Recently, a bankruptcy court in the First Circuit, confronted with whether the debtors’ chapter 12 case could be converted to a chapter 11 case – an issue over which there is split in the case law – determined that the Debtors’ chapter 12 case could not be converted to a chapter 11 case.

Relevant Statutes and Statutory Provisions:

Chapter 11 of the Bankruptcy Code allows both businesses and individuals a mechanism to reorganize their debt, whereas chapter 13 is a mechanism of reorganization of debt available exclusively to individuals. Chapter 7 governs the process of a liquidation bankruptcy.

Chapter 12 of the bankruptcy code is a framework for family farmers or family fishermen (as such terms are defined in the Bankruptcy Code) to reorganize their debt. Chapter 12 of the bankruptcy code was implemented to reduce the complications and costs such debtors would face when attempting to reorganize under chapter 11 of the Bankruptcy Code, as well as to address the issues such debtors would face when reorganizing under chapter 13, which was intended for wage earners who generally have smaller debts than those of family farmers or fisherman.

Section 1208(a) of the Bankruptcy Code provides, in relevant part, that “[t]he debtor may convert a case under this chapter [12] to a case under chapter 7 of this title at any time.”

Section 105(a) of the Bankruptcy Code provides, in relevant part, that “[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”

Facts of the Case:

On January 11, 2016, Carlos H. Ortiz Colón and Maribel Rodríguez Ríos, dairy farmers, and Vaquería Ortiz Rodriguez Inc., a dairy business, (collectively, the “Debtors“), filed for relief under chapter 12 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Puerto Rico. Their cases were subsequently substantively consolidated, with an aggregate debt amounting to $4,489,690.

The Debtors’ secured creditor, Condado 4 LLC (“Condado“) filed a motion to dismiss the Debtors’ cases, arguing that as the Debtors’ aggregate debt exceeded the limit for eligibility under chapter 12 of the Bankruptcy Code, the Debtors’ cases must be dismissed. In response, the Debtors sought to convert their case to a case under chapter 11 of the Bankruptcy Code, which Condado opposed.

The Courts Analysis:

In determining whether to convert the Debtors’ cases from chapter 12 to chapter 11, the bankruptcy court in In re Colon – noting that there was no authority in the First Circuit on the issue of conversion – reviewed case law from other circuits.

The courts in the other circuits that granted conversion tended to do so if three criteria were met: (1) the debtor filed the chapter 12 case in good faith, (2) there is no prejudice to creditors, and (3) the conversion of the case would be equitable. One of the lead cases in support of conversion, a case in the United States Bankruptcy Court of the Eastern District of North Carolina, noted that in certain instances, dismissing a chapter 12 case rather than converting it would be a mere formality, as the debtor could just refile the case as a chapter 11 case.

Other courts have denied conversion from chapter 12 to chapter 11, finding that conversion to chapter 11 was not authorized by Congress. For example, in In re Christy, a case decided by the United States Bankruptcy Court of the Eastern District of Virginia, the court analyzed section 1208 of the Bankruptcy Code and noted that while “[s]ection 1208 provides for conversion of a chapter 12 case to a case under chapter 7, but . . . is silent as to the authority to convert a chapter 12 case to a case under chapter 11,” other sections of the Bankruptcy Code “specifically allow for extensive conversion.” The Christy court found this silence in Section 1208, when juxtaposed against other chapters of the Bankruptcy Code that specifically allowed for conversion, to be significant. The Christy court further found that the legislative history surrounding chapter 12 indicated that “Congress specifically rejected the concept of allowing a debtor to convert a chapter 12 case to a case under chapter 11.”

The Court next noted that the cases that allowed for conversion implicitly relied on the equitable powers of the Bankruptcy Court available under Section 105 of the Bankruptcy Code, and that pursuant to First Circuit case law, Section 105 of the Bankruptcy Code does not authorize the Bankruptcy Court to create substantive rights that are otherwise unavailable under the Bankruptcy Code. The Court thus determined that conversion from chapter 12 to chapter 11 was precluded in this case. Because it was undisputed that the Debtors’ debts surpassed the statutory limits provided for under chapter 12 of the Bankruptcy Code, the Court dismissed the Debtors’ cases.

Takeaway:

Bankruptcy attorneys are often tempted to use Section 105 of the Bankruptcy Code as a tool to provide their clients with substantive rights otherwise unarticulated in the Bankruptcy Code. In re Colon serves as another reminder that Section 105 is not a catch-all provision for substantive rights otherwise unavailable under the Bankruptcy Code. Rather, Section 105 merely serves as an authorization of the bankruptcy court to exercise equity in carrying out the substantive rights already provided for by other provisions of the Bankruptcy Code.