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Property of the EstateTo Be or Not to Be That Is the Question the Trustee Asks of Thee Part I

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Editor's Note: This article was featured in the April 2002 South Texas College of Law (Houston) Continuing Legal Education conference materials.

The U.S. Bankruptcy Code basically provides two alternative types of relief for individual debtors: (1) liquidation under chapter 7, or (2) reorganization under chapter 13. See 11 U.S.C. §§701-784; 11 U.S.C. §§1301-1330. In that connection, if a chapter 7 case is filed, "property of the estate" is defined by §541(a)(1) to generally include "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. §541(a)(1). Likewise, §541(a)(7) includes within the definition of "property of the estate" any interest in property that the estate acquires after the commencement of the case. 11 U.S.C. §541(a)(7).

On the other hand, if a chapter 13 case is filed, the definition of "property of the estate" is not so rigidly demarcated between pre- and post-petition property. Rather, it is broadened to include not only the property brought into the estate via §541, but also all legal or equitable interests of the debtor in property, including earnings from services performed by the debtor, that the debtor acquires after the commencement of the case but before the case is closed, dismissed or converted to a case under chapter 7, 11 or 12, whichever occurs first. 11 U.S.C. §1306(a)(1) and (a)(2).

However, although seemingly clear from the above-referenced statutes, defining "property of the estate" can—and has—become both complicated and controversial when other statutes and rules come into play during the course of an estate's administration. For example, it is unclear how property of the estate is defined in a chapter 13 upon confirmation of the plan. Specifically, §§1306 (property of the estate) and 1327(b) (effect of confirmation upon property of the estate) appear to be in conflict and irreconcilable. Likewise, despite the revisions to §348 of the Code by the 1994 Bankruptcy Reform Act, what constitutes property of the chapter 7 estate upon conversion from a chapter 13 remains a perplexing puzzle in some instances. Thus, as is discussed in this article, the administration of the chapter 7 and/or chapter 13 estate is severely impacted by certain ambiguities in the statutes and rules that purportedly define "property of the estate" and the courts' nebulous interpretations of those statutes and rules.

Property of the Estate Upon Conversion from Chapter 13 to 7

Pre-1994 §348 of the Code: The Lybrook vs. Bobroff Approach to Property of the Estate Upon Conversion

Prior to the 1994 Bankruptcy Reform Act amendments, §348(a) (effect of conversion) was the only purported guidance available to the bankruptcy practitioner in defining "property of the estate" upon conversion. Specifically, §348 of the Code simply provided—and still provides—that conversion does not effect a change in the date of the filing of the petition, commencement of the case or order for relief. 11 U.S.C. §348(a). Unfortunately, while this provision deems the converted case to be filed on the date of the original petition, it does not provide any guidance as to what property is included or excluded from "property of the estate" upon conversion from chapter 13 to chapter 7.1 Rather, §348(a) begs two questions: (1) as of what point in time is the determination of "property of the estate" to be made, and (2) what definition of "property of the estate" is to be used?

In this connection, the courts that addressed these questions formulated two diametrically opposed approaches: the Lybrook approach and the Bobroff approach. These approaches were as follows:

1. The Lybrook Approach. The Lybrook approach was based on the opinion in In re Lybrook, 951 F.2d 136 (7th Cir. 1991), holding that any property acquired after a chapter 13 filing became property of the bankruptcy estate and, upon conversion to chapter 7, remained in the chapter 7 estate. In Lybrook, the court reasoned that if debtors could exclude from the bankruptcy estate any property acquired between the original chapter 13 filing and the chapter 7 conversion, they would be tempted to engage in "strategic, opportunistic behavior that hurts creditors..." Id. at 137. In essence, the Seventh Circuit feared encouraging debtors to abuse the bankruptcy process by filing under chapter 13 to delay the point when their assets could be seized (after conversion to chapter 7), while hoping for a windfall inheritance or lottery winnings that they would then not have to share with creditors. Farmer v. Taco Bell Corp., 242 B.R. 435, 437-438 (W.D. Tenn. 1999).

2. The Bobroff Approach. The Bobroff approach was based upon the opinion in In re Bobroff, 766 F.2d 797 (3rd Cir. 1985), holding that property that was acquired after the chapter 13 filing, but before conversion to chapter 7, was not part of the chapter 7 bankruptcy estate. In Bobroff, the court found this result to be consonant with the Code's goal of encouraging the use of debt repayment plans rather than liquidation. If such repayment plans were not successful, the court reasoned that the debtor's creditors should be put back precisely in the same position as they would have been had the debtor never sought to pay his debts. Id. at 803.

The 1994 Bankruptcy Reform Act Amendment to §348 of the Code

1. Section 348(f)(1). In 1994, by virtue of the Bankruptcy Reform Act, Congress seemingly sought to address the conflict between the Lybrook and Bobroff approaches by amending the Code to include §348(f)(1). Specifically, §348(f)(1) provides:

(f)(1) Except as provided in paragraph (2), when a case under chapter 13 of this title is converted to a case under another chapter under this title—
(A) property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion; and
(B) valuations of property and of allowed secured claims in the chapter 13 case shall apply in the converted case, with allowed secured claims reduced to the extent that they have been paid in accordance with the chapter 13 plan.
11 U.S.C. §348(f)(1).

In amending §348 and providing for subsection (f)(1), Congress specifically decided to reject the Lybrook approach in favor of the Bobroff approach. In fact, the legislative comment to §348(f) states:

This amendment would clarify the Code to resolve a split in the...law about what property is in the bankruptcy estate when a debtor converts from chapter 13 to chapter 7. The problem arises because in chapter 13...any property acquired after the petition becomes property of the estate, at least until confirmation of a plan. Some courts have held that if the case is converted, all of this after-acquired property becomes part of the estate in the converted chapter 7 case, even though the statutory provisions making it property of the estate do not apply to chapter 7. Other courts have held that the property of the estate in a converted case is the property the debtor had when the original chapter 13 petition was filed... This amendment overrules the holding in cases such as Matter of Lybrook, 951 F.2d 136 (7th Cir. 1991) and adopts the reasoning of In re Bobroff, 766 F.2d 797 (3rd Cir. 1985).

See H.R. REP. 103-834, 103rd Cong. 2nd Sess. 42-43 (Oct. 4, 1994), U.S. CODE CONG. & ADMIN. NEWS 1994, p. 3323; 140 CONG. REC. H10752-01, H10770-H10771 (1994). The provisions of the amendment were not made retroactive and do not apply to cases filed prior to Oct. 22, 1994. See In re Sargente, 202 B.R. 1023, 1025 (Bankr. S.D. Fla. 1996) (citing Pub. L. 103-394, §702, 108 Stat. 4106, 4150). By adopting Bobroff, Congress intended to avoid penalizing debtors for their chapter 13 efforts by placing them in the same economic position they would have occupied if they had filed chapter 7 originally. See Wyss, Trustee v. Fobber (In re Fobber), 256 B.R. 268, 277-278 (Bankr. E.D. Tenn. 2000).

In this connection, nothing in the language of the statute or its legislative history indicates a congressional intent to limit §348(f) to chapter 13 pre-confirmation conversions. Farmers, 242 B.R. at 440; see, also, In re Wiczek-Spaulding, 223 B.R. 538 (Bankr. D. Colo. 1998) (involved post-confirmation conversion and court still applied §348(f)(1)(A)). Likewise, §348(f)(1) is not limited to cases commenced as chapter 13, but applies whenever a case is converted from chapter 13 to another chapter regardless of the case's original status. See generally, Fobber, 256 B.R. at 268 et seq.

Notwithstanding the enactment of §348(f), one could argue that it remains unclear as to which definition of "property of the estate" applies in a converted case. Specifically, there is no express limitation on the language "property of the estate" to assure that the §1306 definition will not be applicable upon conversion to chapter 7. See In re Pegues, 266 B.R. 328, 331 (Bankr. D. Md. 2001); Wheeler, David B., "Conversion from Chapter 13 to 7—A Review of the Recent Amendments to §348," 14 Am. Bankr. Inst. J. 16, 26 (1995). However, since the enactment of §348(f), most courts have determined that revised §348 only makes sense if the definition of "property of the estate" set forth in §541(a) is applied. Pegues, 266 B.R. at 331. This reasoning is supported by §103(i) of the Code, which renders §1306 inapplicable to the definition of "property of the estate" by conversion of the case. 11 U.S.C. §103(i).

Additionally, the 1994 amendments to §348 did not specifically address the disposition of funds paid to a chapter 13 trustee pursuant to a confirmed plan, but not yet disbursed at the time of conversion to chapter 7. However, most courts have held that such monies are not property of the chapter 7 estate. Pegues, 266 B.R. at 332 (where the monies remaining in the chapter 13 trustee's hands are derived from post-petition wage withholding payments, pursuant to §348(f) and applying the definition of §541(a), such monies are not property of the chapter 7 bankruptcy estate.) This majority opinion leads to the question of whether the return of the funds to the debtor is equitable since it may create an "unfair windfall" in favor of the debtor. Id. In this connection, a majority of courts have determined that, after confirmation of a plan and conversion of a case to chapter 7, the monies held by the chapter 13 trustee at the time of conversion should be disbursed by the chapter 13 trustee to the estate's creditors consistent with the confirmed plan. Id. at 333; see, also, In re Bell, 248 B.R. 236 (Bankr. W.D.N.Y. 2000).

However, it is important to note that the foregoing principles do not apply to undisbursed funds held by the chapter 13 trustee at the time of conversion that are proceeds of pre-petition assets that would be property of the chapter 7 estate pursuant to §§348(f) and 541(a). Thus, if, before distribution by the chapter 13 trustee, a chapter 7 trustee or other party with standing alleges and proves that monies held by the chapter 13 trustee are proceeds of such pre-petition property, such funds may be required to be turned over to the chapter 7 trustee. Pegues, 266 B.R. at 336, n. 16; see, also, Fobber (256 B.R. at 277-278) (holding that proceeds of a sale that took place while in chapter 13 of an asset owned by the debtors at the commencement of the bankruptcy case are property of the estate in the re-converted chapter 7 case).

Notwithstanding the foregoing, what happens when the debtor uses §348(f)(1) as a safe harbor to fraudulently and surreptitiously dispose of property of the estate while in chapter 13? Interestingly, there is one case worth mentioning that, while the court did not have to apply §348(f)(1), addressed in dicta the shortcomings of §348(f)(1) in dealing with devious debtors. See Fobber, 256 B.R. at 268 et seq. In Fobber, the debtors originally filed chapter 7, then converted to chapter 13 and subsequently reconverted to chapter 7. The chapter 7 trustee filed an adversary complaint seeking revocation of the debtors' discharge for their alleged undisclosed sale of unencumbered estate property, i.e., a 1993 Kenworth tractor sold for $35,000 while in chapter 13. Id. at 270. In response, the debtors filed an answer along with a motion to dismiss or, in the alternative, a motion for summary judgment asserting that the complaint failed to state a claim because there were no allegations that the debtors acquired property of the estate or that the acquisition was concealed. Alternatively, the debtors sought summary judgment alleging that the tractor they sold while in chapter 13 was not an asset of the chapter 7 bankruptcy estate under 11 U.S.C. §348(f) and that they had not acquired property of the estate because they distributed all of the proceeds from that sale to their creditors. Id. at 271.

Specifically, the debtors argued that because the tractor was sold and the proceeds entirely distributed during the chapter 13 so that neither the tractor nor the proceeds were in the debtors' possession at the time their case was reconverted to chapter 7, neither the tractor nor its proceeds were property of the chapter 7 estate. Id. at 276. Therefore, the debtors argued that the chapter 7 trustee had no claim to those assets, and thus, no standing to challenge the debtors' discharge based on the disposition of those assets during the chapter 13 phase of their case. The court found that the property acquired by the debtors during the chapter 13 became property of the estate, not because of the chapter 13 and its expanded definition of property of the estate, but because it was proceeds of property held by the debtors at the bankruptcy case's commencement covered by §541(a)(6), i.e., the facts were different from those under other cases where §348(f) was applied. In its analysis, however, the court found that literal application of §348(f)(1)(A) to the facts of the case would lead to an absurdity. Id. at 276. Specifically, the court noted that if the debtors' position were correct, i.e., despite their actions the chapter 7 trustee had no standing, then §348(f) would give the debtors carte blanche to commit fraud, i.e., a chapter 7 debtor who decides that he does not want to surrender to the trustee an asset that is property of the estate can convert to chapter 13 long enough to dispose of the asset, and then reconvert to chapter 7 and obtain a discharge with impunity. Id. In this connection, the court stated:

Furthermore, application of §348(f) to the present case will not result in placing the debtors in the same financial position they would have been [in] if the case had never been in chapter 13. To the contrary, it will result in the debtors improving their position over what it would have been if they had stayed in chapter 7...
...In light of §348(f)'s purpose as stated in its legislative history, it is unclear to this court why Congress, in enacting that provision, limited property of the estate in the converted case to property which "remains" in the possession or under the control of the debtor on the date of conversion. To be consistent with Bobroff, it would have been more logical for §348(f) to define property in the converted case as simply "property of the estate as of the date of filing of the petition"...
...Regardless of the purpose of the language, this court is convinced that §348(f) was never designed to be a safe harbor for debtors who fraudulently and surreptitiously dispose of property of the estate while in chapter 13. As such, this court holds that §348(f) is inapplicable to the facts of the present case. In other words, notwithstanding §348(f), a chapter 7 trustee in a case originally filed under chapter 7, converted to chapter 13, and then reconverted to chapter 7, may seek to revoke the discharge of a debtor who in the chapter 13 phase of the case disposed of property which was property of the estate in the original chapter 7. [FN6] To hold otherwise would lead to an absurdity and would not further the legislative intent of §348(f). See Vergos v. Gregg's Enterprises Inc., 159 F.3d 989, 990 (6th Cir. 1998) ("The court must look beyond the language of the statute...when the text is ambiguous or when, although the statute is facially clear, a literal interpretation would lead to internal inconsistencies, an absurd result, or an interpretation inconsistent with the intent of Congress.")
[FN6]. It would appear that §348(f) would thwart any attempt by a chapter 7 trustee to challenge a debtor's fraudulent disposition of property which came into the estate solely because of the expansive definition of property of the estate provided by §1306(a), although the court has located no case which has considered this issue. In Baker v. Rank (Matter of Baker), 154 F.3d 534 (5th Cir. 1998), a case commenced prior to the effective date of §348(f), a creditor successfully objected to the debtors' discharge pursuant to 11 U.S.C. §727(a)(2) because prior to the conversion of the case from chapter 13, the debtors used post-petition earnings for a Far East vacation. Similarly, it would appear that §348(f) would bar a chapter 7 trustee from objecting to or seeking to revoke a debtor's discharge based on the debtor's fraudulent disposition during the chapter 13 phase of the bankruptcy case of property held by the debtor at the commencement of the case. And a chapter 7 trustee's ability to avoid unauthorized post-petition transfers under 11 U.S.C. §549 which occurred prior to a case's conversion from chapter 13 would also be questionable.... This court is not convinced that either was the intended effect of §348(f).

Id. (emphasis added).

2. Section 348(f)(2). Unfortunately, as feared by the Fobber court, assets that may have been disposed of since the filing do not come into the estate upon conversion. In re Zamora, 2002 WL 334878, *3 (Bankr. W.D. Tex. Jan. 3, 2002). However, although after-acquired property usually belongs to the debtor under §348(f)(1), if the conversion was made in bad faith, application of the "bad faith exception" under §348(f)(2) is triggered. See In re Siegfried, 219 B.R. 581 (Bankr. D. Colo. 1998). Specifically, §348(f)(2) provides as follows:

(2) If the debtor converts a case under chapter 13 of this title to a case under another chapter under this title in bad faith, the property in the converted case shall consist of the property of the estate as of the date of conversion.
11 U.S.C. §348(f)(2). Thus, with a bad-faith conversion, the chapter 7 estate will include property in possession of the chapter 13 trustee as well as property acquired by the debtor during the chapter 13 case. In re Siegfried, 219 B.R. 581 (Bankr. D. Colo. 1998); see, also, In re Messer, 2000 WL 33673748 (Bankr. M.D.N.C. 2000) (not reported in B.R.). The legislative history states that the amendment
...also gives the court discretion, in a case in which the debtor has abused the right to convert and converted in bad faith, to order that all property held at the time of conversion shall constitute property of the estate in the converted case.
140 Cong. Rec. H. 10,770 (Oct. 4, 1994). Thus, under §348(f)(2), Congress appears to have adopted Lybrook in the event of a bad faith conversion. Messer, 2000 WL 33673748, *3, n.2 (also citing Baker v. Rank (Matter of Baker), 154 F.3d 534 at 536 n.2 (5th Cir. 1998).2

Unfortunately, the Code does not define what constitutes "bad faith" for purposes of §348(f)(2). Therefore, courts usually apply "broad standards and general definitions of bad faith to specific facts of the case to determine if there is fraud, deception, dishonesty, lack of disclosure of financial acts or an abuse of the provisions, purpose or spirit of the Bankruptcy Code." Baker, 154 F.3d at 585. For example, in Messer, the chapter 13 debtor was paying under a confirmed plan when his mother died, leaving real estate to him that was sold for $39,207.97. Those proceeds were turned over to the chapter 13 trustee. Messer, 2000 WL 33673748 at *1. After the chapter 13 trustee filed and noticed out a motion recommending that the plan be modified to pay all filed, allowed claims in full and the balance of the monies be remitted to the debtor, a creditor that elected not to come forward and file a proof of claim ultimately filed a proof of claim to which the debtor objected as untimely. The court disallowed the claim, and the creditor appealed. Id. at *1-2. During the appeal, the debtor converted the case to chapter 7. At that time, the chapter 13 trustee still retained funds sufficient to pay all allowed claims. Initially, the debtor made no claim that the monies held by the chapter 13 trustee should be remitted to him as they were not part of the chapter 7 estate. Then, three months after conversion, the debtor asserted that the inheritance was not property of the estate and should be turned over to him. The chapter 13 trustee successfully sought an order to disburse the funds to the chapter 7 trustee. Id. at *1-2, 4. The court, relying on Siegfried, determined that:

...the debtor acted in bad faith and that the conversion to chapter 7 was an "unfair manipulation of the bankruptcy system to the substantial detriment or disadvantage of creditors." (citation and footnote omitted). It is deceptive, abusive and manipulative for the Debtor to wait until his discharge has been entered to change his position and now demand that the funds held for the payment of his creditors be remitted to him such that the debtor would receive $39,000, and the creditors would only receive a diminimus dividend in the chapter 13 with no dividend in the chapter 7.
Id. at *4. Thus, if bad faith is involved, the statute may still be silent about the procedure, but a prudent chapter 7 trustee should bring a "timely motion" to obtain a determination of bad faith, and presumably "timely" would mean some time before the chapter 13 trustee disburses funds on hand to the debtor. Zamora, 2002 WL 334878 at *1, n.3.

Thus, while the 1994 Bankruptcy Reform Act limits property of the chapter 7 estate in a conversion from chapter 13 to the property of the debtor that existed as of the commencement of the chapter 13 case and still in the possession or control of the debtor pursuant to §348(f)(1)(A), if bad faith is found, property of the chapter 7 estate is determined as of the conversion date pursuant to §348(f)(2). Therefore, what constitutes property of the estate upon confirmation of the plan can be very important to a chapter 7 trustee or a debtor's creditors in a situation where the case is converted post-confirmation.

Property of the Estate in Chapter 13 after Confirmation of the Plan

The Dilemma and Resulting Controversy Between §1306(a) and §1327(b)

In a chapter 13 case, there are three types of property: (1) property owned by the debtor before filing, (2) property acquired by the debtor before confirmation of a plan and (3) property acquired by the debtor after confirmation of a plan. Section 1306 of the Code seems to indicate that property of the estate includes all of the debtor's property acquired after commencement of the case but before the case is closed, dismissed or converted. 11 U.S.C. §1306(a). Section 1327(b), on the other hand, states that unless otherwise provided under the plan, the confirmation of the plan vests all of the property of the estate in the debtor. 11 U.S.C. §1327(b). Thus, the dilemma is that the "vesting" of property of the estate in a debtor upon confirmation contravenes having post-petition, post-confirmation assets included in the property of the estate until the case is closed, dismissed or converted. In this connection, §§1306(a) and 1327(b) are difficult to reconcile and pose problems for both pre- and post-petition creditors with respect to the automatic stay.

Ordinarily, what constitutes property of the estate after confirmation will not generally concern the pre-petition creditors because they are bound by the terms of the confirmed plan and cannot take any action against the debtor pursuant to the automatic stay and §1327. 11 U.S.C. §362; 11 U.S.C. §1327(a). However, a pre-petition creditor can be prejudiced if there is no estate post-confirmation, or post-confirmation earnings are not protected by the automatic stay because then there is no protection by §362 against

Journal Date: 
Sunday, December 1, 2002

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