Matter of Denrose Diamond

• Decision Date: 02 May 1985
• Docket Number: Bankruptcy No. 84 B 11122.
• Citation: 49 BR 754
• Parties: In the Matter of DENROSE DIAMOND, Debtor.
• Court: U.S. Bankruptcy Court — Southern District of New York

49 B.R. 754 (1985)

In the Matter of DENROSE DIAMOND, Debtor.

Bankruptcy No. 84 B 11122.

United States Bankruptcy Court, S.D. New York.

May 2, 1985.

Hahn & Hessen, New York City, for Irving Trust Co.; George A. Hahn and Angela Tese, New York City, of counsel.

Marvin Neiman, New York City, for debtor; Philip E. Weinberger, New York City, of counsel.

Lawrence Ginsburg, New York City, for European-American Bank.

John Campo, New York City, Deputy Asst. U.S. Trustee.

DECISION AND ORDER

HOWARD C. BUSCHMAN, III, Bankruptcy Judge.

Unsecured creditors, Irving Trust Company ("Irving") and European American Bank & Trust Company ("EAB") ("Movants") seek an order pursuant to the Bankruptcy Code, 11 U.S.C. § 1112(b) (1978) (the "Code) converting this case to Chapter 7 and granting any other relief as is just and reasonable under the circumstances or, in the alternative, appointing a Trustee pursuant to Code § 1104 to manage Debtor's business and investigate its financial affairs. (Tr. 4/3/85, p. 2). The United States Trustee for the Southern District of New York joined in the application.

Denrose Diamond Co. Inc. ("Debtor"), manufacturer of and trader in diamonds, filed a petition under Chapter 11 of the Bankruptcy Code (the "Code") on August 9, 1984. The petition alleges that Debtor's filing was spurred by "the substantial drop in the value of diamonds" which in turn caused a "drastic decline in the market value of the debtor's inventory." The Debtor continued in business as debtor-in-possession. In responding to the motion, Debtor moved to amend its petition so to add "The Word Factory" to the creditor list and to change the Movants' creditor status from unsecured to disputed. Movants object to any change in their status as unwarranted and to the amendment as irrelevant to their motion.

I

Section 1112(b) of the Code enables the court "on request of a party in interest," and "after notice and a hearing" to convert a Chapter 11 case to Chapter 7 or dismiss it, whichever is in the best interest of creditors and the estate, "for cause", including:

(1) continuing loss to or dimunition of the estate and absence of a reasonable likelihood of rehabilitation;

(2) inability to effectuate a plan; and,

(3) unreasonable delay by the debtor that is prejudicial to creditors. . . .

Here it is alleged that cause is largely to be found in continuing operating losses, an unexplained shrinkage in the inventory's value, failure to file mandated monthly operating statements, and Debtor's officers' bad faith in their dealings with the Creditors. In this, Movants bear the burden of proof. In re Union Wholesale Tobacco, 8 B.R. 439 (Bankr.D.N.J.1981).

A. Continuing loss to or dimunition of the estate and absence of a reasonable likelihood of rehabilitation

Section 1112(b)(1) codifies a two-prong test of continued deterioration and lack of a reasonable likelihood of rehabilitation. Once met, the bankruptcy judge has discretion over the decision to convert. In re International Airport Inn Partnership, 517 F.2d 510 (9th Cir.1975). However,

at the early stages of a Chapter 11 case, the Court should give the debtor the benefit of the doubt where the evidence is in equipoise or indicates that the pre-bankruptcy losses will not cease over a reasonable period of time.

In the Matter of Pied Piper Casuals, Inc., 40 B.R. 723 (Bankr.S.D.N.Y.1984).

i. Continuing Losses

Thus, short term operating losses where there exists a realistic possibility of rehabilitation do not warrant conversion. In re Garland Corp., 6 B.R. 456 (Bankr.D. Mass.1980). But, a positive cash flow will not guard against conversion when it masks a static enterprise whose financial statements do not account for costs necessary to doing business. In re Tolco Properties, Inc., 6 B.R. 482 (Bankr.E.D.Va.1980). Full collateralization of assets coupled with a negative cash flow and an inability to pay current expenses has, however, prompted conversion. In the Matter of 3868-70 White Plains Road, Inc., 28 B.R. 515 (Bankr.S.D.N.Y.1983).

Here, inasmuch as can be ascertained from the skimpy information contained in the Debtor's post petition operating statements, the Debtor has suffered a relatively small net loss of $21,366 over the four month period subsequent to the filing of the petition in August 1984. Operating statements have not been filed for January, February or March 1985. Though Debtor alleged a slight operating profit for the month of January, Movants dispute its existence. (Tr. 4/3/85, p. 14).

As such, this case differs from Pied Piper where continuing significant losses of nearly $200,000 for the first two months post petition and a failure to come even close to realizing sales projections warranted convertion.

The sparse information gleaned from Debtor's financials is seemingly more optimistic. In September, Debtor claims to have had $99,490 gross profit on sales of $397,948 with a net loss of $7,003. In October, an alleged gross profit fell slightly to $74,910 on sales of $299,633, but Debtor claims to have almost broken even with a slight loss of $181. The Debtor's November financial statements claim a gross profit of $39,330 on sales of $157,322 and a net loss of $13,206. In December, however, it is asserted that the Debtor garnered a $75,216 gross profit on sales of $300,858 and a net loss of only $976. Movants have introduced no evidence contradicting these assertions and consequently have not carried their burden on this issue.

ii. Diminution of the Estate

Diminution of the estate sufficient to motivate conversion has been found where a secured creditor's collateral was rapidly depreciating, no unencumbered assets remained and no prospects existed to produce income. In re Kors, 13 B.R. 676 (Bankr.D.Ver.1981); In re Pappas, 17 B.R. 662 (Bankr.D.Mass.1982). Here, it is undisputed that Debtor's balance sheet shows an 80% drop in inventory value during the year prior to filing the petition. But the Debtor asserts that the 80% decrease reflects a drop in the market value of diamonds. Furthermore, its financial statements, such as they are, indicate that the diminution has not continued as § 1112(b)(1) requires. Movant's introduced no evidence to the contrary and it appears that the assets are sufficient to produce income.

iii. Lack of a Reasonable Prospect of Rehabilitation

While the rehabilitation concept of § 1112(b)(1) contemplates a return to financial good health, In the Matter of Pied Piper Casuals, Inc., 40 B.R. 723, 726 (Bankr.S.D.N.Y.1984), the cases ordering conversion have done so where losses were definite with reorganization nothing more than "a nebulous speculative venture". In re Tracey Service Co., Inc., 17 B.R. 405, 410, 8 B.C.D. 948, 950 (Bankr.E.D.Pa.1982). The cessation of business, as evidenced by an absence of inventory, employees, equipment and/or income, makes unlikely the ability to rehabilitate. Ibid.; In re CCN Realty Corp., 23 B.R. 261 (Bankr.S.D.N.Y. 1982). Conversion has also occurred under § 1112(b)(1) when persons knowledgeable of Debtor's finances reported both the need to infuse large amounts of money into the Debtor and the absence of any realistic prospect of obtaining such financing.

Absent similar circumstances such as in Pied Piper where the cyclical nature of the debtor's business effectively precluded rehabilitation,

the probability that a liquidating plan may be filed does not serve as a ground for conversion or dismissal because the submission of such a plan is proper under Chapter 11.

In re L.N. Scott Co., Inc., 13 B.R. 387 (Bankr.E.D.Penn.1981); 5 L. King & Collier on Bankruptcy ¶ 1112.03ii (15th Ed.) (1985); See § 1112(a)(5)(D) & (b)(4). Further, some courts have ruled that when reorganization no longer remains a viable option, conversion should not be ordered when liquidation would proceed more expeditiously and less expensively under control of the debtor. In the Matter of W.J. Rewoldt Co. Inc., 22 B.R. 459, 462 (Bankr.E. D.MI.1982).

These standards have not been met here. It has not been shown that the Debtor will not likely be rehabilitated. Moreover, the Debtor's alleged ability to sell its inventory for more than double what could be realized in liquidation is unrebutted.

B. Unreasonable Delay and Failure to File a Plan

Movants also assert that seven months have passed without the filing of a plan; conversions have occurred within that time frame. Yet cases ordering such were largely single asset cases presenting factors in addition to the passage of time. In In re CCN Realty Corp., 23 B.R. 261 (Bankr.S.D.N.Y.1982), for example, the debtor failed to collect rent for its one asset and did not produce any books or records. In In the Matter of 3868-70 White Plains Road, Inc., 28 B.R. 515 (Bankr.S.D.N.Y., 1983), the only asset was fully mortgaged. Upon liquidation of the estate, all proceeds would have inured to the sole benefit of the first mortgagee and any plan would have to based on new capital which did not appear forthcoming. Similarly, in In re Kors, Inc., 13 B.R. 676 (Bankr.D.Vt.1981), the debtor filed a plan on the last day of his 120 day exclusivity period and did not submit a proper disclosure statement, only a worksheet listing unreliable numbers. The delay was found "unreasonable" and "prejudicial" to creditors.

Here, discussions between the Debtor and Movants broke down; the hostility between the parties being very apparent from the allegations bandied back and forth at the two hearings. It does not appear, however, that Debtor was unilaterally responsible for having retarded the consensual process, or that the delay was unreasonable and prejudicial. The movants did not sustain their burden under § 1112(b)(2).

C. Cause

A debtor's lack of good faith does constitute cause for conversion to Chapter 7. In re Kors, Inc., 13 B.R. 676, 680 (Bankr.D.Ver.1981); In re G-2 Realty Trust, 6 B.R. 549, 552 (Bankr.D.Mass. 1980). Such bad faith has been found, inter alia, where

the debtor either kept no

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