The Third Circuit in In re Michael, 699 F.3d 305 (3d Cir. 2012), held that funds acquired by a debtor after filing a Chapter 13 bankruptcy which, at time of conversion, had not been distributed to his creditors revert back to the debtor unless the conversion occurs in bad faith.
Introduction
In a case of first impression involving § 348(f) of the Bankruptcy Code,[1] the Third Circuit in In re Michael[2] considered whether wages acquired by a debtor after filing bankruptcy and held by the Chapter 13 Trustee for distribution to creditors pursuant to a Chapter 13 plan belonged to the debtor or his creditors upon conversion of his Chapter 13 case to a Chapter 7 liquidation case.[3] A majority of the court held that, while § 348(f) did not provide a clear answer, the most natural reading of the statute in light of its legislative history leads to the conclusion that these funds revert back to the debtor unless the conversion occurs in bad faith.[4] The dissent, however, would have carved out an exception to this general rule where, as in the present case, the debtor made voluntary payments to the Chapter 13 estate pursuant to a confirmed plan.[5]
Facts and Procedural History
In September 2005 Barry L. Michael filed a Chapter 13 bankruptcy and confirmed a repayment plan in June 2006 under which he agreed to pay $277 per month for 53 months to his creditors.[6] To fund the plan, the debtor’s wages were attached and paid directly to the Chapter 13 Trustee, who then made payments to creditors on the debtor’s behalf.[7] The plan provided that secured and priority creditors would be paid in full, while unsecured creditors would receive payments on a pro rata basis from any funds that remained in the Chapter 13 estate after the secured and priority creditors were paid.[8] The debtor’s mortgage lender, GMAC, received payments under the plan as a secured creditor and also collected regular mortgage payments from the debtor outside of the plan.[9]
Only two months after confirmation, the debtor was unable to make his mortgage payments.[10] GMAC then successfully requested relief from the automatic stay and initiated foreclosure proceedings.[11] At this time, GMAC stopped accepting payments from the Trustee (presumably to preclude a potential estoppel or waiver defense to its foreclosure).[12] Because neither the debtor nor his creditors modified the plan or wage-attachment order, the funds slated for distribution to GMAC simply accumulated in the Trustee’s account month after month.[13]
In October 2009, the debtor converted his Chapter 13 case to a Chapter 7 liquidation case and filed a motion compelling the return of the undistributed funds, which totaled $9,181.62.[14] The Trustee objected, contending that the funds should be distributed to the debtor’s unsecured creditors in accordance with the Chapter 13 plan.[15] Both the bankruptcy court and district court accepted the debtor’s construction of § 348(f), and this appeal followed.[16]
Applicable Law
Consumer Bankruptcy Basics
Consumers typically file bankruptcy under Chapter 7 or Chapter 13 of the Bankruptcy Code.[17] In a Chapter 13 case, the debtor repays creditors pursuant to a plan that is funded chiefly by the debtor’s future income.[18] In bankruptcy parlance, wages earned after filing bankruptcy are considered “property of the estate,”[19] which the Chapter 13 Trustee then distributes to creditors in accordance with the repayment plan.[20] Conversely, in Chapter 7, creditors are paid from proceeds of the sale of non-exempt property that the debtor owns at the time of filing.[21] Thus, any property acquired by the debtor after filing does not become “[p]roperty of the estate,”[22] and hence cannot be liquidated for the benefit of his creditors in a Chapter 7 case.
Effect of Conversion
A debtor who initially files a Chapter 13 case has the right to convert the case to a Chapter 7, even after a plan has been confirmed.[23] Because conversion creates a new bankruptcy estate under Chapter 7, it is integral to determine which property of the debtor becomes property of the newly created estate—and can thus be liquidated for the benefit of his creditors. Prior to the enactment of § 348(f) in 1994, courts reached three separate conclusions regarding the disposition of undistributed, post-petition property held by a Chapter 13 Trustee at the time of conversion: (1) the property becomes part of the new estate;[24] (2) it reverts back to the debtor;[25] or (3) it is paid to creditors under terms of the Chapter 13 plan.[26]
Section § 348(f) eliminated the first possibility. Under § 348(f) the property of the converted case consists of “property of the estate, as of the date of filing of the petition,”[27] and the date of filing of the converted case relates back to the date of filing of the initial bankruptcy petition.[28] However, if the debtor converts in bad faith, the estate is comprised of “property of the estate as of the date of conversion.”[29] Thus, absent bad faith, the property of the newly created Chapter 7 estate consists of property that the debtor possessed when filing the original Chapter 13 case, which by definition excludes post-petition property.
Section § 348(f), however, does not explicitly resolve whether this post-petition property reverts back to the debtor or is distributed to his creditors pursuant to the Chapter 13 plan upon conversion. The Third Circuit in In re Michael was the first court to consider this precise issue at the circuit level.
Court’s Reasoning
In resolving this statutory ambiguity in favor of the debtor, the In re Michael majority considered the legislative history of § 348(f) and how its competing interpretations comport with the larger scheme of the Bankruptcy Code.[30]
Support in Legislative History
The court determined that the pro-debtor view of § 348(f) best achieved Congress’s goal of incentivizing debtors to attempt Chapter 13 reorganization before liquidating under Chapter 7.[31] Fortunately, Congress included an example in its drafting history detailing how § 348(f) should achieve this goal. That example outlined how a debtor who would have been able to keep his house if he initially filed under Chapter 7, instead lost his house because he opted to file under Chapter 13. The debtor in the example paid off a second mortgage, leaving him (and his Chapter 13 estate) with $10,000 in equity.
In jurisdictions holding that post-petition equity becomes part of the converted Chapter 7 estate, the debtor would be forced to sell his house if he converted to Chapter 7 so that the equity could be liquidated for the benefit of his creditors. Congress felt that this rule would dissuade debtors from filing under Chapter 13 first because a debtor who initially filed a Chapter 7 case would never risk losing post-petition property to his creditors.[32] Thus, Congress enacted § 348(f) with the intention of placing a debtor who converted in the same position he would have been if he had filed a Chapter 7 case initially—which, in this example, would exclude post-petition equity from the converted Chapter 7 estate and allow the debtor to keep his house.
Accordingly, the Third Circuit reasoned, any construction of § 348(f) in the present case must reach the same result—that is, shielding the debtor’s post-petition equity from creditors and enabling the debtor to keep his house.[33] This outcome clearly exemplifies a pro-debtor interpretation because the equity would revert back to the debtor upon conversion (unless the debtor converted in bad faith). On the other hand, the Trustee’s construction would yield a result that Congress disapproved of because it would require the Trustee to sell the debtor’s house in order to liquefy the post-petition equity for distribution to the Chapter 13 creditors.
The majority also found that the pro-debtor interpretation accords with the legislative history of the bad faith provision.[34] Congress included the provision in order to penalize debtors who “abused the right to convert and converted in bad faith” by including post-petition, undistributed property in the Chapter 7 estate, which is then liquidated for the benefit of creditors.[35] The majority inferred from this proposition that a debtor—not his creditors—is entitled to the post-petition property upon conversion unless the conversion occurred in bad faith. Once again, the majority found the Trustee’s construction conflicted with purpose behind the bad faith provision because a debtor who did not convert in bad faith would still lose the post-petition property to creditors under the terms of the Chapter 13 plan.
Consistency with the Bankruptcy Code
The In re Michael court also concluded that the debtor’s interpretation of § 348(f) better aligned with other relevant provisions of the Bankruptcy Code.[36] Most notably, § 1327(b) explicitly provides that, upon confirmation of a Chapter 13 plan, property of the estate vests in the debtor. By contrast, creditors have a right to payment under the Code but never a vested interest in property of the estate.[37] The majority also noted that conversion from a Chapter 13 case effectively “terminates” the Chapter 13 estate.[38] Combining these two principles, the court reasoned that undistributed wages—property of the now-defunct Chapter 13 estate—should revert back to the debtor since he retained a vested interest in them at the time of conversion.
Lastly, the court pointed to § 348(e), which once again “terminates” the duties of the Chapter 13 Trustee upon conversion of the case.[39] In the majority’s opinion, this provision indicates that the Trustee’s post-conversion duties should be very limited, and that returning undistributed funds to the debtor would be permissible, but distributing funds in accordance with the former Chapter 13 plan would not.
The Dissent’s View
The dissent agreed with the construction that allows debtors to recover undistributed, post-petition property but with one important caveat—that the rule not apply to debtors who voluntarily contributed property into the Chapter 13 estate pursuant to a confirmed Chapter 13 plan.[40] In the dissent’s view, confirmation of a plan creates a special relationship between a debtor and his creditors in which each party enjoys certain benefits in exchange for performing various responsibilities.[41] Adhering to the general rule in this case would allow the debtor to obtain the benefits of the confirmed plan without fulfilling his concomitant responsibility of paying his creditors.
Analysis
The majority’s construction of § 348(f) is preferable to the interpretation advanced by the Trustee and dissent because it better comports with § 348 as a whole and more logically fits into the larger statutory scheme of the Bankruptcy Code. While § 348(f) clearly bars post-petition property held by the Chapter 13 trustee at the time of conversion from becoming part of the new Chapter 7 estate, the majority justified making the inferential leap that that the provision more broadly prevents creditors from receiving this property via liquidation or distribution under a Chapter 13 plan unless the debtor converts in bad faith.
The Importance of the Bad Faith Provision
The majority’s construction has attractive logical appeal in light of Congress’s decision to include a bad faith provision. By enacting both the general rule, § 348(f)(1)(A), and the bad faith provision, § 348(f)(2), at the same time, it is justifiable to conclude that Congress intended for the good-faith converter and bad-faith converter to be treated differently. The Trustee’s interpretation does not account for this conclusion because it punishes both good-faith and bad-faith converters. That is, the good-faith converter loses his post-petition property since it is distributed to his creditors under the Chapter 13 plan, while the bad-faith converter also loses this property to his creditors as it becomes property of the Chapter 7 estate. On the other hand, the majority’s construction creates a meaningful distinction between the two, as the good-faith converter retains the post-petition property and the bad-faith converter loses it to his creditors.
In a related manner, the pro-debtor interpretation comports with the stated legislative policy of encouraging consumer debtors to file under Chapter 13 reorganization before resorting to Chapter 7 liquidation. Simply put, few debtors would attempt Chapter 13 reorganization if they had to risk losing post-petition property upon conversion. Rather, a debtor would simply file under Chapter 7 at the outset because this post-petition property never becomes property of the estate. Thus, placing debtors in the same position that they would have been in had they filed a Chapter 7 initially establishes a safety net that Congress intended to provide for debtors who tried but were unable to complete a Chapter 13 reorganization.
Additionally, the majority’s construction is consistent with other provisions of the Bankruptcy Code that govern Chapter 13 conversions. Given that conversion terminates both the Chapter 13 estate and the Trustee’s services, it follows that the Trustee is without power to perform one of his core duties—distributing property in accordance with the Chapter 13 plan—at a time when the Chapter 13 estate no longer exists. Similarly, at the time of conversion, the debtor has a vested interest in the property of the Chapter 13 estate under § 1327(b), while his creditors have no such right. Therefore, absent bad faith, the debtor should be able to enjoy the statutorily granted reversion in that property.
The Role of Plan Confirmation
The dissent’s argument rests on the view that a plan confirmation is a sacred step in a Chapter 13 case and that the debtor would therefore reap a windfall by enjoying the benefits of the plan without honoring his attendant obligation to pay his creditors. In addition to overlooking the context that the statutory provisions discussed above provide, a closer inquiry reveals that the pro-debtor interpretation does not result in the injustice that the dissent alleges. Indeed, in order for a Chapter 13 plan to be confirmed, priority and secured creditors must be paid in full[42] and unsecured creditors may not receive less than they would in a Chapter 7 liquidation.[43]
Thus, if plan is confirmed, creditors will only be in the same or better position than they would have been had the debtor filed a Chapter 7 case initially. For example, as the majority highlighted, creditors who receive payments under a Chapter 13 plan funded by a debtor’s future income are instantly in a better position because, if the debtor filed a Chapter 7 at first, those creditors would not have been able to benefit from the liquidation of the debtor’s post-petition property.[44]
Implications for Debtors and Creditors
Both debtors and creditors can learn important lessons from In re Michael. Because the holding arguably invites opportunistic behavior on the part of a debtor,[45] creditors should take proactive steps to ensure that any property that comes into the Chapter 13 estate is quickly paid out to them in accordance with the Chapter 13 plan. These steps include seeking more frequent distributions from the Chapter 13 Trustee,[46] modifying the Chapter 13 plan if funds are accumulating,[47] or moving for the distribution of funds in response to a debtor’s motion to convert.[48] The unsecured creditors in In re Michael should have exercised the second or third options, particularly because of the large amount of funds that accumulated in the Chapter 13 estate.
The majority also suggested that creditors (or the Trustee) could add language to a plan designating that payments received by the Trustee vest in the creditors.[49] Similarly, these parties could request that the bankruptcy court condition its approval of a Chapter 13 plan upon an analogous “vesting” provision.[50] Without expressing a view on the matter, the majority noted that such language, either in the plan or in the court’s order, may be enough to ensure that this property is not “under the control of the debtor on the date of conversion,” as provided for in § 348(f)(1)(A), and therefore not subject to this provision.[51]
As for debtors, while the majority certainly adopted a pro-debtor interpretation of § 348(f), debtors seeking to convert from Chapter 13 should remember that the bad-faith provision of the statute prevents them from converting with impunity. Bad-faith conversions typically result when “the debtor has been repeatedly dishonest and has manipulated the system unfairly.”[52] However, debtors who convert because they are unable to complete a Chapter 13 plan will not likely be found to have converted in bad faith.[53]
Francis Weber
Temple University School of Law, J.D. Candidate 2014
[1] 11 U.S.C. § 348(f) (2012).
[2] 699 F.3d 305 (3d Cir. 2012).
[3] Id. at 306–07.
[4] Id. at 316.
[5] Id. at 319 (Roth, J., dissenting)
[6] Id. at 307 (majority opinion).
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] Id.
[14] Id.
[15] Id.
[16] Id.
[17] Consumer debtors may file under Chapter 11, but that avenue is typically used by businesses. See 2 Collier on Bankruptcy ¶ 109.05 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2012) (noting that while Chapter 11 is intended for commercial businesses, the plain language of the Code permits individual debtors to reorganize under Chapter 11).
[18] 8 id. ¶ 1322.01.
[19] 11 U.S.C. § 1306(a) (2012).
[20] Id. § 1326(c).
[21] 6 Collier on Bankruptcy, supra note 17,¶ 700.01; see also 11 U.S.C. § 541(a)(1) (providing that the bankruptcy estate consists of all “legal and equitable interests of the debtor as of the commencement of the case”) (emphasis added).
[22] 11 U.S.C. § 1306(a).
[23] 11 U.S.C. § 1307(a).
[24] E.g., In re Boggs, 137 B.R. 408, 411 (Bankr. W.D. Wash. 1992).
[25] E.g., Waugh v. Saldamarco(In re Waugh), 82 B.R. 394, 400 (Bankr. W.D. Pa. 1988).
[26] E.g., Calder v. Job (In re Calder), 973 F.2d 862, 865–66 (10th Cir. 1992); Matter of Lybrook, 951 F.2d 136, 138 (7th Cir. 1991); Armstrong v. Lindberg (In re Lindberg), 735 F.2d 1087, 1089–90 (8th Cir. 1984).
[27] 11 U.S.C. § 348(f)(1)(A) (emphasis added).
[28] Id. § 348(a)
[29] Id. § 348(f)(2) (emphasis added).
[30] In re Michael, 699 F.3d 305, 309–15 (3d Cir. 2012).
[31] In re Michael, 699 F.3d at 314–15 (citing H.R. Rep. No. 103-835, at 57 (1994), reprinted in 1994 U.S.C.C.A.N. 3340, 3366).
[32] In support of this policy, Congress noted that § 348(f) should reflect the reasoning of an earlier Third Circuit case, Bobroff v. Cont’l Bank (In re Bobroff), 766 F.2d 797, 803 (3d Cir. 1985). H.R. Rep. No. 103-835, at 57. In In re Bobroff, the court excluded a debtor’s post-petition tort claim from property of the converted Chapter 7 estate because “[i]f 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 . . . a try will be greatly diminished.” 766 F.2d at 803.
[33] Id. at 315.
[34] Id.
[35] Id. (quoting H.R. Rep. No. 103-835, at 57).
[36] Id. at 309–14.
[37] 11 U.S.C. § 1326(a)(2), (c) (2012).
[38] 699 F.3d at 313.
[39] Id. at 314.
[40] Id. at 319–321 (Roth, J., dissenting).
[41] These benefits include “saving a residence from foreclosure, curing a mortgage delinquency over time with more affordable payments, maintaining possession over an automobile or other personal property, or having the benefit of the automatic bankruptcy stay remain in place for an extended period of time.” Id. at 320 n.7.
[42] 11 U.S.C. § 1325(a)(5), 1322(a)(2) (2012).
[43] Id. § (a)(4).
[44] In re Michael, 699 F.3d at 312 (quoting In re Boggs, 137 B.R. 408, 410 (Bankr. W.D. Wash. 1992)).
[45] That is, the “best” time for a debtor to convert is immediately after he makes a payment to the Trustee but before the Trustee can distribute the funds in accordance with the plan.
[46] In re Michael, 699 F.3d at 316–17.
[47] Id. at 317 n.9.
[48] Id.
[49] Id.
[50] Id.
[51] Id. (quoting 11 U.S.C. § 348(f)(1)).
[52] 3 Collier, supra note 17, at ¶ 348.07; see, e.g., Mullican v. Moser (In re Mullican), 417 B.R. 408, 414–15 (E.D. Tex. 2009) (finding that debtor who converted after inheriting a significant amount of post-petition property did so in bad faith because his sole purpose was to avoid distributing this post-petition property to his unsecured creditors).
[53] 3 Collier, supra note 17, at ¶ 348.07.