The Restructuring Report

The United States District Court for the District of Minnesota recently rejected a creditor’s argument that when a Chapter 11 case is converted to one under Chapter 7 and the estate is administratively insolvent 11 U.S.C. § 726(b) requires disgorgement of amounts approved and paid to Chapter 11 administrative claimants.

Section 726 sets forth the scheme for distribution of property of the Chapter 7 estate, including cases converted from Chapter 11. It provides that the “payment on claims . . . shall be made pro rata among claims.” 11 U.S.C. § 726(b). At times, certain creditors holding unpaid Chapter 11 administrative claims have argued that this text creates a right of disgorgement of payments made to professionals during the Chapter 11 cases.

Such was the case in the Upper Midwest Sealcoat bankruptcy case, which was originally filed as a Chapter 11 reorganization, later involved the appointment of a Chapter 11 trustee and sale of all assets and concluded with conversion to Chapter 7. One creditor holding an unpaid administrative expense claim objected to the Chapter 7 Trustee’s final report, arguing that § 726(b) requires disgorgement of amounts approved and paid to Chapter 11 professionals to pay in full the creditor’s administrative expense claim. The Bankruptcy Court rejected the creditor’s argument, and the creditor appealed the decision to the United States District Court for the District of Minnesota.

The District Court noted that neither the Supreme Court nor the Eighth Circuit has addressed the issue, but many other courts have. The District Court recognized that these courts’ holdings fall into three categories:

1. Some courts hold that § 726(b) requires disgorgement of such amounts “when necessary to achieve pro rata distribution of a Chapter 7 bankruptcy estate[.]” See, e.g., Specker Motor Sales Co. v. Eisen, 393 F.3d 659, 664–65 (6th Cir. 2004).
2. Some courts hold that the Bankruptcy Code forbids disgorgement of such amounts merely to satisfy § 726(b)’s pro-rata-distribution requirement. See, e.g., In re Santa Fe Med. Grp., LLC, 557 B.R. 223, 231 (Bankr. D.N.M. 2016).
3. Some courts suggest that bankruptcy courts possess discretion to order or not order disgorgement of such amounts to satisfy § 726(b)’s pro-rata-distribution requirement. See, e.g., In re NETtel Corp., 00-01771, 2020 WL 2047965, at *22–26 (Bankr. D.D.C. Apr. 28, 2020).

The District Court held that “the Bankruptcy Code precludes disgorgement of amounts approved and paid to Chapter 11 administrative claimants when a case is converted to one under Chapter 7 and the debtor is administratively insolvent merely to satisfy § 726(b)’s pro-rata-distribution requirement.” In so holding, the Court relied on the following principles:

1. The statutory interpretation of In re Headlee Mgmt. Corp., 519 B.R. 452, 461 (Bankr. S.D.N.Y. 2014), which held that a Chapter 7 Trustee “can comply with  726(b)by distributing those assets (and any others he recovers) in accordance with the distribution scheme therein without the need to disgorge professional fees.”
2. The critiques of the mandatory-disgorgement approach in Headlee Mgmt. Corp. and In re Santa Fe Med. Grp., LLC, 557 B.R. at 231, which held that “Congress did not intend to give bankruptcy courts authority to order disgorgement upon insolvency. Using § 105, 329–331, and/or 729 to create such a remedy would be an improper encroachment on legislative power and a misreading of the Code.”
3. The Bankruptcy Court’s analysis in In re Hyman Freightways, Inc., 342 B.R. 575, 579 (Bankr. D. Minn. 2006), aff’d, No. 06–2607, 2006 WL 3757972 (D. Minn. 2006), which held that the disgorgement interpretation leads to absurd and impractical results: “Carried to its logical conclusion, the argument would require the trustee to recover every payment made during the chapter 11 case, and then redistribute the money . . . thereby unwinding the chapter 11 process. The impracticality and absurdity of this is obvious.”