Ninth Circuit Creates a Legal Fiction to Uphold Recovery of an Unauthorized Transfer

If a chapter 13 debtor commits an unauthorized post-petition transfer and the case is converted to chapter 7, is there property of the estate that the chapter 7 trustee is entitled to recover?

The bankruptcy court and the Bankruptcy Appellate Panel proffered four rationales, and the Ninth Circuit added a fifth. Unlike the other theories, the concurring opinion in the BAP would allow recovery without creating a legal fiction.

The Fraudulent/Unauthorized Transfers

A chapter 13 debtor listed his assets as including an expected $2,500 inheritance. It turned out that he received more than $55,000. Without amending the schedules and without notice to the chapter 13 trustee, the debtor transferred the $55,000 to his siblings.

After learning about the transfers, the chapter 13 trustee moved for conversion to chapter 7. The bankruptcy court granted the conversion motion “for cause.”

The chapter 7 trustee filed an adversary proceeding to recover the transfers as fraudulent under Section 548 or as unauthorized post-petition transfers under Section 549. The bankruptcy court granted summary judgment under Section 549 for the amount of the transfers.

The bankruptcy court said that the inheritance was property of the chapter 13 estate as of the filing date. The bankruptcy court reasoned that the inheritance remained property of the estate after conversion to chapter 7 because the transfer was made in bad faith.

The Bankruptcy Appellate Panel affirmed. Among the three judges on the BAP, they had two reasons for upholding the avoidance of the transfers. One of the siblings appealed to the Ninth Circuit.

The Ninth Circuit’s Rationale

Section 348(f)(1)(A) defines property of the estate when a case is converted from chapter 13 to chapter 7. It provides that “property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the [chapter 13] petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”

In the court of appeals, the sibling argued under Section 348(f)(1)(A) that the transferred property was not property of the chapter 7 estate that the trustee could recover because it was no longer in the possession or control of the debtor on the date of conversion.

As Ninth Circuit Judge Mary M. Schroeder explained in her March 23 opinion, the phrase “that remains in the possession” or control of the debtor “prevents creditors from seeking to recover funds that were lawfully spent during the Chapter 13 proceeding and [are] therefore no longer property of the estate.” She said that the “ambiguous” text of the section is “problematic.”

Judge Schroeder cited courts going both ways. Some hold that creditors are barred by Section 348(f)(1)(A) from recovering the payment of unauthorized expenses in chapter 13. Other courts, she said, believe that a “literal application” of the statute “could lead to an absurd result, one rewarding bad faith.”

Although “fraudulently transferred funds should be recoverable by creditors as part of the converted estate under Section 348(f)(1)(A),” Judge Schroeder said the text of the statute is “much less” obvious.

To interpret the ambiguous text, Judge Schroeder looked to the “structure, object, and policies of the Bankruptcy Code.” In the Code, she found “a firm policy of not rewarding fraud or bad-faith debtors.” She went on to find “no basis . . . for treating the fraudulent transfers as beyond the reach of creditors merely because the estate was converted.”

Judge Schroeder was persuaded by criminal law, where courts hold that property can be in the constructive possession of criminal defendants. Those cases recognize, Judge Schroeder said, that requiring “actual physical possession could lead to unfair or untoward results.” Those cases “have consistently rejected efforts to evade the operation of the law by disguising ownership of fraudulently obtained funds or contraband.”

In distinction to the rationales given by the lower courts, Judge Schroeder adopted a different approach based on criminal law. The bankruptcy court, she said, found that “the debtor transferred the funds with the fraudulent purpose of avoiding payments to creditors.”

Judge Schroeder therefore held that the transferred funds “remained within [the debtor’s] constructive possession or control, and hence should be considered property of the converted estate under § 348(f)(1)(A).”

Observation

This writer sees no need for reliance on the legal fiction of constructive possession or control. In this writer’s view, Bankruptcy Judge A. Spraker of Anchorage, Alaska, got it right in his opinion concurring with the result reached by the BAP.

To begin with, the transfers made in the chapter 13 case were voidable under Sections 548 and 549. Concededly, the transfers were made with property of the chapter 13 estate. The moment the chapter 13 debtor made the transfers, the transfers gave rise to claims of the chapter 13 estate under Sections 548 and 549.

Since the claims belonged to the chapter 13 estate on the conversion date, it stands to reason that the chapter 7 trustee was authorized to prosecute the claims after conversion.

Thus, it does not matter whether the transferred funds were property of the estate, because the chapter 7 trustee inherited the right to pursue the claims.

We invite our readers to tell us how they would resolve the issue.