In re Karlinger-Smith, CASE NO. 15–10214–tmd

544 B.R. 126

In re: Tracy Erin Karlinger–Smith, Scott Davis Smith, Debtors.

CASE NO. 15–10214–tmd

United States Bankruptcy Court, W.D. Texas, Austin Division.

Signed January 21, 2016

Glen L. Work, Law Office of Glen L. Work, PLLC, Round Rock, TX, for Debtors.

MEMORANDUM OPINION

TONY M. DAVIS, UNITED STATES BANKRUPTCY JUDGE

Can wage-earners who have sought refuge from creditors, and a fresh start, by filing a chapter 7 liquidation be forced into a chapter 11 reorganization, and be compelled to repay creditors in a five-year plan? In general, yes. But not here, where the Debtors have made extensive and diligent efforts—over a period of seven years—to repay creditors prior to bankruptcy, only to run into one implacable creditor, and where the Debtors have timely paid their taxes and secured creditors.

I. BACKGROUND AND FACTS

By most measures, Tracy Karlinger–Smith and Scott Smith (the "Debtors") are models of financial responsibility. Despite their above median take-home income, the Debtors maintain a reasonable budget for their family of four that is mostly within the IRS National and Local Standards.¹ Their only material deviations from the IRS Standards are tuition for a religiously-affiliated private school and extracurricular activity expenses for their two teen-aged sons.² After accounting for their expenses and secured debt payments, the Debtors' take-home pay leaves a monthly disposable income of $2,762.³ Using this disposable income, the Debtors diligently attempted to satisfy their creditors. Usually, mixing adequate income, moderate expenses, and manageable debt with genuine effort to pay creditors is not a recipe for bankruptcy. So why are the Debtors before this Court?

A. The path to bankruptcy begins with Dr. Karlinger–Smith's failing business.

The Debtors' schedules of assets and liabilities, with two exceptions, reflect nothing out of the ordinary for a Texas family in financial difficulty. They own various exempt assets, including a house, three cars, three dogs, and a cat,⁴ and owe on a mortgage, car loans, and credit cards.⁵ The first exception is that they owe no priority debt—most cases involve at least some amount of unpaid taxes.⁶ The second exception is a substantial business debt owed to Wells Fargo Practice Group,⁷ which was incurred in connection with a veterinary hospital venture attempted by Dr. Karlinger–Smith.⁸

Like many new businesses, the veterinary hospital ultimately failed. Shortly after opening in 2003, the hospital was unable to generate enough cash flow to make timely payments on its outstanding debts.⁹ For a time, though, the business (or the Debtors) continued to make at least some payments to its various creditors. The Debtors also continued to pay their consumer debts while Dr. Karlinger–Smith drew minimal income in her efforts to steady the hospital's finances. In 2008, however, the Debtors closed the business, and Dr. Karlinger–Smith went to work for a more established veterinary hospital.¹⁰

But the Debtors did not cut and run on the business debts. Using the services of a credit counseling group, they continued to pay these creditors, and did so at some sacrifice. Indeed, after using their disposable income to pay their creditors "there was usually nothing left at the end of the month."¹¹ Although the record is not clear regarding the total amount of business debt the Debtors satisfied after closing the hospital,¹² only the Well Fargo debt now remains.¹³

B. The Debtors and Wells Fargo were unable to reach an agreement.

The Debtors continued to make payments to Wells Fargo until 2011, when they turned back to the credit counseling group.¹⁴ The group had been successful in settling the Debtors' other business debt, including another business debt owed to Wells Fargo, and so the Debtors hoped the group would be able to devise a similar solution for the remaining Well Fargo debt.¹⁵

The Debtors then made monthly payments to the credit counseling group. At least some of this money was held in trust by the group while it attempted to negotiate a settlement with Wells Fargo. Although the group proposed several offers to Wells Fargo, and Wells Fargo made at least one counteroffer, no agreement was ever reached.¹⁶

In January of 2015, Wells Fargo filed a lawsuit in state court seeking to collect its debt against the Debtors.¹⁷ Wells Fargo claimed that the Debtors were liable for $139,750 of principal, $44,000 of interest, and at least $40,000 in attorney's fees.¹⁸ The credit counseling group decided it could no longer assist the Debtors and remitted the money it was holding on the Debtors' behalf.¹⁹

C. The Debtors file for bankruptcy under chapter 7.

In response to the Wells Fargo lawsuit, the Debtors filed a petition for chapter 7 relief.²⁰ According to Dr. Karlinger–Smith's uncontroverted testimony, the Debtors were current on all their debts except the business debt to Wells Fargo.²¹

The Debtors' amended schedules reflect $442,245 of total debt.²² No one disputes that most of this is non-consumer debt. The Debtors scheduled Wells Fargo's debt at the $223,774 claimed by Wells Fargo in its lawsuit.²³ The Debtors also listed $188,419 in secured debt related to their homestead and vehicles.²⁴ The Debtors stated their intent to reaffirm their auto loan and mortgage on their homestead, continue making payments without reaffirming their home equity line of credit, and surrender their leased Smart Car.²⁵ The remainder of their debt—$30,052—is unsecured credit card debt.²⁶

The Debtors, a veterinarian and a teacher, take home $9,880 each month, and their regular monthly expenses total $7,118, which include $1,849 comprising private school tuition, music lessons, sports fees, and other extracurricular activities for their two children.²⁷ This leaves $2,762 in monthly disposable income.²⁸

D. The U.S. Trustee seeks conversion of the Debtors' case to chapter 11.

The U.S. Trustee asserts that conversion is appropriate as the debtors have the ability to pay a substantial dividend to their creditors based on their significant disposable income. Further, the U.S. Trustee claims that the debtors are enjoying luxuries that most chapter 7 debtors cannot afford: private school tuition and extracurricular activities for their two children. If these expenses were eliminated, as might be required if the case was converted to chapter 11, the Debtors would be able to pay even more to creditors through a chapter 11 plan. The Debtors contend that the private school tuition, which is paid to Saint Dominic Savio Catholic High School, a school affiliated with the Roman Catholic Diocese of Austin, is a reflection of their deeply held religious beliefs, and therefore not a luxury expense.²⁹

The Court held a hearing on the motion on September 2, 2015. The U.S. Trustee introduced the Debtors' Schedules F, I, and J, and IRS Publication 526³⁰ into evidence without objection from the Debtors. The Debtors called Dr. Karlinger–Smith to provide testimony, and she testified credibly as to the Debtors' efforts to repay their debt before bankruptcy. Although Wells Fargo did not intervene in the motion prior to the hearing, or offer evidence or testimony, its counsel made an appearance. The Court took the matter under advisement and invited the Debtors to consider whether a settlement with Wells Fargo was possible before the Court set a briefing schedule. At a status hearing held on November 3, 2015, counsel for the Debtors indicated that the negotiations had been unsuccessful. The Court set a briefing schedule, and the U.S. Trustee, the Debtors, Wells Fargo, and an amicus curiae provided briefs.³¹

II. ANALYSIS

The U.S. Trustee does not seek dismissal for abuse under section 707(b), which is not available because the Debtors do not have primarily consumer debts.³² Nor does the U.S. Trustee seek dismissal for cause under section 707(a). Instead, the U.S. Trustee seeks conversion under section 706(b) because the Debtors have disposable income. Section 706(b) allows the Court to convert a chapter 7 case to a chapter 11 case "[o]n request of a party in interest ...."

A. Conversion pursuant to section 706(b) is within the discretion of the Court based on what will inure to the benefit of all parties, including the Debtors.

Unlike the detailed requirements for dismissal under section 707(b), and unlike dismissal under section 707(a), which at least requires "cause," there are no statutory standards for conversion under section 706. Only two limitations are provided: the court cannot convert to chapter 12 or 13 without the debtor's consent, and the debtor must qualify to be a debtor under the chapter to which the case is being converted.³³ Nearly 30 years ago, interpreting identical language and citing legislative history, the Fifth Circuit stated that in considering a decision to convert from chapter 7 to chapter 11, over the debtor's objection, the bankruptcy court should exercise its discretion "based on [a] determination of what will most inure to the benefit of all parties in interest."³⁴

The Fifth Circuit's directive to examine the "benefit to all parties in interest" suggests not an inquiry solely into the best interests of the creditors, or even the best interests of the estate, but rather a broader inquiry into what will collectively benefit the debtor, the creditors, and any other parties with a stake in the case.³⁵ Thus, the decision should not be made based on the interests of any one party or class of parties.

Other cases have acknowledged this by looking at the benefits of conversion to the debtor, along with the benefits to others. In In re Gordon,³⁶ the U.S. Bankruptcy Court for the Northern District of Georgia found a benefit to the individual debtor from conversion to chapter 11 because resolving ongoing litigation, including the non-dischargeability of certain debts, was best handled in chapter 11.³⁷ In In re Decker³⁸ and In re Baker,³⁹ the bankruptcy courts for the District of Alaska and the Middle District of Florida...