Pay Me, Maybe? Creditors’ Superior Claim to Undistributed Funds After a Conversion from Chapter 13 to Chapter 7

By:  Rosa Aliberti

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, the Fifth Circuit held, in Viegelahn v. Harris (In re Harris),[i] that any funds held by a chapter 13 trustee at the time of conversion to chapter 7 should be distributed to creditors in accordance with the chapter 13 payment plan.[ii] In In re Harris, the debtor filed for bankruptcy under chapter 13 of the Bankruptcy Code.[iii] The chapter 13 plan required the debtor to make monthly payments to a trustee for distribution to secured creditors and unsecured creditors.[iv] The debtor also was required to make monthly mortgage payments directly to Chase, his mortgage lender. After failing to do so, the bank foreclosed on his home.[v] The debtor did not modify the plan and continued making the required monthly payments to the trustee for approximately a year before converting his case to chapter 7.[vi] Since Chase no longer had a claim against the debtor, the funds that were allocated for Chase under the plan began to accumulate.[vii] After the debtor converted to chapter 7, the chapter 13 trustee distributed the funds in her possession to pay the debtor’s attorneys’ fees, the remaining secured creditor, the six unsecured creditors, and her commission.[viii] The debtor moved to compel the chapter 13 trustee to return those funds, arguing that the trustee was not authorized to distribute the funds once he converted the case to chapter 7.[ix] The bankruptcy court ordered the chapter 13 trustee to return the funds to the debtor,[x] and on appeal, the district court affirmed.[xi] The trustee appealed again, and the Fifth Circuit reversed,[xii] concluding that the creditors’ claim to the undistributed funds was greater than that of the debtor.[xiii]

While lower courts across the country have split on the issue before the Harris court, prior to the Fifth Circuit’s decision, “only one appellate court has squarely answered it.”[xiv] Specifically, in In re Michael, the Third Circuit held that undistributed funds held by a chapter 13 trustee at the time a case is converted from chapter 13 to chapter 7 must be returned to the debtor absent bad faith.[xv] Relying on section 1327(b) of the Bankruptcy Code, the Michael court noted that under a confirmed plan all of the property of a chapter 13 estate vests in the debtor “until the trustee affirmatively transfers the funds to creditors.”[xvi] Additionally, the Michael court determined that since, at conversion, the effective date of the chapter 7 petition is the same date that the chapter 13 petition was filed, interest in post-petition property acquired by the debtor remains vested in the debtor and does not become part of the chapter 7 estate.[xvii] The Michael court also reasoned that such a holding narrowly construed a chapter 13 trustee’s post-conversion duties, and holding otherwise would “dissuade debtors from filing under Chapter 13” in contravention of the policy of “[e]ncouraging them to attempt to repay their debts through a reorganization plan rather than liquidate.”[xviii] On the other hand, some lower courts have held that upon conversion to the chapter 7, a chapter 13 trustee has a duty to “wind up” the chapter 13 estate, which includes distributing the funds in her possession to creditors in accordance with the confirmed chapter 13 payment plan.[xix] Further, these courts have held that the disbursement of these funds to creditors remains faithful to the legislative intention of section 348 while not discouraging individuals from filing under chapter 13.[xx]

Finding the Third Circuit’s reasoning unpersuasive and agreeing with the line of courts holding that funds should be distributed to creditors upon conversion, the Fifth Circuit created a circuit split. The Harris court acknowledged that while section 348(e) terminates a trustee at the time of conversion, the trustee continues to have duties after the conversion.[xxi] The Harris court also recognized that under sections 1306(b) and 1327(b) a debtor generally retains vested interest in the property of the estate, which includes post-petition wages, for a chapter 13 case.[xxii] However, the Fifth Circuit disagreed with the Third Circuit’s focus on section 1327(b), reasoning that the Michael court ignored the exception to that rule––specifically, the language which states “except as otherwise provided in the plan or the order confirming the plan.”[xxiii] Furthermore, the Harris court rejected the Michael court’s reasoning that because a debtor who converts in bad faith is not entitled to post-petition property under section 348(f)(2) the statute “logically requires that a debtor receive the property if he acts in good faith.”[xxiv] Rather, the Harris court noted that the funds held by the trustee signify only a portion of the debtor’s post-petition property, which would have to be returned if the debtor were to convert in bad faith, and thus, distributing the funds to creditors would be neither a disincentive for bad faith filings nor nullify the language of section 348(f)(2).[xxv] The Harris court ultimately relied on “equity and policy” in reaching its decision that a creditor has a superior claim to the undistributed funds than a debtor.[xxvi]

On a practical level, a debtor generally converts from chapter 13 to chapter 7 because it no longer makes economic sense to continue making payments under the chapter 13 plan, and it is unlikely that an attorney would advice a debtor to convert simply on the basis of reclaiming some funds paid under a chapter 13 payment plan. However, the practical implications of the Harris decision are important to chapter 13 trustees and debtors. A chapter 13 trustee should know which side of the split the court in his jurisdiction follows since it will determine whether post-conversion funds should be returned to the debtor or distributed to creditors. At the same time, a debtor should be cognizant of timing if he chooses to convert from chapter 13 to chapter 7. If a debtor wants to convert his case, there is no reason for him to continue making payments under the payment plan. Similarly, by converting his case earlier, a debtor may prevent the additional accumulation of funds with the trustee, which he might lose to creditors. Ultimately, whether a debtor gets any of the money that accumulated under a chapter 13 plan may come down to the luck of the draw.