Chapter 13 Escape Hatch Closing?

How many times have you seen this happen? A chapter 7 bankruptcy trustee discovers an asset, or a prepetition transfer of assets, conveniently omitted from the schedules. The trustee takes the first step to recover the asset or avoid the transfer. The debtor then escapes by converting the case to chapter 13, divesting the trustee of power to pursue the asset.
In the Ninth Circuit, conversion as of right under Bankruptcy Code section 706(a) was available even in a case of bad faith. In re Croston, 313 B.R. 447 (Bankr. App. 9th Cir. 2004). In the Southern District of California, our chapter 13 trustees are keeping track of these converted cases, in order to avoid later dismissal for failure to prosecute, or after a default under a confirmed plan.
As of February 21, 2007, there is authority for a creditor, or a chapter 7 trustee, to prevent bad faith conversion in the first instance. In Marrama v. Citizensbank of Massachusetts, 2007 WL 517340 the Supreme Court ruled 5-4 that the debtor’s motion to convert may be denied in a case of bad faith. As stated in the opinion:

Marrama made a number of statements about his principal asset, a house in Maine, that were misleading or inaccurate. For instance, while he disclosed that he was the sole beneficiary of the trust that owned the property, he listed its value as zero. He also denied that he had transferred any property other than in the ordinary course of business during the year preceding the filing of his petition. Neither statement was true. In fact, the Maine property had substantial value, and Marrama had transferred it into the newly created trust for no consideration seven months prior to filing his Chapter 13 petition. Marrama later admitted that the purpose of the transfer was to protect the property from his creditors.

In creating a judicial qualification to the apparent absolute right to convert under section 706(a), the Court stated “the broad authority granted to bankruptcy judges to take any action that is necessary or appropriate ‘to prevent an abuse of process’ described in § 105(a) of the Code is surely adequate to authorize an immediate denial of a motion to convert filed under § 706 in lieu of a conversion order that merely postpones the allowance of equivalent relief and may provide a debtor with an opportunity to take action prejudicial to creditors.” Take that, strict constructionists! Not surprisingly, the dissenters included Alito, Thomas and Scalia. Chief Justice Roberts joined the dissent, which serves as our first indication of how he may factor on the bankruptcy "strict construction" debate in the future.