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Structured Dismissals - How They Work Part II: Proving That Cause Exists to Dismiss the Case Under Section 1112(b)

A.    Where We Left Off

As noted in Part I, movants seeking approval of a structured motion to dismiss must generally prove that: (1) the court has the power to enter an order approving a structured dismissal; (2) "cause" exists to approve the structured dismissal; and (3) the structured dismissal is in the best interest of the debtor's creditors. Part I addressed courts' authority to enter orders approving structured dismissals under section 105(a) of the Bankruptcy Code. This section will address how movants can prove that "cause" exists to dismiss a bankruptcy case.

B.    How it Works

The term "cause" is not defined in the Bankruptcy Code. Even so, section 1112 of the Bankruptcy Code provides a non-exhaustive list of examples of "cause" for conversion or dismissal. Among those examples of cause for dismissal are the debtor's gross mismanagement of the bankruptcy estate, unauthorized use of cash collateral, and failure to comply with court orders. In the context of structured dismissals, however, movants more often set forth one of the two following grounds for cause to dismiss a case: (1) there is a substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation; and/or (2) the debtor has no possibility of proposing a feasible plan of reorganization.

In order to prove cause pursuant to the two-fold inquiry found in section (1) above, and at section 1112(b)(4)(A) of the Bankruptcy Code, the movant must first show a continuing diminution to the estate. More simply put, the movant must prove that the Debtor is losing money as time passes. In most cases, movants can easily meet that burden. As noted above, structured dismissals are frequently found in cases involving the sale of substantially all of the debtor's assets prior to the plan process. Following the sale of substantially all of the debtor's assets, the amount of funds in the estate is typically fixed. For example, if the debtor liquidated its assets for $500,000 and satisfied $450,000 in secured debt, the debtor's estate is left with $50,000. Aside from potential causes of action, the debtor lacks any additional sources of revenue. As time goes by and professional fees and U.S. Trustee fees accrue, the $50,000 that could have gone to unsecured creditors will begin to get earmarked for other expenses and will shrink. The shrinkage of free funds, known as the diminution of the estate, satisfies the first element of the 1112(b)(4)(A) test.

Next, movants must show that there is no reasonable likelihood of rehabilitation. As used in section 1112 of the Bankruptcy Code, the term "rehabilitation" means "to put back in good condition; re-establish on a firm, sound basis." Accordingly, confirming a liquidating plan of reorganization may not satisfy the "rehabilitation" requirement. Rehabilitation requires reorganizing into a going concern. Thus, when a debtor no longer owns any assets or sources of revenue, and has few remaining employees if any, there is no real hope of rehabilitation within the meaning of section 1112(b)(4)(A), and the debtor's case is likely to be dismissed.

As noted above, a movant may also establish cause by showing that the debtor cannot propose a feasible plan of reorganization, which may include even a liquidating plan of reorganization. As courts have reasoned, there is no point in spending estate assets on administrative expenses, or delaying creditors their right to seek payment from a debtor if the debtor has no chance of confirming a plan of reorganization. In administratively insolvent cases, this means of establishing cause is especially applicable. For example, in Al Liebers Golf Equipment, Case No. 12-23698 (Bankr. S.D.N.Y. 2013) [Docket No. 125 - Order Dismissing Case] the liquidation of a debtor's assets failed to net sufficient proceeds to pay secured claims in full, let alone to satisfy administrative and priority claimants as required by section 1129 of the Bankruptcy Code. Thus, despite its best efforts, the debtor was incapable of confirming even a liquidating plan of reorganization in accordance with the Bankruptcy Code. As a result, the court found cause for dismissal, and entered an order approving a structured dismissal.

Proving that cause exists to dismiss a case is an integral step in obtaining court approval of a structured dismissal. In 2005, the United States Congress amended the language of section 1112 of the Bankruptcy Code with respect to the conversion and dismissal of bankruptcy cases. Prior to the 2005 amendments, bankruptcy courts had wide discretion to dismiss cases upon movant's proof that "cause" for dismissal existed. Following the 2005 amendments, courts must enter an order dismissing or converting a bankruptcy case upon a showing of cause, so long as dismissal is in the best interest of creditors. As the court in In re TCR of Denver, LLC, 338 B.R. 494, 498 (Bankr. D. Colo. 2006) noted, "Congress has purposefully limited the role of [the court] in deciding issues of conversion or dismissal such that [the court] has no choice, and no discretion in that it 'shall' dismiss or convert a case under Chapter 11 of the elements for 'cause' are shown…."

Once a movant has established that (1) the court has authority to approve the structured dismissal and (2) that cause exists to dismiss or convert the case, the movant must establish (3) that dismissal and not conversion is the best interest of the creditors. Part III will address the "best interest of creditors" element under section 1112(b) of the Bankruptcy Code, and an alternative means of obtaining approval of a structured dismissal under section 305(a) of the Bankruptcy Code.