In re Waterworks, Inc., 538 B.R. 445

Background

Debtor Waterworks, Inc., a two-season landscaping/snow-removal small-business Chapter 11 debtor, is owned and operated by Karen and Roger Garbacz; case filed July 16, 2013, debtor in possession.
Illinois State Bank (ISB) holds significant secured claims based on prepetition loans and judgments (petition-date claim ~ $649k); much collateral included vehicles and real property (including McCullom Lake property later surrendered).
Debtor obtained multiple agreed interim orders (cash-collateral orders) authorizing use of ISB cash collateral in exchange for replacement liens and adequate-protection payments; ISB received substantial postpetition payments/applications to principal (~$238,917 through June 2014, and additional proceeds later).
ISB moved under 11 U.S.C. § 1112(b) to convert to Chapter 7 (or dismiss) and alternatively under § 1104(a) to appoint a Chapter 11 trustee, alleging cause: unauthorized use of cash collateral, gross mismanagement, failure to pursue avoidance actions, improper transfers of collateral, and other reporting/pay issues.
Evidence showed some early unauthorized cash-collateral spending (first two weeks postpetition and occasional budget overruns, and an unapproved emergency equipment purchase), but the Debtor later substantially complied with budgets, improved profitability, and made significant payments to ISB and surrendered collateral; no creditor shown to be substantially harmed.
Court held evidentiary hearings, found Debtor can likely confirm a feasible plan (proposed plan pays ISB in full over time), and concluded conversion or trustee appointment was not warranted; ISB's motion denied.

Issues

Issue	Plaintiff's Argument (ISB)	Defendant's Argument (Waterworks/Garbacz)	Held
Whether cause exists under §1112(b) to convert to Chapter 7 for unauthorized use of cash collateral and gross mismanagement	ISB: Debtor used cash collateral without court approval, made unauthorized postpetition loans/payments, mismanaged estate and failed to pursue avoidance actions	Debtor: Early departures were isolated/miscommunications; postpetition conduct remedied; replacement liens and adequate-protection payments improved ISB's position; debtor improved operations and profitability	Court: DENIED conversion — unauthorized uses were isolated, creditors not substantially harmed, and Debtor shows likelihood of rehabilitation
Whether failure to commence avoidance/adversary actions constitutes gross mismanagement warranting conversion	ISB: Debtor failed to timely sue insiders/prepetition transferees to recover potentially avoidable transfers	Debtor: No evidence transfers were preferential or fraudulent; recovery not necessary to effectuate proposed plan; debtor and principals actively working to repay creditors	Court: DENIED — lack of pattern of egregious misconduct; no showing that inaction amounts to gross mismanagement
Whether prepetition disposition of collateral (vehicles) supports conversion or shows bad faith	ISB: Some pledged vehicles unaccounted for or disposed/sold prepetition without consent	Debtor: Most vehicles were inoperable/junk or of little value; sales received reasonable value and bank received proceeds where appropriate	Court: DENIED — dispositions were mostly of junk vehicles or for fair value; no evidence of intent to deprive creditor
Whether appointment of a Chapter 11 trustee under §1104(a) is warranted	ISB: Same grounds as conversion—fraud, dishonesty, incompetence, gross mismanagement	Debtor: Trusteeship would be costly, disrupt operations, and creditors (including ISB) benefit from Debtor’s continued management and recent performance	Court: DENIED — appointment is extraordinary; ISB failed to prove cause by clear and convincing evidence and trustee appointment not in creditors’ best interests

Key Cases Cited

In re Woodbrook Assocs, 19 F.3d 312 (7th Cir.) (movant bears initial burden to show cause to convert)
In re Jartran, Inc., 886 F.2d 859 (7th Cir.) (conversion/dismissal not mandatory; court discretion)
In re SAL Caruso Cheese, Inc., 107 B.R. 808 (Bankr.S.D.N.Y.) (pattern of egregious pre/postpetition misconduct can justify conversion)
In re Hampton Hotel Investors, L.P., 270 B.R. 346 (Bankr.S.D.N.Y.) (multiple unauthorized postpetition transfers and concealment supported conversion)
In re ARS Analytical, LLC, 433 B.R. 848 (Bankr.D.N.M.) (persistent mismanagement and missing revenues supported conversion)
In re Visicon Shareholders Trust, 478 B.R. 292 (Bankr.S.D.Ohio) (unauthorized use of cash collateral for insiders’ personal expenses demonstrated substantial harm)
In re LHC, LLC, 497 B.R. 281 (Bankr.N.D.Ill.) (appointment of trustee is extraordinary and requires clear and convincing proof of cause)
G–I Holdings Inc. v. Reliance Ins. Co., 385 F.3d 313 (3d Cir.) (section 1104 appointment is fact-specific and committed to court’s discretion)