Chapter 11 Dismissal vs Conversion: 5 Factors Under §1112(b)

In Chapter 11 parlance, dismissal and conversion are the two things that most businesses and their owners want to avoid at all costs. If the court finds cause, the Chapter 11 must be either converted to Chapter 7 or dismissed, whichever is in the best interests of the estate and its creditors. There is no formula; the decision turns on the facts. As opposed to a dismissal, a conversion means your business’s bankruptcy case will become a liquidation case - that is, the trustee will liquidate your company’s assets and make distributions to creditors as such assets become available. In a dismissal, the bankruptcy case is closed, and creditors can proceed to recover their debts from the debtor, outside of the bankruptcy process. Ultimately, the court will look at five questions to decide whether to dismiss your Chapter 11 or convert it to Chapter 7.

Cause to Dismiss or Convert

There are at least 16 different reasons the court may decide there is cause to dismiss or convert. Some examples include continuing losses with no reasonable likelihood of rehabilitation, gross mismanagement, unpaid post-petition taxes, and unpaid U.S. Trustee fees. Many of the examples are serious and imply some misconduct on the part of the debtor, but not all. Once a motion is filed, it has to happen fast. The hearing on the motion to convert or dismiss must start within 30 days after the filing of the motion, unless the party requesting it agrees to wait, or the court finds compelling reasons for the delay. In general, the court must rule within 15 days after the hearing begins.

Avoiding a dismissal or a conversion can be difficult. To refuse to dismiss or convert, the court must find unusual circumstances and a likelihood that the debtor will confirm the plan within the required time. For cause attributable to the debtor, the debtor must show a reasonable justification and a feasible plan to cure the condition within a reasonable period of time established by the court. In a regular Chapter 11, the court can appoint a trustee or examiner instead of dismissing or converting, if that serves the creditors and the estate better. That option isn’t available in Subchapter V cases. Subchapter V debtors must file a plan within 90 days after the order for relief. Extensions are only for circumstances the debtor should not justly be held accountable for.

Decide Between Dismissal and Conversion

First, could the creditors get any assets or the benefits of any claims, like lawsuits, if the case were converted to Chapter 7? If the creditors would get at least something in a Chapter 7 case, conversion could be more appealing than a dismissal, since the trustee would take over and administer the case.

The second and third factors are whether any creditors received preferential payments and whether dismissal would sacrifice any rights. Bankruptcy dismissal can bring back pre-bankruptcy custodianships. Any orders avoiding transfers or liens can be vacated.

The fourth factor: If there’s a dismissal, would the debtor just refile the case? And the fifth: How much would it cost to liquidate the business, or process a Chapter 7 case? A liquidating plan or Chapter 7 case often takes significant time and involves administrative expense. Dismissal avoids all that.

It’s a balancing test. The debtor’s potential personal tax liabilities can also affect the court’s decision.

If the court dismisses the case, it usually does it without prejudice, and the parties go back to where they were before the case started. The court will try to undo anything that happened during the bankruptcy, to the extent reasonably possible. Usually, that means any property of the estate goes back to the debtor, unless the court finds cause to make a different order. And secured lenders keep any rights or remedies they had under non-bankruptcy law. Debtors sometimes ask for a structured dismissal. That’s a dismissal that includes conditions, like required payments or releases. In Jevic, the Supreme Court rejected the idea of a structured dismissal where the payments go to creditors outside the priority order. But some courts still approve them if they follow the priority of claims.

In re Pourteymour is a good example. He was a real estate investor, and the bank had begun foreclosure proceedings. He filed Chapter 11, to keep the bank from foreclosing on three of his properties. The bankruptcy court lifted the stay and let the bank foreclose on one property. The debtor moved to dismiss, saying that losing the property meant he could not confirm a plan. Converting to Chapter 7 would mean higher taxes, he said. He would pay the creditors anyway, over time. The U.S. Trustee asked for a conversion, so a neutral Chapter 7 trustee could evaluate and maybe settle claims against the bank. As you might expect, the bank also opposed a structured dismissal. The judge found cause but said conversion was not in creditors’ best interests. It ordered a plain dismissal, with no conditions.

The bank appealed, but the appellate panel affirmed the court’s decision. It explained that the requirements for dismissing a case are not the same as those required to confirm a Chapter 11 plan. The dismissal returned the parties to the positions they were in before the Chapter 11. So the bank was still free to enforce any state law rights against the debtor. The debtor’s promises to pay certain creditors in court did not make a difference because there were no such promises in the dismissal order. The ruling was unpublished and not binding precedent, but it shows the danger of relying on what parties say in the courtroom instead of the actual words of the order.

The key is to try to prevent cause from developing. Make sure your U.S. Trustee fees are paid up and stay paid up. If you’re not in Subchapter V, you have to pay at least $250 a quarter, whether or not there are any disbursements. You need to think about which outcome you want, conversion or dismissal, and then set out why that outcome will serve the interests of your creditors. If there are any deals, or conditions for a dismissal, get them in the written order.