Does the court have discretion to deny a debtor’s motion to convert a Chapter 7 bankruptcy filing to another chapter if the debtor meets the technical requirements for the other chapter?
Robert Marrama sought to convert his Chapter 7 bankruptcy case to a Chapter 13 after meeting the requirements for Chapter 13. The bankruptcy court denied Marrama’s motion to convert based on Marrama’s prior bad faith conduct in failing to report in his bankruptcy schedules the value of a tax refund and vacation home. The Bankruptcy Appellate Panel and Court of Appeals for the First Circuit affirmed. In this case, the Supreme Court will determine whether courts have discretion to deny conversions based on an evaluation of the debtor’s conduct. The decision will hinge on the statutory language and legislative history of the Bankruptcy Code. While this issue may be limited to filings that occurred before Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, it will give the court the opportunity to clarify the scope of the good faith requirement in bankruptcy proceedings and the amount of discretion afforded to bankruptcy judges.
Questions as Framed for the Court by the Parties
Whether the right to convert a Chapter 7 bankruptcy case to another chapter can be denied notwithstanding the plain language of the statute and the legislative history.
Robert Marrama entered the flooring business as a teenager and grew his family’s small enterprise into a multi-million dollar company. Sonia Nezamzadeh, Medill—On the Docket: Marrama, Robert v. Citizens Bank of Massachusetts, et al., posted on June 13, 2006. However, Marrama’s financial fortunes took a turn for the worse, and he requested Citizens Bank of Massachusetts to increase a credit line it had extended to him. Brief for Petitioner at 3. The bank refused, recalling the note and requesting payment in full. Id. When Marrama was unable to pay, the bank commenced
With $800,000 of debt, Marrama filed for bankruptcy protection on March 11, 2003. Nezamzadeh. Following the advice of a former attorney, Marrama filed under Chapter 7 of the Bankruptcy Code. Brief for Petitioner at 3. Under Chapter 7, a debtor releases all nonexempt assets (such as cars, work-related tools, and basic household furnishings) to a trustee who liquidates the assets and distributes the cash to creditors. 11 U.S.C. §§ 701, 704 (2000). While Chapter 7 is a neat way of administering the bankruptcy process, both creditor and debtors prefer Chapter 13 reorganization proceedings. Brief for the Nat’l Ass’n of Consumer Bankruptcy Attorneys as Amicus Curiae Supporting Petitioner (“NACBA Brief”) at 4–5. Under Chapter 13, which applies to natural persons, debtors restructure their assets to fully repay their creditors and still retain control of certain assets (like a mortgaged house or car). 11 U.S.C. §§ 1325, 1326, 1328 (2000). To qualify for Chapter 13, debtors must have a regular income stream and keep their amount of secured and unsecured debts below certain levels. 11 U.S.C. § 109(e) (2000). Section 706(a) of the Bankruptcy Code allows debtors one opportunity to convert their case from Chapter 7 to Chapter 13. 11 U.S.C. § 706(a) (2000).
After securing work and a steady income at his brother’s flooring company, Marrama applied to the U.S. Bankruptcy Court for the District of Massachusetts to convert to Chapter 13. Brief for Petitioner at 4. The bankruptcy court refused Marrama’s application on grounds of bad faith, indicating that Marrama had failed to report a $11,000 tax refund and had concealed his ownership of real estate valued at $85,000 by placing it in a spendthrift trust, making his girlfriend the trustee and himself the sole beneficiary, just seven months before filing for bankruptcy. In re Marrama, 430 F.3d 474, 476 (1st Cir. 2005). Marrama claimed the failures were mere oversights but the decision was affirmed by the Bankruptcy Appellate Panel (“BAP”). Id.
Marrama appealed to the U.S. Court of Appeals for the First Circuit, claiming that section 706 of the Bankruptcy Code gave an eligible debtor who had not previously converted his case an “absolute right” to seek conversion. Id. at 477. On October 31, 2005, the First Circuit disagreed and unanimously upheld the BAP decision. Id. at 483. According to the majority, section 706 granted only a presumptive right to convert that could be denied if the court found an “extreme circumstance.” Id. at 478. According to the Court, an “extreme circumstance” exists when the debtor acts in bad faith by concealing assets from the bankruptcy process. See id. at 483. The Court contended that limiting the right to convert to honest debtors conforms to a fundamental purpose of Bankruptcy Code: to prevent abuse or manipulation of the bankruptcy process. See id. at 480. On June 12, 2006, the Supreme Court accepted review. Brief for Petitioner at 5.
Marrama argues that debtors have an unqualified and absolute right to Chapter 13 conversion. Brief for Petitioner at 27. He bases his argument on his interpretation of the statutory language of section 706(a) and Congress’s intentions for enacting the section. Id. Because section 706(a) reads that a debtor, as opposed to a court, may convert to Chapter 13, Marrama and the National Association of Consumer Bankruptcy Attorneys (“NACBA”) maintain that the decision to convert is vested solely in the debtor. Brief for Petitioner at 10; Brief for NACBA as Amicus Curiae Supporting Petitioner (“NACBA Brief”) at 8. For support, the NACBA compares 706(a) to 706(b), which provides that the court may convert to a Chapter 11 filing. NACBA Brief at 11. In addition, they argue the verb “may” is permissive, and vests all decision-making power in the debtor. Id. at 8. Therefore, the argument goes, provided the debtor has not already converted and meets the requirements for Chapter 13 filings, the debtor is free to convert and the court is compelled to grant the conversion. Id. at 13–16.
Marrama further argues that Congress intended section 706(a) to give debtors an absolute right to convert. Brief for Petitioner at 12. This is apparent from the legislative history of section 706(a), in which Congress specifically declared that the provision vests the debtor with an “absolute right” to convert. Id. (quoting H.R.Rep. No. 95-595, at 380 (1977); S.Rep. No. 95-989, at 94 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5880). This is also evident from the way that Congress drafted the surrounding provisions of the Bankruptcy Code. For instance, because Congress inserted good faith requirements in other provisions, see e.g., 11 U.S.C. § 1325(a)(3) (2000) (requiring a debtor’s good faith conduct before a court confirms a Chapter 13 reorganization plan), it must have deliberately omitted a good faith requirement from 706(a). NACBA Brief at 15–16. In the same vein, Congress enumerates how courts should punish debtors in other provisions (see e.g., 11 U.S.C. §§ 156, 727 (2000)) and therefore did not intend for courts to withhold conversion as a means of punishment. Brief for Petitioner at 8. Further, Marrama points out that Congress removes judicial discretionary powers in other provisions of the Code. Id. at 13 (pointing out that if a Chapter 13 plan meets the minimum statutory requirements, a judge is compelled to accept the plan). Therefore, Marrama argues, it is reasonable to assume that Congress deliberately deprived judges of discretion in 706 conversions.
Marrama also argues that grafting a good faith requirement onto 706 conversions runs counter to the general purpose of the bankruptcy process: to make creditors whole while giving debtors a fair chance to regain their financial footing. Id. at 20. Marrama points out that by Congressional stipulation even debtors who commit actual fraud are given an opportunity to clear their financial ledgers through Chapter 13. Id. at 21. Furthermore, because “bad faith” is difficult to define, individual judicial definitions and findings will vary widely and courts will not administer justice uniformly or predictably. Id. at 17–18. Thus, debtors will have no guidance on whether their actions constitute bad faith conduct. Id. Thus, construing a good faith requirement into 706 conversions deprives debtors a fair chance to repay their debt.
Citizens Bank’s Arguments
Citizens Bank, the trustee appointed to the case, and the National Association of Bankruptcy Trustees (“NABT”) argue that statutory language and legislative intent dictate that bankruptcy judges may deny conversion in cases of extreme circumstances such as a debtor’s bad faith conduct. In re Marrama, 430 F.3d 474, 478 (1st Cir. 2005); Brief for Respondent at 19, 45. They maintain that the verb “may” suggests conditionality, meaning that the right to convert to Chapter 13 is presumptive but not absolute. In re Marrama, 430 F.3d at 478. Comparatively, section 1307(b) provides that a court “shall” dismiss a case at the request of a debtor. Id. This illustrates that Congress affirmatively chose to use “may” as opposed to “shall” to indicate the conditional quality of the right to convert. Id.; Brief for Respondent at 29–30
Citizens Bank and the NABT also argue that the term “absolute” used in the legislative history should be read in the context of the entire Bankruptcy Code. In re Marrama, 430 F.3d at 478–80; Brief for Respondent at 29. There is a general requirement of good faith conduct in all bankruptcy proceedings, and the Code provides latitude for judges to ensure that parties act in good faith. See In re Marrama, 430 F.3d at 478–80; Brief for Respondent at 29. Section 105, in particular, confers broad powers on bankruptcy court judges to prevent abuse of the bankruptcy process. 11 U.S.C. § 105 (2000). In light of section 105, Citizens Bank argues that Congress did not intend section 706(a) to check the bankruptcy court’s power to prevent abuse of the bankruptcy process. In re Marrama, 430 F.3d at 478; Brief for Respondent at 35–37. Also, bankruptcy courts have the power to reconvert Chapter 13 proceedings to Chapter 7 proceedings after a showing of a debtor’s bad faith. In re Marrama, 430 F.3d at 481. As the lower court pointed out, it would be illogical and inefficient for a bankruptcy court, which has already found evidence of the debtor’s bad faith conduct, to perfunctorily convert a case to Chapter 13 and then reconvert the case to Chapter 7. Id.; Brief for Respondent at 34–35.
Similarly, Citizens Bank and the NABT argue that allowing Marrama to convert violates the fundamental principle of bankruptcy law that the bankruptcy process not be used for fraudulent purposes. See In re Marrama, 430 F.3d at 477; NABT Brief at 3; Brief for Respondent at 45. Thus, debtors who act in bad faith should not be permitted to avail themselves of the benefits of bankruptcy proceedings. See NABT Brief at 3. They argue that allowing a debtor who conceals, undervalues, or otherwise intentionally misrepresents assets while in Chapter 7 to regain control of those assets in Chapter 13 would undercut the compliance and enforcement provisions of Bankruptcy Code. See id. at 9; Brief for Respondent at 48. Section 707 illustrates this by preventing debtors from availing themselves of Chapter 7 if they “substantially abuse” the system. Marrama transferred his real estate to a spendthrift trust seven months before filing for bankruptcy for the sole purpose of concealing the estate from his creditor. In re Marrama, 430 F.3d at 482. By converting to Chapter 13, Marrama intended to remove control of the spendthrift trust from the court-appointed trustee. Id. at 482. In cases where the debtor clearly attempts to thwart the bankruptcy process, the argument is that courts should have the authority to exercise their section 105 powers and prevent abuse of process. See id. at 477.
Bankruptcy in America and the BAPCPA
When Robert Marrama filed for bankruptcy in 2003, he was not alone. In 2003, over 1 million Americans filed for individual bankruptcy. 2003 by Chapter, Bankruptcy Statistics. Two years earlier, more people filed for bankruptcy than suffered heart attacks, were diagnosed with cancer, filed for divorce, or graduated from college. Elizabeth Warren, Edward M. Spear Lecture at the Brooklyn Law School, The Growing Threat to Middle Class 3–4. While the majority of these debtors are middle class, an increase in bankrupt consumers affects all segments of society by increasing the cost of credit. See Warren at 6–7;
Marrama’s case unfolded against a backdrop of a larger national debate that took center stage during the proposed reforms to the Bankruptcy Code in 2005, encapsulated in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23 (2005) (“BAPCPA”). The reforms created controversy by making Chapter 7 less attractive and thus prompting debtors to structure their bankruptcy under the less debtor-friendly Chapter 13. NACBA Truth at 4–5. For instance, the amended section 707 allows a court to dismiss a Chapter 7 case if it finds that granting relief under that chapter would be a “substantial abuse” of the system. 11 U.S.C. § 707(b) (2000).
The fact pattern in Marrama is ironic in light of the BAPCPA, because in this case the broad issue is whether bad faith should prevent a debtor from entering Chapter 13. Furthermore, the BAPCPA spoke directly to the issue here by requiring good faith even at the stage of filing the petition. 11 U.S.C. § 1325(a)(7), added by BAPCPA § 102(g)(3) (2005); cf. 11 U.S.C. § 1325(a)(3) (2000) (requiring good faith at stage of proposing plan). In light of the 2005 amendments to the Bankruptcy Code, the impact of this decision may be limited to its facts. Nevertheless, Marrama is still important in resolving whether the scheme of federal bankruptcy contains an implied requirement of good faith.
Marrama argues that a qualified debtor under section 706 has an “absolute right” to convert from Chapter 7 to Chapter 13. Brief for Petitioner at 27. He claims that the language of section 706, which provides that the debtor “may convert a case under this chapter to a case under chapter . . . 13 . . . at any time” and that “[a]ny waiver of the right to convert a case . . . is unenforceable,” plainly places discretion to convert solely in the debtor. See id. at 9–15. This effectuates the underlying policy of bankruptcy court to maximize a debtor’s opportunity to repay creditors. Id. at 15, 23. Citizens Bank, on the other hand, maintains that the language on its face expresses only a conditional right and that allowing conversion even given evidence of bad faith allows the debtor to undermine the enforcement and compliance provisions of the Bankruptcy Code. Brief for National Association of Bankruptcy Trustees as Amicus Curiae Supporting Respondent (“NABT Brief”) at 9, 11.
Impact of Decision by the Supreme Court
If the U.S. Supreme Court finds for Marrama, courts and trustees may be less able to effectively manage bankruptcy proceedings. Determining that a debtor can convert automatically and unconditionally to Chapter 13 and thereby unilaterally divest the Chapter 7 trustee of powers under the Code, will inhibit the ability of the trustee to investigate fraud and protect creditors’ interests. NABT Brief at 9. A victory for Citizens Bank, on the other hand, would allow a bankruptcy court to retain more control over the transfer to Chapter 13 and the attendant legal implications (e.g., the appointment of a new trustee under section 1302, and the distinct obligations and rights of the parties (see, e.g., section 1303)).
The Court may also resolve whether the Bankruptcy Code contains an implied requirement of good faith. A decision for Marrama might be a pyrrhic victory because although Marrama could automatically enter Chapter 13, he would be required to file a plan and attend a hearing in which the court considers lack of bad faith in confirming or denying the plan. 11 U.S.C. §§ 1321, 1325 (2000). However, allowing debtors to automatically obtain the benefits of Chapter 13, despite their abuse of the bankruptcy proceedings, suggests a general lack of a good faith requirement unless explicitly mandated by Congress.
If the Court finds for Citizens Bank, it may be confirmation that bankruptcy courts have the power to inquire into bad faith even absent an explicit directive. This would give courts more discretion to control the bankruptcy process by expanding the reach of section 105(a), which allows courts to “take[e] any action or mak[e] any determination necessary or appropriate to . . . prevent any abuse of [the bankruptcy] process.” 11 U.S.C. § 105(a) (2000). Although this could aid trustees in managing the bankruptcy process, it would make the process less predictable for creditors, bankruptcy attorneys, and debtors, by subjecting the process to a requirement with fuzzy contours.
Regardless of the outcome, a Supreme Court decision will clarify the good faith issue. The term “bad faith” is not defined in the Code and has suffered from a lack of uniformity in lower court findings. Erin J. Koffman, Notes & Comments: What is Bad Faith Conversion? See The Need for a Uniform Determination, 18 Bank. Dev. J. 425, 426 (2002). Instead, courts have applied a “sniff test,” in which they will find that parties acted in bad faith when they sense “something fishy.” Id. at 450. Commentators have criticized this approach as too subjective and instead proposed courts use a “totality of the circumstances” test, which would employ easily identifiable subjective and objective factors like improper conduct, debtor response to court orders, and seemingly tactical filing timing. Id. at 450–51. But given that there has not yet been an authoritative statement about whether the Bankruptcy Code implies a good faith requirement, the Supreme Court’s ruling in Marrama will inject clarity into the Code regime.
In light of the 2005 amendments to the Bankruptcy Code, the impact of this decision may be limited to its facts. Section 707 of the Code now gives bankruptcy courts more authority to dismiss or convert Chapter 7 cases in light of evidence of abuse of process by the debtor. Section 1325 has been amended to require a court to consider whether a debtor filed for Chapter 13 in good faith. Regardless of its limited application, the case gives the Court an opportunity to better define the scope of the general good faith requirement in bankruptcy proceedings as well as the amount of discretion given to bankruptcy judges to ensure good faith dealings between parties.