Update courtesy of David Simonds and Edward McNeilly (Hogan Lovells)
In re McHugh, No. BAP CO-24-20, 2025 WL 2779101 (10th Cir. BAP (Colo.) Sept. 30, 2025)
In a non-precedential opinion, the Bankruptcy Appellate Panel for the United States Court of Appeal for the Tenth Circuit (the “BAP”) affirmed the decision of the United States Bankruptcy Court for the District of Colorado (the “Bankruptcy Court”) to convert an individual chapter 11 debtor’s case to chapter 7 after finding that (i) the debtor was not in financial distress, (ii) the filing served as a tactical advantage in ongoing litigation, and (iii) the dispute was essentially between two parties.
While this case involved an individual, and not a corporate debtor, it offers a further reminder that, while there is no insolvency requirement to be a debtor under the Bankruptcy Code, an entity that files for bankruptcy without financial distress risks seeing its case dismissed as a bad faith filing or, as here, converted from chapter 11 to chapter 7.
BACKGROUND
In 2019, Kenton Hopkins (the “Appellee”) filed a state court lawsuit against his former business partner, David McHugh (“Debtor” or “Appellant”), alleging breach of a 2010 partnership agreement relating to their real estate business. Following extensive litigation and a multi-day trial, the state court found that Appellant had materially breached the partnership agreement and, in February 2024, entered a substantial judgment and attorneys’ fees in favor of Appellee. Appellant appealed the judgment but did not request a stay pending appeal from the state trial court or the appellate court. Appellee then began collection actions. Rather than objecting to the garnishment in state court or asserting exemptions therein or seeking a stay pending appeal, Appellant filed for chapter 11 bankruptcy protection on August 1, 2024.
Appellee then filed a motion to dismiss or convert under 11 U.S.C. § 1112(b), arguing the case was filed in bad faith in connection with a two-party dispute to frustrate enforcement of the judgment. Appellant, however, claimed the purpose of the bankruptcy case was to pause collection efforts, allow time for his state court appeal of the judgment to proceed and conclude, and permit him to resolve his long-standing tax issues with the IRS.
The evidence before the Bankruptcy Court showed that Appellant had net equity exceeding $3.5 million, was current on all debts other than the judgment and tax liabilities, had no collection activity other than the judgment, and had recently entered into a lease agreement for a luxury vehicle (despite owning several other cars), and also provided substantial monthly financial support to his girlfriend. However, it was undisputed that Appellant’s bank accounts had been frozen by Appellee when Appellant filed for bankruptcy.
The Bankruptcy Court ordered the case to be converted to chapter 7 for cause, finding that Appellant was not in financial distress and had filed the case for a tactical litigation advantage and that the bankruptcy case primarily involved a two-party dispute between Appellant and Appellee. Appellant appealed the Bankruptcy Court’s ruling.
DISCUSSION
Section 1112(b) of the Bankruptcy Code, which governs motions to dismiss or convert a chapter 11 case, requires a bankruptcy court to convert a chapter 11 case to chapter 7 or dismiss it, whichever is in the best interests of creditors, “for cause.” Section 1112(b)(4) provides a non-exhaustive list of what constitutes cause for conversion under this provision. Although not part of this list, bankruptcy courts across the country have found that bad faith constitutes cause for conversion. Courts in the Tenth Circuit engage in a “totality of the circumstances” test to evaluate a debtor’s good faith.
Here, the BAP found that the Bankruptcy Court did not err in finding that Appellant was not in financial distress and considering it as an additive factor in its “totality of the circumstances” analysis. The record showed that Appellant’s claimed liquidity crisis was of his own making given available state-law remedies and substantial unencumbered assets. Specifically, the record showed Appellant was not insolvent. Additionally, the record reflected that Appellant maintained healthy financial stability and access to significant resources, including unencumbered or lightly encumbered real estate and valuable unencumbered personal property. The lack of financial distress was one factor indicating a lack of valid bankruptcy purpose for the filing.
Next, the BAP found that the Bankruptcy Court did not err in finding that Appellant’s entire reason for filing was to obtain a tactical litigation advantage as a substitute for posting an appeal bond. While filing a bankruptcy petition as a substitute for posting an appeal bond is not per se bad faith, Appellant’s failure to take meaningful steps to seek a bond or pursue a stay in state court, file missing tax returns needed to obtain a bond, and his decision to continue with liberal discretionary spending combined with his overall solvency indicated a lack of valid bankruptcy purpose.
Finally, the BAP found that the Bankruptcy Court did not err in finding that the case was primarily a two-party dispute. Appellee was the only creditor taking action to collect from Appellant and, despite Appellant’s issues, which included a failure to file tax returns, he was under no pressure from the IRS and had been making substantial quarterly tax payments to the IRS over the prior ten years.
All these factors, taken as a whole, provided sufficient indicia of bad faith for the Bankruptcy Court to convert the case.
This case serves as a reminder that, while there is no insolvency test to be a chapter 11 debtor, a solvent entity that files for bankruptcy without financial distress risks having its chapter 11 case not merely dismissed but also converted to a liquidation under chapter 7.
