversion or appointment of a chapter 11 trustee were better options. Bankruptcy judges know that dismissal is available under section 1112(b). Isn’t the better view that the bankruptcy court in this case implicitly determined, based on the debtor’s bad faith and gross incompetence (and perhaps because of the trust’s and the debtor’s prior bankruptcy history), that his schedules could not be trusted and that an independent fiduciary was needed to determine whether there were, in fact, nonexempt assets to be administered and unsecured creditors to be paid? (To that end, subsequent filings by the chapter 7 trustee and U.S. Trustee alleged that the debtor concealed assets, that the debtor has diverted postpetition income of the estate, and that approximately $85,000 of unsecured creditor claims have been filed.)
These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles (email@example.com). Editorial contributions were provided by Michael T. Delaney of Baker & Hostetler, LLP, in Los Angeles.
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The Bankruptcy Section of the Beverly Hills Bar Association, together with several other non-California bar associations, has filed an amicus brief in the United States Supreme Court in support of the appellant in Baker Botts LLP v. ASARCO LLC, No. 14-103. The Baker Botts law firm appealed from the decision of the Fifth Circuit Court of Appeals denying the payment of fees requested by Baker Botts, for the attorney fees it incurred defending against an objection to its fee application. By most accounts, including the trial court’s, Baker Botts had obtained an exceptional outcome in the bankruptcy case. The Fifth Circuit’s opinion established a per se rule against allowing payment of fees incurred in defense of bankruptcy fee applications, in direct conflict with the Ninth Circuit’s In re Smith, 317 F.3d 918 (9th Cir. 2002) decision, which places such a determination within the sound discretion of the bankruptcy judge.
Danning-Gill has settled and obtained court approval of the Settlement Agreement in a class action it filed nearly four years ago against the California State Controller, on behalf of bankruptcy trustees whose claims to debtor funds that escheated to the State of California prepetition were denied based on the argument that trustees lacked standing to assert such claims. Pursuant to the Settlement Agreement, the Controller has agreed to abandon its long-standing policy of denying trustee claims to escheated funds.
R. Todd Neilson, the Chapter 7 trustee in the consolidated bankruptcy case of Marion “Suge” Knight, Jr. and Death Row Records, Inc., filed the class action to recover escheated funds held in trust by the Controller. The Controller had previously refused to pay such funds to the Trustee, even though Mr. Knight and Death Row Records had owned interests in the funds prior to their bankruptcy filings. In refusing to turn over the funds, the Controller stated, “[i]t is the long-standing position of [the Controller] that once unclaimed property has escheated to the State of California, it is not subject to claims by bankruptcy trustees claiming on behalf of a bankruptcy estate or debtor.” Danning-Gill noted that many other bankruptcy trustees had their claims rejected based on this legally incorrect policy.
On behalf of the Trustee, Danning-Gill asserted that the Controller’s policy conflicted with 11 U.S.C. section 541(a)(1), which states that property of a bankruptcy estate includes the debtor’s legal and equitable interests in property as of the commencement of the case. Because an owner of escheated funds maintains an interest in the funds even after they escheat to the State, that interest becomes property of the debtor’s bankruptcy estate and the funds must be turned over to the debtor’s trustee under 11 U.S.C. section 542. Danning-Gill further asserted that the Controller’s policy violated the automatic stay established by 11 U.S.C. section 362(a)(3), constituting an exercise of control over property of the estate.
The settlement between the Trustee and Controller provides, among other things, that the Controller will no longer engage in the above policy, will pay trustee claims previously denied solely based on the above policy upon resubmission of such applications, and pay attorneys’ fees to Danning-Gill, as class action counsel.