Danny Newman Recaps Ninth Circuit Decisions for Debtor-Creditor Newsletter

Attorney Danny Newman has an in-depth article reviewing several recent Ninth Circuit case decisions, published in the latest installment of the OSB Debtor-Creditor Section Newsletter. You can read Danny’s article in full below.

Ninth Circuit Case Notes

By Danny Newman

Party Seeking Conversion from Chapter 11 to Chapter 7 Has Burden of Persuasion

In re Baroni, 36 F.4th 958 (2022)

The Ninth Circuit (and Oregon’s Judge Forrest) confirmed a long line of lower court cases in the circuit that the movant has the burden of persuasion to show “cause” when seeking conversion from Chapter 11 to Chapter 7.

Debtor Allana Baroni defaulted under her Chapter 11 plan by refusing to pay Bank of New York Mellon (NYM) after she lost her adversary proceeding challenging the bank’s secured claim on one of several mortgages she had obtained to purchase rental properties. It was not the first time that Baroni had failed to pay a secured creditor as required under her plan. As a result, the bankruptcy court granted NYM’s motion to convert the bankruptcy case from Chapter 11 to Chapter 7 and ordered Baroni to turn over unadministered rent and sale proceeds to the Chapter 7 trustee. The district court affirmed in two separate appeals. 36 F.4th 958, 963.

Taking all the issues together, the Ninth Circuit began by affirming the multistep approach to conversion laid out in Section 1112(b) of the Bankruptcy Code. Depending on the arguments advanced by the parties, there are three primary inquiries for conversion: “(1) whether cause exists for granting relief under Section 1112(b)(1); (2) whether granting relief is in the creditors’ and the estate’s best interests; and (3) if so, which form of relief best serves the creditors’ and the estate’s interests.” Id. at 965.

First, the Ninth Circuit acknowledged that it had never directly addressed the question of who has the burden to establish that cause exists for conversion. The panel adopted the logical and apparently unanimous position that the burden to show cause lies with the movant. The court then found that failure to make several payments to secured creditors under a confirmed plan is “material default” constituting cause under § 1112(b)(4)(N). Id. at 966-67.

Second, the Ninth Circuit affirmed the BAP’s previous holdings that courts may not convert cases if it finds and identifies “unusual circumstances,” which the BAP and now the Circuit “contemplates” conditions that are not common in chapter 11 cases.” The Ninth Circuit then held that failure to make plan payments, disputes over validity or claim amounts, and other such issues are not unusual circumstances sufficient to defeat a motion to convert. Thus, Baroni failed to establish unusual circumstances.

Third, the circuit panel considered whether the bankruptcy court erred by failing to consider whether dismissal or conversion best served the creditors. It concluded that there was no error by granting conversion or failing to consider dismissal, reasoning that no creditor objected to the motion to convert and the bankruptcy court had concluded (correctly) that conversion would bring about quicker resolution for creditors than dismissal after more than six years of Baroni’s bankruptcy case and plan pending.

The decision is not earth-shattering. However, it does good work by fully settling a question that could lead to litigation and affirming that common bankruptcy court considerations on motions to convert are indeed the proper ones to follow.

Debts Owed by Attorney to Clients or to State Bar on Clients’ Account Are Dischargeable

Kassas v. State Bar of California, 42 F.4th 1123 (2022)1

In its continuing saga of what costs or payments to state bars after disciplinary proceedings are dischargeable in bankruptcy, the Ninth Circuit has held that restitution payments owed to the California State Bar’s Client Security Fund (CSF) for payments they made to the debtor’s victims are dischargeable because they are restitution to compensate victims for actual pecuniary loss.

Chapter 7 debtor Anthony Kassas was disbarred in 2014, and the California Supreme Court ordered Kassas to pay restitution to 56 former clients for a total of $201,706 plus interest, and costs for his disciplinary proceedings ($61,122.27), and to reimburse any funds eventually paid out by the CSF to his victims. Kassas filed a Chapter 7 petition in 2019 and received a discharge in 2020. After the discharge, Kassas sought a declaration that all his debts to the State Bar were discharged in the bankruptcy. The State Bar argued that Kassas’s disciplinary costs and reimbursements to the CSF were excepted from discharge pursuant to 11 U.S.C. § 523(a)(7) as “a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and … not compensation for actual pecuniary loss.” The bankruptcy court granted summary judgment for the State Bar, concluding that (a) the restitution payments were discharged, but (b) the disciplinary costs and reimbursements paid from the CSF to 51 victims in the amount of $1,367,978.12 were not.

The appeal was certified directly to the Ninth Circuit. Reviewing de novo, the Ninth Circuit began with the common policy statement that “(b)ecause a fundamental policy of the Bankruptcy Code is to afford debtors a fresh start, exceptions to discharge should be strictly construed against an objecting creditor and in favor of the debtor.” The panel then analyzed whether the payments made from the CSF to victims—and Kassas’s obligation to reimburse the CSF for them—were dischargeable. The panel recounted that, in In re Findley, 593 F.3d 1048, (9th Cir. 2010), the Circuit had concluded that costs for disciplinary proceedings were not dischargeable because costs of the proceedings are a penalty under § 523(a)(7). However, the Ninth Circuit concluded these payments owed to the CSF were sufficiently different to not fall under that same discharge exception, reasoning that CSF reimbursement payments are intended to compensate for actual pecuniary loss, as shown by various evidence—including the California Business and Professional Code itself, which plainly states the purpose of the CSF is to relieve victims of actual pecuniary loss from dishonest conduct by lawyers, and the fact that the amounts owed to the CSF by Kassas were identical to those paid out by the CSF to the victims.

The saga of what debts related to malpractice that attorneys can discharge will no doubt continue. Although the statutes are different, some of the reasoning is applicable to Oregon law, including potentially what the state and its instrumentalities can collect. Thus, we will continue covering it in this space.

Unimpaired Unsecured Creditors of Solvent Debtor Potentially Entitled to Contractual Interest Rate for Post-Petition Interest

In re PG&E Corporation, — F.4th —- (2022)

The Ninth Circuit held in the latest published decision to come out of Pacific Gas and Electric Company’s multibillion dollar Chapter 11 filed in San Francisco in the wake of catastrophic wildfires caused by the Debtor’s that the “solvent debtor exception” survived enactment of the Bankruptcy Code and (absent countervailing equitable considerations) required the debtor to pay contract interest on unsecured claims if it wished to classify them as unimpaired and accepting of plan treatment without a right to vote.

PG&E was a rare solvent debtor—its assets exceeded its liabilities by $20 billion. Debtors’ plan listed several classes of unsecured creditors (including appellants) as unimpaired, deeming them to accept the plan without a right to vote, despite paying them post-petition interest only at the federal judgment rate. See 11 U.S.C. § 1126(f). Appellants argued that as unimpaired creditors, they were entitled to post-petition interest at their contract rates. The lower courts agreed with the debtor. The Ninth Circuit reversed.

The panel noted that generally, interest ceases to accrue on a claim once a debtor has filed for bankruptcy, but that under the pre-Code “solvent debtor exception,” solvent debtors were required to pay creditors post-petition interest at contract rates before retaining value to the estate.

The panel determined that the solvent debtor exception survived passage of the Bankruptcy Code, stating: “we join multiple sibling circuits in recognizing that the equitable solvent-debtor exception—and its core principle that creditors should be made whole when the bankruptcy estate is sufficient—persists under the Code.”

The panel distinguished In re Cardelucci, 285 F.3d 1231 (9th Cir. 2002). That case, it reasoned, governed only the rate of interest that must be paid on impaired claims of a solvent debtor under § 726(a)(5) of the Code, as applied to chapter 11 cases through the best-interests test of § 1129(a) (7). Thus, Cardelucci’s determination that such impaired claims were only entitled to interest at the federal judgment rate did not apply.

Finally, the panel noted that the solvent debtor exception was equitable in nature and “compelling equitable considerations” could allow payment of postpetition interest at a rate other than the contract rate. Accordingly, it remanded to allow the bankruptcy court to determine if such considerations were present.

This has been a hot-button issue across the country for several years. In her dissent, Judge Ikuta argued that unsecured creditors should not have been allowed any postpetition interest—a position the majority pointed out not even PG&E argued for. Whether the opinion will have any impact beyond those rare cases involving solvent debtors remains to be seen.

This article was originally published in the Fall 2022 issue of the Oregon State Bar Debtor-Creditor Newsletter.

1 The original opinion at this cite has been amended and superseded by 2022 WL 4473346 to correct a factual issue.