A Penny Returned Is a Penny Earned Who Gets the Money Upon Conversion of a Chapter 13 Case to Chapter 7 Before Confirmation

Under the Bankruptcy Reform Act of
1978,¹ there was a split of authority as to the disposition
of funds paid to the chapter 13 trustee after commencement of a case
where the case was converted to a chapter 7 case before confirmation of
a plan.² In 1994, Congress amended §348 of the Code,
adding subsection (f)(1) to ensure uniformity in returning to the
debtor any property acquired after commencement of the
case.³ Congress sought to encourage the use of chapter 13
over chapter 7 by removing a "penalty" for failure in the
chapter 13.⁴

Congress provided a "backstop"
against the abusive conversion of a case,⁵ codified in
subsection (f)(2),⁶ which provided for forfeiture to the
estate if the conversion to chapter 7 was in bad faith. Unfortunately,
neither the Code nor the Bankruptcy Rules offer any guidance as to how
the issue of bad faith should be framed post-conversion.⁷

There is neither a deadline nor a procedure established for
challenging a conversion.

At least one court has suggested that
raising a challenge to whether a conversion is in good faith should be
done by motion.⁸ However, since the issue is an attempted
recovery of assets to the estate, which would otherwise be presumed to
be property of the debtor, it would seem that the challenge should be
done through an adversary proceeding.⁹ One court has
suggested that a matter brought before it by motion and dealing with
the good-faith of a conversion should have been brought as an
adversary proceeding.¹⁰ This is distinguished from a motion
to compel turnover of property of the estate from the
debtor.¹¹

Commonly, the reported cases regarding the
allegedly bad-faith conversion of a chapter 13 case are brought in the
context of objections to exemptions or a motion for
turnover.¹² The standard for determination of a bad-faith
conversion is the "totality of the
circumstances."¹³

Congress created §348(f)(2) to
implement specific policies encouraging the use of chapter 13 and
limiting the "sting" of failure to only those cases in which
bad faith was at the root of a conversion. In the 12 years since the
effective date of that section, only five reported opinions actually
deal with a conversion from chapter 13 to chapter 7 allegedly in bad
faith.¹⁴ Of those five reported opinions, only one resulted
in inclusion of the assets acquired during the chapter 13 case in the
post-conversion chapter 7 estate. It is possible that this section is
underutilized due to the vagueness of the statute, and the utter lack
of implementation through Bankruptcy Rules.

It appears that the
conversion of a chapter 13 case to a chapter 7 will almost always
result in "a penny returned."

Footnotes

1 Hereinafter
referred to as the Code.

2 Prior to the Act's amendments to
§348, the issue of whether post-petition chapter 13 income
remains property of the estate on conversion to chapter 7 was
confusing and had created a circuit split. See Baker v. Rank
(In re Baker), 154 F.3d 534, 536 (5th Cir. 1998); compare In
re Bobroff, 766 F.2d 797, 803-04 (3d Cir. 1985) with In re
Lybrook, 951 F.2d 136, 138 (7th Cir. 1991), and In re
Lindberg, 735 F.2d 1087, 1089-90 (8th Cir. 1984). Similar
dicta was contained in Lowe v. Sandoval (In re
Sandoval), 103 F.3d 20, 23 (5th Cir. 1997). There we also noted that
the Act was designed to resolve the circuit split on the instant
issue. Stamm v. Morton (In re Stamm), 222 F.3d 216, 218
(5th Cir. 2000).

3 Except as provided in paragraph (2), when a
case under chapter 13 of this title is converted to a case under
another chapter under this title—

(A)
property of the estate in the converted case shall consist of property
of the estate, as of the date of filing of the petition, that remains
in the possession of or is under the control of the debtor on the
date of conversion; and
(B) valuations of property and of
allowed secured claims in the chapter 13 case shall apply in the
converted case, with allowed secured claims reduced to the extent
that they have been paid in accordance with the chapter 13 plan.

(2) If the debtor converts a case under chapter 13 of
this title to a case under another chapter under this title in bad
faith, the property in the converted case shall consist of the
property of the estate as of the date of conversion. 11 U.S.C.
§348(f)(1)

4 Congress amended
the Bankruptcy Act in 1994 to protect property, earnings and equity
interests acquired during the pendency of chapter 13 proceedings to
encourage chapter 13 filings. See, e.g., In re Woodland, 325 B.R.
at 585; In re Nichols, 319 B.R. at 856-57; Warren v.
Peterson, 298 B.R. 322, 324-25 (N.D. Ill. 2003); In re
Archie, 240 B.R. 425, 431-32 (Bankr. S.D. Ala. 1999); In re
Pearson, 214 B.R. 156, 164 (Bankr. N.D. Ohio 1997) ("the
legislative history makes clear that Congress was concerned that
debtors would be counseled to file chapter 7 cases rather than chapter
13 cases because, in the event the plan could not be completed and the
debtor would have to convert to chapter 7, debtors would lose any
equity in the collateral they may have gained by making payments on
the secured claim during the chapter 13"). In re Boyum,
2005 U.S. Dist. LEXIS 20054, 8-9 (D. Or. 2005).

5 11 U.S.C.
§348(f)(2) eliminates the policy concern that debtors may use
conversion to abuse the bankruptcy process... This provision provides a
deterrent and remedy if debtors seek conversion in an abuse of the
bankruptcy process. DiBraccio v. Ferretti (In re
Ferretti), 230 B.R. 883, 889 (Bankr. S.D. Fla. 1999).

6

See Note 3 supra.

7 The latest version of the Rules
provide only the following guidance for conversions:

B.R. 1017(f) Procedure for dismissal, conversion and
suspension.
(1) Rule 9014 governs a proceeding to dismiss or
suspend a case, or to convert a case to another chapter, except
under §1307(a) or (b).
(2) Conversion or dismissal under
§1307(b) shall be on motion filed and served as required by
Rule 9013.
(3) A chapter 13 case shall be converted without
court order when the debtor files a notice of conversion under
§1307(a). The filing date of the notice becomes the date of the
conversion order for the purposes of applying §348(c) and Rule
1019. The clerk shall promptly transmit a copy of the notice to the
U.S. Trustee.
B.R. 1019 (5)(b) Conversion of chapter 13
case. Unless the court directs otherwise, if a chapter 13 case
is converted to chapter 7,

(I) the debtor, not
later than 15 days after conversion of the case, shall file a
schedule of unpaid debts incurred after the filing of the petition
and before conversion of the case, including the name and address of
each holder of a claim; and
(ii) the trustee, not later
than 30 days after conversion of the case, shall file and transmit
to the U.S. Trustee a final report and account;
(c) Conversion
after confirmation of a plan.

Unless the court
orders otherwise, if a...chapter 13 case is converted to chapter 7
after confirmation of a plan, the debtor shall file:

(I) a schedule of property not listed in the final report and
account acquired after the filing of the petition but before
conversion, except if the case is converted from chapter 13 to
chapter 7 and §348(f)(2) does not apply;
(ii) a
schedule of unpaid debts not listed in the final report and account
incurred after confirmation but before the conversion; and

(iii) a schedule of executory contracts and unexpired leases entered
into or assumed after the filing of the petition but before
conversion.

Emphasis added.

8
Though the statute is silent about procedure, someone (presumably the
chapter 7 trustee in most cases) would have to bring a "timely
motion" to obtain a determination of bad faith, and presumably
"timely" would mean some time before the chapter 13 trustee
disburses funds on hand to the debtor. There is no requirement in the
statute (or the rules) for the chapter 13 trustee to hold the funds
for some period to see whether such a motion might be filed by some
interested party. In re Zamora, 274 B.R. 268, 270 n.3 (Bankr.
D. Tex. 2002).

9 Bankruptcy Rule 7001, provides, in pertinent
part:

An adversary proceeding is...a proceeding (1)
to recover money or property, except a proceeding to compel the
debtor to deliver property to the trustee or a proceeding under
§554(b) or §725 of the Code, Rule 2017 or Rule 6002, (2)
to determine the validity, priority or extent of a lien or other
interest in property, other than a proceeding under Rule 4003(d)...(7)
to obtain an injunction or other equitable relief, (9) to obtain a
declaratory judgment relating to any of the foregoing....

10 In re Carter, 260 B.R. 130, 131 n.2
(Bankr. D. Tenn. 2001).

11 The Code includes an affirmative duty
upon the debtor to turn over property of the estate. 11 U.S.C.
§521 provides, in pertinent part, "The debtor shall...(4) if
a trustee is serving in the case, surrender to the trustee all
property of the estate...."

12 Unified People's Fed.
Credit Union v. Yates (In re Yates), 2005 Bankr. LEXIS 1889
(Bankr. Fed. App. 2005) (motion for turnover by undersecured creditor
denied). In re Bejarano, 302 B.R. 559 (Bankr. N.D. Ohio 2003)
(objection to exemption overruled). In re Carter, 260 B.R. 130,
131 (Bankr. D. Tenn. 2001) (motion by chapter 7 trustee seeking a
judicial determination denied). In re Wiczek-Spaulding, 223
B.R. 538 (Bankr. D. Minn. 1998) (objection to exemption with respect
to severance pay and stock options from employment, overruled as to
alleged bad-faith conversion). In re Siegfried, 219 B.R. 581,
582 (Bankr. D. Colo. 1998) (creditor's motion to determine that
debtor's conversion from chapter 13 to chapter 7 was in bad faith
granted).

13 Warren v. Peterson, supra at 327, 328;

In re Siegfried, supra at 584, 585.

14 See
note 12, supra.