When Can a Court Convert Your Chapter 11 Reorganization to a Chapter 7?

Businesses under financial duress can choose from two alternative courses in bankruptcy. If they believe they can reorganize and return to profitability, they can opt for Chapter 11. If not, then the path is Chapter 7, by which the business’s assets are liquidated and distributed to creditors and the company ceases to exist.

A business owner who initially files for Chapter 11 usually has the right to convert voluntarily to Chapter 7 at any point in the case. Additionally, the Bankruptcy Code allows a creditor to ask the court to convert the case from Chapter 11 to Chapter 7 “for cause” — namely, that the debtor appears to be using Chapter 11’s restructuring process to frustrate creditors while retaining control of the business.

Motions to convert to Chapter 7 for cause may be granted if the court examines the facts of the case and finds one or more of the following:

• The debtor has no profitable core business around which to structure a reorganization.
• The debtor cannot or will not formulate a reasonable reorganization plan.
• The debtor’s financial picture indicates little or no ability to generate income and as such there is little reasonable likelihood of rehabilitation.
• The debtor’s business is suffering continuing losses by remaining in operation, which may be shown by its negative cash flow during Chapter 11 and/or its inability to pay ordinary costs of business such as insurance, taxes and interest.
• The debtor has failed to comply with the court’s filing and reporting requirements, thus showing that it has not exercised the due diligence expected of a Chapter 11 debtor.
• The debtor is not using Chapter 11 for a legitimate reorganization effort or is otherwise not acting in good faith.

Assuming that converting to Chapter 7 is in the best interest of creditors, the court will grant the motion and a trustee will be appointed to liquidate the debtor’s assets and distribute the proceeds to creditors.

For most debtors, the prospect of an involuntary conversion from Chapter 11 to Chapter 7 is a harrowing one. Conversion means a cessation of business, which is a hard pill to swallow. A debtor wishing to challenge a conversion motion must have highly experienced legal counsel to rely on.

At the Law Offices of Michael Jay Berger in Beverly Hills, I have handled conversions for debtors and creditors, so I know the issues from all angles. If you need advice regarding a possible conversion, please call 310-271-6223 or contact me online to schedule a free initial consultation.