Converting a Bankruptcy and Bad Faith

Bankruptcy conversion can lead to losing an asset for bad faith

Converting a Bankruptcy and Bad Faith

Bankruptcy Conversion to Chapter 7 Could Risk a Postpetition Asset if Debtor Acted in Bad Faith

Summary

In Pancic v Lokan (In re Lokan), BAP No. OR-22-1249-CLB, Bk. No. 6:20-bk-62593-TMR (9th Cir. BAP 6/14/2023)(unpublished opinion), the Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”) held that the chapter 13 debtors converted their case to Chapter 7 in good faith and therefore a post-petition inheritance was not property of the chapter 7 estate.

Facts

Stephen and Brenda Lokan filed a Chapter 13 bankruptcy in Oregon on November 23, 2020 with unsecured claims of approximately $100,000.  Their plan was confirmed with plan payments of $150 per month giving unsecured creditors about 10% of their claims.

In November 2021, almost a year after the case was filed, Stephen received an inheritance from his recently deceased brother of $400,000 and a 50% share of real estate valued at $500,000. This brought Stephen’s portion of the inheritance to about $650,000, enough to pay all unsecured debts, and certainly far more than the 10% creditors were receiving through the chapter 13 plan.

The Lokans notified their attorney of the inheritance seeking advice. He recommended conversion to Chapter 7. He subsequently filed amended schedules to disclose the inheritance noting that it was received over 180 days after filing.  At the postconversion § 341(a) meeting of creditors, Stephen testified that the reason for the conversion was their desire to stop operating the struggling business, and to retire.

The chapter 7 Trustee filed a motion seeking turnover of the inheritance arguing that the conversion was in bad faith and therefore, under § 348(f), the inheritance was property of the chapter 7 estate to seek turnover. The bankruptcy court found, after an evidentiary hearing, that the Lokans converted to Chapter 7 in good faith and denied the motion. The BAP affirmed.

Reasoning

Section 348(f)

The BAP began by noting that Chapter 13 debtors have the absolute right to convert to Chapter 7 at any time, citing Harris v. Viegelahn, 575 U.S. 510, 514, (2015), and then highlighted that conversion doesn’t start a new case nor affect the date of filing. The parties agreed that the inheritance was part of the chapter 13 estate, per § 1306 but disagreed that it was part of the chapter 7 estate.

Section 348 of the Bankruptcy Code, at subsection (f)(1)(A), states that, “property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  This seems to settle the issue, as the inheritance was not property of the chapter 13 estate at the date of filing.

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However, subsection (f)(2) contains this limitation: “If the debtor converts a case under chapter 13 of this title to a case under another chapter under this title in bad faith, the property of the estate in the converted case shall consist of the property of the estate as of the date of conversion.”

The battle lines, then, are drawn over the issue as to whether the case was converted in bad faith or not. If conversion was in bad faith, the chapter 7 trustee gets the inheritance and the unsecured creditors will be paid in full. If good faith, the trustee gets nothing.

Determining bad faith in converted bankruptcy cases

In an effort to define good faith or bad faith in converted cases, the BAP then turned to the Bankruptcy Code, and found neither is defined. It then referred to the Ninth Circuit Court of Appeals case for guidance in In re Leavitt, 171 F.3d 1219 (9th Cir, 1999).

In Leavitt, the Ninth Circuit held that bad faith was cause for dismissal for cause under Sections 349 and 1307 of the Bankruptcy Code.  To determine bad faith, the Ninth Circuit said the bankruptcy court should determine these factors, a totality of the circumstances analysis:

  1. whether the debtor misrepresented facts in his [petition or] plan, unfairly manipulated the Bankruptcy Code, or otherwise [filed] his Chapter 13 [petition or] plan in an inequitable manner;
  2. the debtor’s history of filings and dismissals,
  3. whether the debtor only intended to defeat state court litigation,
  4. whether egregious behavior is present

Id. at 1224 (cites and quotation marks omitted).

The BAP further noted from Leavitt that no one factor is determinative. A finding of bad faith does not require fraudulent intent by the debtor, nor is evidence required of the debtor’s ill will directed at creditors, or that the “debtor was affirmatively attempting to violate the law – malfeasance is not a prerequisite to bad faith.”

In the BAP’s consideration of the facts, and analysis of the totality of the circumstances, it noted that the bankruptcy court used the proper standard.  On appeal, the trustee alleged that only the first and fourth factors are at issue.  That narrowed it to whether the debtors: 1) misrepresented facts or unfairly manipulated the Code; and 4) whether they engaged in egregious behavior.

Misrepresentation of Fact

To determine if there’s a misrepresentation of fact or unfair manipulation of the Bankruptcy Code, the bankruptcy court must find dishonesty pervading the bankruptcy proceedings, such as when a debtor fails to fully disclose assets and financial dealings and fails to correct disclosure or offer an explanation for his conduct. Leavitt at 1225, and In re Tomlin, 105 F.3d 933, 941 (4th Cir 1997)

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Egregious Behavior

As to egregious behavior, debtor’s conduct must demonstrate a blatant disregard for the bankruptcy process, such as refusing to fully and accurately disclose financial affairs, concealing information from the court, violating injunctions, and obstructing the trustee in his duties.

Totality of the Circumstances

Here, the BAP noted that “the record demonstrates that the Lokans (1) disclosed the inheritance (albeit delayed) to their bankruptcy attorney prior to conversion, (2) listed the inheritance in their conversion schedules, and (3) answered the trustee’s questions about the inheritance at the post-conversion meeting of creditors”

There was no evidence of misrepresentation or egregious behavior, and the bankruptcy court’s finding that there was no bad faith is supported by the record.

Author’s Comment

It’s axiomatic that the top three keys to success for debtors and debtor’s attorneys in bankruptcy is to “Disclose, disclose, disclose.”

It’s not uncommon for circumstances to change for debtors in a chapter 13 case, and for an acquisition of post-petition assets which triggers the tension between §§ 1306 and 1327.

Debtors need to disclose: when there is an inheritance or some other asset acquired after filing or confirmation, attorneys representing debtors must urge their clients to disclose it by amendment, even if it’s with a note to say it’s not property of the estate but for full disclosure purposes. By doing so, they insulate their clients and their assets, which ironically can be more at risk if they were not disclosed but then later discovered.

Trustees should use discretion: while a half-million dollars in cash and land is tempting to pursue, not every case features egregious misrepresentations of fact. Discretion and a careful review of the facts and legal standards should be used in determining whether to litigate a potential asset before tying up the courts and making everybody spend money.

Courts, as here, should properly review the totality of the circumstances. Debtors aren’t perfect and sometimes make missteps. These, by themselves, should not be disqualifying. In the facts provided, there was delay by debtors in disclosing the inheritance. However, the explanation was sufficient to allay the concerns of the bankruptcy court, to which the BAP deferred. One or two misteps does not equate “dishonesty pervading the bankruptcy proceedings.” The bankruptcy court and BAP here should be applauded in their measured and balanced approaches.