The United States Supreme Court has issued its decision in Marrama v. Citizen’s Bank of Massachusetts, 549 U.S. ___, 127 S.Ct. 1105 (2007) in which the Court resolved a conflict among the circuits as to whether a Chapter 7 debtor, who has acted in bad faith in his liquidation proceeding, has an absolute right under §706 of the Bankruptcy Code to convert his case to a Chapter 13 proceeding or whether his bad faith conduct can be considered as a ground to deny conversion of the case. In a 5-to-4 decision, a divided Court concluded that a debtor, who engaged in bad faith conduct in his Chapter 7 case, might be barred from converting his case to Chapter 13.

The Legal Framework
The courts are in virtual unanimous agreement that bad faith conduct by the debtor prior to or during his Chapter 13 bankruptcy case provides cause for the Bankruptcy Court to dismiss the case to bar the debtor from obtaining the “fresh start” relief otherwise granted under the Code. Examples of bad faith by the debtor include the debtor concealing assets, which should properly be included in the debtor’s bankruptcy estate; transferring assets with the intent to conceal them from a trustee or the court; or deliberately failing to schedule a claim, either to prevent the creditor from obtaining notice of the bankruptcy and participating in the case. Another example includes allowing the debtor to conceal his liability and continue paying the debt post-bankruptcy to the detriment of other creditors, or because the debt would cause the debtor to be ineligible for relief under the Chapter 13 debt limitations.

Another context in which a debtor’s bad faith and its right to pursue relief in Chapter 13 arises is when a debtor first files a bankruptcy petition under Chapter 7 and then seeks to convert the case to Chapter 13 pursuant to §706 of the Bankruptcy Code. Section 706(a) states in pertinent part 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, if the case has not been converted under §1112, §1208 or §1307.”

In addition, §706(d) states that a debtor may only convert his case to a case under another chapter of the Code if the debtor is eligible to be a debtor under that other chapter. For example, only individuals with regular income and who meet certain debt restrictions are eligible to be a debtor under Chapter 13.

Facts of the Marrama Case
In Marrama, the debtor filed a voluntary Chapter 7 petition initiating his bankruptcy case. Marrama filed bankruptcy schedules, signed under penalty of perjury, which included inaccurate or misleading statements regarding certain real property located in Maine, his principal asset. Marrama specifically valued the real estate at zero on his schedules and also denied having made any out of the ordinary course transfers during the year prior to his bankruptcy filing. Both of these statements were false. Marrama in fact had transferred the Maine property to a trust he created several months prior to the bankruptcy. The property was very valuable and was transferred for no consideration in an apparent attempt to conceal it from the trustee.

The Chapter 7 trustee investigated the asset and advised the debtor at the conclusion of his §341(a) first meeting of creditors that he intended to take action to recover the Maine property for the benefit of the bankruptcy estate. Shortly thereafter, the debtor filed a notice of his intent to convert his Chapter 7 case to a case under Chapter 13. The Chapter 7 trustee and Citizens Bank, one of the debtor’s creditors, filed objections. The Bankruptcy Court treated the debtor’s notice as a motion to convert and set a hearing on the motion and objections.

Marrama claimed his statements and omissions regarding the Maine property were mistakes and felt he should be allowed to convert his case to Chapter 13. The trustee and the bank claimed he acted in bad faith and had no right to convert the case. The debtor appealed to the Bankruptcy Appellate Panel for the First Circuit, which affirmed the bankruptcy court’s decision denying conversion, and thereafter to the Court of Appeals for the First Circuit, which also upheld the rulings of the lower courts.

The First Circuit specifically held that the language of §706 does not create an absolute right for a debtor to convert his case from Chapter 7 to Chapter 13, and that as a practical and legal matter, where the facts of a case would support dismissal of a Chapter 13 case for bad faith if the case had been initiated under Chapter 13, there is nothing in the provisions of §706 that grant an absolute entitlement to the debtor to convert to Chapter 13.

Issue in Conflict Among the Circuits
The issue determined by the Supreme Court in Marrama is a narrow, procedural one but one with practical significance to creditors when a debtor acting in bad faith files a Chapter 7 petition and later tries to convert his case to Chapter 13 to gain the benefit of the delay, confusion and increased expense for creditors resulting from the conversion. There are published decisions in a number of circuits holding that §706(a) creates an absolute right by the debtor to convert his case from Chapter 7 to Chapter 13 so long as he meets the two express conditions of §706(a) and (d), specifically that the debtor has not previously converted his case to Chapter 7 from another chapter of the Code, and that the debtor meets the eligibility requirements to be a debtor in a case under the chapter of the Code to which the debtor seeks conversion.

The First Circuit, however, concluded that the language of §706(a), which uses the word “may” rather than “shall,” indicates the language is not absolute. Further, all courts agree, including those that hold the right to convert is absolute, that after a bad faith debtor’s case is converted from Chapter 7 to Chapter 13, the Court may dismiss the Chapter 13 case for bad faith. Therefore, since a bankruptcy court is entitled to consider the debtor’s good faith when a case is commenced under Chapter 13, the First Circuit found the bankruptcy court was entitled to consider the debtor’s bad faith in the Chapter 7 case in determining whether conversion of the case to Chapter 7 should be allowed.

The First Circuit concluded there is no basis for the drafters of the Code to have intended §706 to create a distinction in the treatment of those debtors who file under Chapter 7 and convert from those who file a case under Chapter 13 from the outset.

The Supreme Court’s Analysis and Decision
The divergence of views on the “absolute” nature of the Chapter 7 debtor’s right to convert his case to Chapter 13 apparently lies in part in the existence of certain loose language in the Committee Reports, which accompanied the bills enacted as the Bankruptcy Code of 1978. The Committee Reports use the language “absolute” in relation to the right to convert. The Supreme Court found the reference to be ambiguous in context and unpersuasive as a statement of intention that a debtor always be permitted to convert from Chapter 7 to Chapter 13, particularly given the express eligibility limitation in §706(d).

The majority of the Court held also that the requirement of the debtor to be eligible to be a debtor under Chapter 13 in order to convert his case to that chapter implicitly incorporates the provisions of §1307, which provide for dismissal of a Chapter 13 case “for cause.” Bankruptcy courts routinely treat bad faith as cause for dismissal of a case under Chapter 13, and indeed, the courts from the other circuits, which have held that conversion to Chapter 13 is an absolute right nevertheless also hold that once converted, the debtor’s pre-conversion misconduct in Chapter 7 and prior to bankruptcy provide grounds for dismissal of the case after conversion from Chapter 7.

The majority on the Supreme Court thus concluded that a ruling where the debtor engaged in pre-filing or pre-conversion bad faith conduct “is tantamount to a ruling that the individual does not quality as a debtor under Chapter 13.” The majority also found support in the provisions of §105(a), which authorize the court to issue any order necessary to prevent an abuse of the bankruptcy process as sufficient authority to permit the court to deny the motion for conversion of the debtor’s case from Chapter 7 to Chapter 13.

The dissenting opinion, joined in by four of the justices, claimed the plain language of the provisions of §706 did not incorporate the broader grounds for dismissal of a case for cause but only the specific eligibility requirements under §109(e). The dissent found that the denial of the right to convert circumvented the procedural safeguards of §1307, which requires a motion to be filed to seek dismissal of a case under Chapter 13, and provides the debtor an opportunity to respond to the motion.

The practical effect of the Supreme Court’s ruling is that the debtor’s good faith prior to and during his Chapter 7 case can be tested and determined in that chapter when he attempts to convert his case to another chapter of the Code. The ruling denies the debtor who is acting in bad faith the benefit of using the procedure of conversion to delay a determination of his eligibility for substantive relief in bankruptcy where he has engaged in misconduct prior to filing or during the case sufficient to warrant dismissal.

Nothing in §706(a) requires notice or a hearing on a debtor’s request to convert its case to another chapter, and as a practical matter, if a creditor is not closely monitoring the status of filings in the Chapter 7 case, in many jurisdictions the battle over the debtor’s bad faith may end up being fought in the Chapter 13 case in any event if the conversion occurs upon the debtor’s request and without notice to creditors or a hearing.

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Lesley Anne Hawes is a partner with McKenna Long & Aldridge, LLP, a full-service law firm of 400 lawyers and public policy advisors with offices in Atlanta, Brussels, Denver, Los Angeles, Philadelphia, San Diego, San Francisco and Washington, DC. The firm provides business solutions in the areas of corporate law, government contracts, intellectual property and technology, complex litigation, public policy and regulatory affairs, international law, real estate, environmental, energy and finance as well as bankruptcy and creditor’s rights. To learn more about the firm and its services, visit www.mckennalong.com.