Does a debtor who has paid part of his wages to a trust as part of a Chapter 13 bankruptcy agreement recover the wages upon conversion to Chapter 7 bankruptcy, or do those wages belong to the creditors?
The Supreme Court will determine whether undistributed funds in a Chapter 13 trustee’s possession must be returned to the debtor upon conversion to Chapter 7, or whether creditors have a right to those funds. Harris argues that the Third Circuit’s rule is right in that a debtor’s post-petition wages become part of the property of the estate and thus revert back to the debtor upon conversion. Viegelahn, however, counters that the Fifth Circuit’s rule is the correct one because funds belong to creditors, as the Bankruptcy Code creates an escrow relationship between the trustee and creditors. The resolution of this case has the potential to affect the incentives a debtor has to file under Chapter 13, and may also implicate the balance of equitable considerations between debtor and creditor.
Questions as Framed for the Court by the Parties
Chapter 13 of the Bankruptcy Code allows debtors to repay their creditors by turning a portion of their monthly income over to a Chapter 13 trustee for distribution to those creditors. At any time, however, a debtor may convert a Chapter 13 bankruptcy case to one under Chapter 7. Congress has provided that "[e]xcept" where the conversion is made in bad faith, the resulting Chapter 7 estate is limited to the debtor's property "as of the date" the original Chapter 13 petition was filed; it does not include wages or property that the debtor acquired after the petition date. 11 U.S.C. § 348(f).
The question presented is:
When a debtor in good faith converts a bankruptcy case to Chapter 7 after confirmation of a Chapter 13 plan, are undistributed funds held by the Chapter 13 trustee refunded to the debtor (as the Third Circuit held in In re Michael, 699 F.3d 305 (2012) [sic] or distributed to creditors (as the Fifth Circuit held below)?
In February of 2010, after falling $3,700 behind on his mortgage loan, Charles E. Harris III filed for bankruptcy under Chapter 13 of the Bankruptcy Code. His reorganization plan was confirmed in April of 2010. The plan required that he make monthly payments to his bankruptcy trustee—Mary K. Viegelahn—of $530. These payments were to come from Harris’s gross monthly income of $4,082.87 and last for 60 months. Viegelahn was to distribute the payments to Harris’s creditors; “secured” creditors would be paid first followed by “unsecured” creditors. Specifically, Viegelahn was to pay the two secured creditors first—Chase (Harris’s mortgage holder) was to receive $352/month and Conns was to receive approximately $75/month (to pay off a $900 television set). Next, Harris’s lawyer would receive payment. Thereafter, the balance of Harris’s monthly payment would be divided up between the remaining unsecured creditors, to which he owed over $20,000. Under the plan, Harris was also required to keep making $960 monthly mortgage payments to Chase.
By November of 2010, however, Harris was failing to make those monthly mortgage payments to Chase. Thus, “the Bankruptcy Court lifted the automatic stay preventing [Chase] from foreclosing on [Harris’s] residence.” Harris then vacated the house and Chase “presumably” initiated foreclosure proceedings. At this point, Viegelahn placed a hold on the portion of Harris’s monthly payments that would have been remitted to Chase. For about a year after the stay was lifted Harris continued to make his $530 monthly payments to Viegelahn. Since Viegelahn was not distributing anything to Chase, the funds began to accumulate in Viegelahn’s possession.
On November 22, 2011, Harris converted his plan to a Chapter 7 bankruptcy. By this time, the accumulated funds in Viegelahn’s possession totaled $5,519.22. The conversion plan designated that $1,200 of the total undistributed funds belonged to Harris’s legal counsel, and Viegelahn accordingly paid that amount. Viegelahn distributed the balance of $4,319.22 as follows: “$397.68 to Conns; $3,583.78 to six unsecured creditors; and $267.79 to herself as commission.” Viegelahn then filed the final reports for the Chapter 13 case.
Upon learning of these disbursements, Harris demanded that the $4,319.22 be returned to him. Harris argued that Viegelahn lacked authority to distribute the funds after the conversion.The bankruptcy court ordered Viegelahn to return the $4,319.22 of undistributed funds to Harris. Viegelahn appealed the order to the United States District Court for the Western District of Texas, which affirmed the bankruptcy court’s order. Viegelahn then appealed to the United States Court of Appeals for the Fifth Circuit, which reversed the district court’s holding. The United States Supreme Court granted certiorari to decide whether trustee funds revert back to debtors or are disbursed to creditors upon conversion from Chapter 13 to Chapter 7 bankruptcy.
This case presents the Supreme Court of the United States with an opportunity to resolve a circuit split on the issue of whether funds paid to a Chapter 13 trustee, but which have not yet been disbursed to creditors, revert back to the debtor upon conversion to Chapter 7 bankruptcy. Harris, consistent with the Third Circuit, argues that a debtor’s income paid to the trustee after the Chapter 13 repayment is in progress returns to the debtor because the Chapter 13 trustee is immediately terminated upon conversion and the funds revert to the property of the estate. However, Viegelahn, consistent with the Fifth Circuit, contends that the relevant statutes create an escrow-like relationship between the creditors and the trustee, meaning that undistributed funds belong to creditors.
DOES THE PLAIN LANGUAGE OF THE BANKRUPTCY STATUTES IN QUESTION DICTATE A PARTICULAR INTERPRETATION ?
Harris submits that the language of the bankruptcy statutes in question is clear on its face. Harris explains that a debtor can convert its restructuring plan from Chapter 13 to Chapter 7 bankruptcy at any time under the Bankruptcy Code. Additionally, Harris notes that unless this conversion takes place in bad faith, the relevant date for amassing property to the estate is the date of the bankruptcy petition itself. Harris argues that Congress was clear in § 348(f), where Congress states that property belonging to a debtor at the date of the filing would be amassed as the debtor’s estate, which a Chapter 13 trustee would then disburse to satisfy debts. Thus, Harris contends, given the statutory language, post-petition wages are not part of the estate at the moment that bankruptcy proceedings begin. Accordingly, Harris explains, post-petition wages are not part of the estate that becomes liquidated at conversion to Chapter 7; these wages are returned to the debtor.
Harris also references § 348(e), which provides that the Chapter 13 trustee, who previously oversaw disbursement of debtor funds to creditors, immediately “terminates” upon conversion, and a new Chapter 7 trustee oversees liquidation. This, to Harris, indicates that at the moment of conversion, the Chapter 13 trustee is “incapacitate[d]” and can no longer handle the debtor’s funds in any way, thus preventing Viegelahn’s actions in this case. Harris further points out that upon conversion, a Chapter 13 trustee retains a very limited set of administrative duties specifically defined by statute. These duties, Harris asserts, do not include “blank check” authority to continue disbursing the debtor’s funds. Finally, Harris argues that § 1327(b) provides the “default rule” that all of the debtor’s property at the moment of confirmation of the Chapter 13 repayment plan vests to the debtor unless the repayment plan says otherwise. In this case, Harris notes, the plan specifically required that any property re-vest in the debtor “upon dismissal, conversion, or discharge.” Thus, according to Harris, the debtor’s post-petition wages should return to the debtor because conversion to Chapter 7 has taken place.
In opposition, Viegelahn counters that there is no single provision in the Bankruptcy Code that speaks to this issue directly. Thus, Viegelahn argues, the Bankruptcy Code must be interpreted as a whole and against applicable common law principles. Under this interpretation, Viegelahn contends that the repayment plan is the “lynchpin” of Chapter 13 bankruptcy, and the trustee’s task of collecting and disbursing payments according to the plan becomes paramount. Viegelahn states that the relationship between creditors, debtor, and trustee mirrors the common law escrow relationship. As such, Viegelahn maintains, creditors have rights to any post-petition wages whether or not they have been disbursed before conversion.
Furthermore, Viegelahn explains that the escrow relationship is contractual, and the creditor-debtor-trustee relationship under Chapter 13 also mirrors a contractual trust. Thus, Viegelahn argues, under the common law the trustee becomes an agent obligated to execute the terms of the contract (repayment) between the creditor and the debtor. Viegelahn states that like the escrow holder, the trustee has a mandatory duty to ensure that the property is properly vested to its new owner, the creditor; the debtor no longer retains a property interest in the wages in question. Viegelahn also argues that when read as a whole, the Bankruptcy Code can also be analogized to the common law trustee relationship. In this scenario, Viegelahn explains, the trustee is required to satisfy any unpaid trust obligations whether or not they were paid before termination (or in this case, conversion). Thus, according to Viegelahn, the debtor’s post-petition wages belong to the creditors and must be used to satisfy debts, not returned to the debtor upon conversion.
DO THE LEGISLATIVE HISTORY AND PURPOSE OF THE RELEVANT STATUTORY PROVISIONS SUPPORT A PARTICULAR INTERPRETATION?
Harris cites the legislative history of § 348(f) to note that Congress created § 348(f) specifically to resolve a prior circuit split on the issue of what property is part of the estate when a debtor converts. Harris argues that by creating § 348(f), Congress explicitly rejected the precise arguments made by cases of the time, eventually reprised by Viegelahn and the Fifth Circuit. Furthermore, Harris highlights the bad faith exception written into § 348(f)(2), and argues that Congress would have no need to write an exception in which post-petition wages would be included in the estate (because the property of the estate is measured by the date of conversion in this exception), unless the wages would not otherwise be included in the estate in a good faith conversion.
Viegelahn counters that with regard to § 348(f), the circuit split at issue at that time was whether an asset—such as land or a tort claim—could be included in the estate upon conversion. Viegelahn notes that these types of assets are not at issue in the instant case, and thus Congress’s reasoning in § 348(f) does not speak to the current question. Viegelahn also characterizes Chapter 13 bankruptcy as a “bargain” or “quid pro quo” between debtors and their creditors. Viegelahn states that debtors filing under Chapter 13 keep their assets in exchange for agreeing to repay creditors out of future earnings via a court-approved repayment plan. A debtor under Chapter 13, states Viegelahn, thus agrees to surrender all income to the trustee to be disbursed according to the plan. Consequently, Viegelahn explains, the purpose of Chapter 13 would be undermined if a debtor were allowed to keep those payments at conversion simply because they had not yet been disbursed. To that end, Viegelahn argues, Congress neither intended to incentivize a race to disburse, nor make the analysis turn on the individual disbursement practices of each trustee.
The Supreme Court will determine who has the right to undistributed funds remaining in a bankruptcy trustee’s possession when a debtor converts from a Chapter 13 to a Chapter 7 bankruptcy plan. Harris claims that distributing post-conversion funds to creditors imposes a significant disincentive for debtors to choose Chapter 13 and is therefore at odds with Congressional intent. Nevertheless, Viegelahn argues that the Fifth Circuit’s ruling best honors the quid pro quo between debtors and creditors that underlies the bankruptcy scheme. The Supreme Court’s decision will implicate debtor incentives to file for Chapter 13 bankruptcy instead of Chapter 7.
DEBTOR INCENTIVES TO FILE UNDER CHAPTER 13
The National Association of Consumer Bankruptcy Attorneys (“NACBA”) contends, in support of Harris, that Congress enacted Chapter 13 specifically to encourage debtors to choose Chapter 13 over Chapter 7. NACBA argues that giving creditors the right to receive undistributed, post-conversion, assets would undermine the goal of having debtors choose Chapter 13. Specifically, debtors like Harris—who convert from Chapter 13 to Chapter 7—would be penalized because they would at the same time be required to: (1) surrender their Chapter 7 property, as if they originally proceeded under Chapter 7, and (2) forfeit their post-petition income as if they were still subject to Chapter 13. This would impose, NACBA argues, a significant disincentive for debtors to attempt a Chapter 13 plan. G. Eric Brunstad Jr., a Law Professor and practicing attorney writing amicus in support of Harris, further notes that Congress intended debtors to receive post-petition funds because “creditors should be put in precisely the same position as they would have been had the debtor never sought to repay his debts” upon conversion.
Viegelahn counters by arguing that the Fifth Circuit’s rule of giving post-conversion funds back to the debtor best comports with Congress’s intent in enacting the bankruptcy scheme. First, Viegelahn claims that distributing post-conversion funds to creditors would not provide any disincentive for a debtor to proceed under Chapter 13. Viegelahn argues that this is because the situation that Harris faces—an accumulation of funds that had not yet been distributed by the trustee at the time of conversion—is purely “a matter of happenstance . . . [that] would be impossible to predict at the time of filing [for conversion to Chapter 7].” In other words, Viegelahn argues, a debtor choosing between Chapter 7 and Chapter 13 would fairly assume that any funds the debtor delivered to the trustee would be duly distributed. But even if that were not true, Viegelahn claims that the Fifth Circuit’s rule would not create a disincentive for a debtor to initially proceed under Chapter 13. Specifically, a rule permitting a debtor to recoup these funds would only result in trustees making more frequent and timely distributions to creditors. Any funds available to the debtor, Viegelahn concludes, would therefore likely be minimal and, again, not affect a debtor’s choice to proceed under Chapter 13.
EQUITABLE CONSIDERATIONS IN PERMITTING A DEBTOR TO RECOUP UNDISTRIBUTED FUNDS
NACBA argues that fairness compels a reversal of the Fifth Circuit’s decision to distribute post-conversion funds to creditors. NACBA highlights the underlying policy rationale of bankruptcy—“a new opportunity in life [for the debtor] and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” Debtors emerging from Chapter 7 frequently have little money or assets, especially those debtors who converted from Chapter 13 to Chapter 7 because they had previously been using substantial portions of their income to pay off creditors. The Fifth Circuit’s decision, NACBA argues, is therefore at odds with the policy goal of bankruptcy; returning undistributed funds to the debtor would significantly assist in giving debtor’s a “fresh start” from bankruptcy.
Viegelahn counters that fairness compels the opposite result—an affirmance of the Fifth Circuit. Specifically, Viegelahn notes that there is a certain quid pro quo that Chapter 13 sets up: the debtor pays creditors his or her disposable income in return for the debtor keeping her property. Retroactively changing to whom those funds belong—just because a debtor converted to Chapter 7—would, Viegelahn argues, frustrate the bargain the parties agreed to under Chapter 13.
This case gives the Supreme Court the opportunity to resolve a circuit split over whether a debtor has the right to recover undistributed funds in a bankruptcy trustee’s possession after she or he petitions to convert from Chapter 13 to Chapter 7 bankruptcy. Harris argues that the post-petition wages at issue in this case belong to him because they are the property of the bankruptcy estate and must revert back to the debtor upon conversion. Viegelahn counters that any undistributed funds in the trustee’s possession must belong to creditors because trustees essentially hold the funds in escrow for the creditors. The resolution of this case may have a wide-reaching impact on the bankruptcy scheme enacted by Congress, particularly because it may affect the incentives a debtor has to file under Chapter 13 in the first instance. The bargain between debtor and creditor under Chapter 13 also hangs in the balance—with both sides claiming that fairness compels that they should receive undistributed funds after a debtor converts from a Chapter 13 to Chapter 7 case.
- The Knowledge Effect: Debtor wants Supreme Court to resolve where post-petition funds go after conversion, Thomson Reuters Blog (Oct. 23, 2014).
- Michael Lipkin: Justices To Decide Who Gets Funds In Bankruptcy Conversion, Law360 (Dec. 12, 2014).