The facts are simple. A debtor files for chapter 13 and proposes a plan, which is confirmed. The debtor makes payments pursuant to the terms of the plan but is unable to continue funding the plan a considerable time later. The case is converted to chapter 7, and on the date of conversion, the chapter 13 trustee is holding funds that were earmarked for creditors but have not been paid out. The trustee intends to disburse the accumulated funds to the creditors under the plan, but the debtor files a motion requesting that the trustee refund those funds. So who gets the money? In In re Smith,[1] the U.S. Bankruptcy Court for the Western District of Missouri was charged with the task of making that determination. This article addresses a question that has been an enigma for many courts, the answer to which has not been as straightforward as the facts.[2]
Statutory Background
Prior to 1994, a split existed among the circuits on the issue of whether post-petition chapter 13 income remained property of the estate upon conversion to chapter 7. Some courts held that if a case was converted, after-acquired property or monies paid to the trustee during the pendency of the chapter 13 case became property of the estate in the converted chapter 7 case.[3] Others held that property of the estate in a converted case was limited to the property that the debtor had when the original petition was filed.[4] The 1994 amendments to the Bankruptcy Code resolved that split by providing that the debtor’s payments from post-petition earnings pursuant to a chapter 13 plan were not part of the chapter 7 estate upon conversion except in limited circumstances.[5] While Congress clarified the disposition of such funds as between the chapter 7 estate and the debtor, it did not address the rights that the chapter 13 creditors may have to those funds when conversion occurs post-confirmation.[6]
Several Code provisions address the issue tangentially, but do not resolve it. For example, § 1326(a)(2) sets forth the chapter 13 trustee’s obligation to distribute funds pursuant to a confirmed plan as soon as it is practicable.[7] Notwithstanding that requirement, it is not administratively possible to make a distribution to creditors immediately upon receipt of each payment; as a result, accumulation may occur. The question then becomes whether conversion to chapter 7 abrogates the duty of the chapter 13 trustee to distribute those funds in accordance with § 1326.
The Pro-Debtor Camp
The leading case ruling that the undisbursed funds be returned to the debtor is In re Michael.[8] In that case, neither the bankruptcy court nor the district court found a clear answer to the disbursement question in the Code, but both concluded that the funds must be returned to the debtor. The Third Circuit affirmed:
Section 348(f) clarifies what becomes of property of the now nonexistent Chapter 13 estate. It provides that property of the Chapter 7 estate “consist[s] of property of the estate, as of the date of filing of the [Chapter 7] petition, that remains in the possession of or is under the control of the debtor on the date of conversion.” Because [§] 1327(b) vests all property of the Chapter 13 estate in the debtor, including any post-petition property held by the Chapter 13 trustee at the time of conversion (such as funds transferred to the estate for eventual distribution to creditors), on conversion property of the Chapter 13 estate usually is “under the control of the debtor.” And because § 348(a) establishes that conversion does not change the effect of the Chapter 13 petition’s filing, the Chapter 7 petition date is deemed to be the same date that the debtor began the Chapter 13 case. Hence, property acquired post-petition that is in the Chapter 13 estate at the time of conversion is not property of the new Chapter 7 estate. Rather, the debtor retains a vested interest in the property, and thereby the property reverts to the debtor on conversion.[9]
The Michael court also pointed to the termination of the chapter 13 trustee’s services under § 348(e), noting that although a trustee must file a final report under Fed. R. Bankr. P. 1019, “it does not follow that he is permitted to distribute funds under a plan that is no longer operative.”[10] In addition, the court found that the legislative history of § 348(f) indicated that Congress sought to eliminate the serious disincentive to file chapter 13 filings. If creditors received a portion of the chapter 13 estate upon conversion, debtors would be dissuaded from filing under chapter 13.[11]
In a lengthy dissent, the judge argued that the debtor’s attached wages funding the plan were under the trustee’s supervision and control. They were the quid pro quo that the debtor gave up in return for being permitted to stave off foreclosure of his residence, retain his automobile and enjoy the automatic stay.[12] In addition, the applicable local rule mandated that the chapter 13 trustee distribute funds that were received before conversion according to the plan terms.[13] Finally, the dissent distinguished Bobroff, the case on which the majority relied.[14] In that case, the court feared that inequities might result when the recovery from the debtor’s post-petition litigation was included in the converted chapter 7 estate (i.e., creditors would receive a windfall from funds that would not have been in the estate if the initial filing had been under chapter 7).[15] In Michael, if the undistributed funds reverted to the debtor, he would receive a windfall.[16]
Much of the reasoning on which the Michael majority opinion is based was adopted by the court in In re Harris.[17] After conversion to chapter 7, the chapter 13 trustee distributed accumulated funds to the creditors. The debtor filed a motion to compel the return of those funds, and the bankruptcy court granted the relief requested. On appeal, the trustee argued that (1) confirmation of a plan vested certain rights in the creditors and created an irrevocable trust in the funds; (2) § 1326 mandated distribution to the creditors; (3) § 348(e) did not relieve the trustee of the duty to disburse the funds to creditors; and (4) permitting a debtor to recoup the funds would force trustees to make distributions to creditors on a daily basis, which is an impractical result.[18]
The district court affirmed and, citing Michael and other cases favoring the debtor, agreed that underlying policy should guide its interpretation of the Code provisions: “These courts focus on the congressional policy of encouraging debtors to attempt a Chapter 13 bankruptcy — through which a debtor will pay his creditors at least as much and likely more than he would have under Chapter 7 — without penalty if that attempt fails.”[19] The court also reasoned that there was no inherent inequity in returning the funds to the debtor since the creditors would be put back in precisely the same position as they would have been had the debtor never filed under chapter 13.[20] Lastly, the Harris court rejected the argument that the creditors had a vested right in the funds and instead concluded that the debtor retained a vested interest until they were affirmatively transferred by the trustee to creditors.[21]
The Pro-Creditor Camp
There is considerable precedent to support the distribution of funds to the creditors. While many of these cases predate the 1994 amendments, they are not negatively affected by them.[22] In fact, it does not appear that the enactment of § 348(f) indicates a congressional intent to address this particular dilemma.[23] Nevertheless, the reasoning underlying this line of cases is that the chapter 13 statutory scheme supports the distribution of accumulated funds to creditors. For example, one of the questions raised in In re Lennon[24] was whether § 1326(a)(2) was limited to pre-confirmation payments. The court concluded that based on the interplay of that provision with others governing chapter 13 cases, Congress must have intended post-confirmation payments to also be disbursed to creditors.[25]
Several courts liken a confirmed chapter 13 plan to a binding contract between a debtor and his/her creditors: The plan generates benefits for the parties as well as corresponding responsibilities.[26] Courts adopting this view maintain that conversion constitutes a breach by the debtor of his/her implicit obligation to maintain the case for the life of the plan, and therefore, awarding the undisbursed plan payments to the nonbreaching creditors is a compelling remedy.[27]
In re Smith
The recent case of In re Smith involved competing claims to undisbursed funds. The bankruptcy court denied the debtors’ motion to return those funds and ordered the trustee to disburse them to the creditors, pursuant to the plan terms.[28]
First, the court noted that the applicable local rule dictated that plan payments received by the trustee before conversion be disbursed to creditors.[29] The debtors challenged its validity, but the court found that the rule was valid and applicable.[30]
Second, the order confirming the plan expressly stated that funds paid to the trustee per a confirmed plan before conversion must be distributed pursuant to that plan. The trustee argued that a confirmation order was res judicata as to all issues decided or those that could have been decided at the confirmation hearing. Since the debtors never challenged the order, it was binding on the parties. The court agreed, but the debtors asserted that conversion acted to revoke the confirmation order and, therefore, the trustee was not authorized to disburse the funds. The court rejected that argument, stating that such a result was not supported by statute and revocation would render chapter 13 unworkable. For instance, a secured creditor who took surrendered collateral in satisfaction of its claim would possibly have to return it to a chapter 7 trustee if the case was converted.[31]
Third, § 1326(a)(2) was controlling. The court concluded that based on the plain language of that provision and the statutory scheme of chapter 13, Congress intended post-confirmation payments made pursuant to the plan to be distributed to creditors.[32]
Next, the court dismissed as unrealistic the contention that a debtor would lose the incentive to file under chapter 13 if he/she thought that undisbursed funds would be distributed to creditors in the event of a conversion. The court also undertook the contract analysis articulated by the Michael dissent. In a chapter 13 case, a debtor receives certain benefits afforded by the automatic stay and the bankruptcy plan itself, and in turn, the creditors receive the money that it paid into the estate.[33] Conversion is tantamount to a breach of their “contract,” so disbursing accumulated funds to creditors puts them in the position they were in prior to the breach.[34]
In addition, contrary to the debtors’ assertion, the court concluded that the services of the chapter 13 trustee did not end at conversion.[35] Since Fed. R. Bankr. P. 1019 requires a trustee to file a final report and account after conversion, Congress must have intended that the trustee conduct whatever duties were called for to wind up the affairs of the estate, including disbursing monies on hand to the appropriate recipients.[36]
Finally, the court rejected the debtors’ argument that the funds were property of the estate that was vested in the debtors at the time of confirmation and were free and clear of any creditor claims.[37] It was persuaded by the line of cases holding otherwise: A creditor’s interest in plan payments vests when each payment is made and, upon conversion to chapter 7, any undistributed payments do not become property of the converted estate but must be disbursed according to the terms of the plan.[38] The court added that even if this were not the result absent a relevant provision in the confirmation order, it certainly would be if the order so provided, and in this case, it did.
Conclusion
For a variety of reasons, once a chapter 13 plan is confirmed and the debtor begins funding it, the accumulation of funds in the trustee’s hands can occur. The Bankruptcy Code does not provide a clear answer to the question of who gets the money when the case is converted. Courts grappling with this issue typically consider the congressional policy promoting chapter 13 filings over chapter 7, the avoidance of windfalls to either the debtor or the creditors and the binding nature of the plan. From a practical standpoint, factors tipping the scales to the creditors include the existence of a local rule mandating distribution per the confirmed plan and similar language in the confirmation order. The Smith case presents a survey of the arguments made by both sides in terms of the interpretation of the relevant Code provisions as they relate to the parties’ respective rights to the undisbursed funds.
[1] -- B.R. --, 2014 WL 1873419 (Bankr. W.D. Mo. May 8, 2014).
[2] As the In re Markham court stated, “[t]he fact that all courts agree that the funds are not property of the bankruptcy estate does not generate harmony in determining who gets the money. It is an enigma.” 2013 WL 6903753 at *2 (Bankr. D. Mass. Dec. 31, 2013).
[3] See, e.g., In re Lybrook, 951 F.2d 136 (7th Cir. 1991).
[4] See, e.g., In re Redick, 81 B.R. 881 (Bankr. E.D. Mich. 1987).
[5] Pub. L. No. 103-394 (1994), codified as 11 U.S.C. § 348(f). The exception to the rule is conversion in bad faith.
[6] In re Hardin, 200 B.R. 312, 313 (Bankr. E.D. Ky. 1996).
[7] 11 U.S.C. § 1326(a)(2).
[8] 699 F.3d 305 (3d Cir. 2012) (Roth, J., dissenting).
[9] Id. at 313 (citations omitted) (emphasis in original).
[10] Id. at 314.
[11] Id. at 315 (“If debtors must take the risk that property acquired during the course of an attempt at repayment will have to be liquidated for the benefit of creditors if chapter 13 proves unavailing, the incentive to give chapter 13 — which must be voluntary — a try will be greatly diminished.”) (citing In re Bobroff, 766 F.2d 797 (3d Cir. 1985) (quotations omitted)).
[12] Id. at 319.
[13] Id. at 318 (citing Western District of Pennsylvania Local Bankruptcy Rule 3021-1(f)).
[14] 766 F.2d 797 (3d Cir. 1985).
[15] 699 F.3d at 319.
[16] Id. at 320, 321 (“He would obtain the benefits of the confirmed plan offered without having to pay his creditors. Such a result would not only be patently unfair, but also contradict the reasoning of Bobroff. Michael would be in a better position (and his creditors in a worse position) than he would have been if he had initially filed for bankruptcy under Chapter 7.”) (footnote omitted).
[17] 491 B.R. 866 (W.D. Tex. 2013).
[18] Id. at 872-73.
[19] Id. at 873-74.
[20] Id. at 874 (citing In re Hannan, 24 B.R. 691, 692 (Bankr. E.D.N.Y. 1982)).
[21] Id. at 874-75.
[22] Hardin, 200 B.R. at 313 (Bankr. E.D. Ky. 1996) (citing In re Galloway, 134 B.R. 602 (Bankr. W.D. Ky. 1991); In re Halpenny, 125 B.R. 814 (Bankr. D. Haw. 1991); In re Leonard, 150 B.R. 709 (Bankr. W.D. Ark. 1992)).
[23] Hardin, 200 B.R. at 313.
[24] 65 B.R. 130 (Bankr. N.D. Ga. 1986).
[25] Id. at 137. Contra Williams v. Marshall, 2014 WL 14578828 (N.D. Ill. April 11, 2014).
[26] Markham, 2013 WL 6903753 at *5. See also § 1327(a), which provides that “the provisions of a confirmed plan bind the debtor and each creditor.”
[27] Id. at *6 (citing Michael, 699 F.3d at 320).
[28] See also In re Harris, 2014 WL 3057095 (5th Cir. July 7, 2014) (applying reasoning similar to that of Smith court and reaching same conclusion).
[29] Local Rule 3089-1.
[30] Smith, 2014 WL 18373419 at *3.
[31] Id. at *4 (citing Markham, 2013 WL 6903753 at *6).
[32] Id. (quoting Lennon, 65 B.R. at 137).
[33] Id. at *6, n.5 (citing Michael, 699 F. 3d at 320 (citations omitted)).
[34] Id. at *6 (citing Markham, 2013 WL 6903753 at *6).
[35] The debtors cited 11 U.S.C. § 348(e), which provides that “[c]onversion of a case under [§ 1307] ... terminates the service of any trustee or examiner that is serving in the case before such conversion.”
[36] Smith, 2014 WL 18373419 at *6 (citing In re Pegues, 266 B.R. 328, 336-37 (Bankr. D. Md. 2001)).
[37] See 11 U.S.C. §§ 1306, 1327(b) and (c).
[38] 2014 WL 18373419 at *8.