Circuit Split on Undistributed Funds at Time of Conversion

Posted by NCBRC - July 8, 2014

Relying on policy and equity considerations, the Fifth Circuit found that funds paid into a plan but not yet distributed at the time of conversion should be distributed to creditors. Viegelahn v. Harris (In re Harris), No. 13-50374 (5th Cir. July 7, 2014) (disagreeing with In re Michael, 699 F.3d 305 (3d Cir. 2012)). After the debtor defaulted on his direct mortgage payments, the trustee began to set aside the plan payments that had been earmarked for arrears on that mortgage. At the time of conversion, the trustee held over $5,500 in these funds. The bankruptcy court granted the debtor’s motion to compel return of the funds and the district court affirmed.

The Fifth Circuit reversed and remanded.

The court began its analysis with a walk through the statutory landscape beginning with section 348(f). That provision resolved a prior disagreement among the courts by specifying that upon conversion, the new chapter 7 estate is made up of property that the debtor had at the time of the original chapter 13 petition (unless the conversion is in bad faith). The philosophy being that this rule would alleviate an inherent disincentive to file chapter 13 arising if post-petition property could be lassoed into the converted chapter 7. Based on section 348(f), therefore, the court acknowledged that funds held by the trustee at the time of conversion did not become part of the chapter 7 estate.

The court rejected the debtor’s argument, however, that under section 348(e), which terminates the service of the chapter 13 trustee upon conversion, the trustee loses her power to make distributions according to the now-defunct plan. The court found instead that funds still in the trustee’s control had to be released somewhere, either to the creditors or to the debtor, and so to say that the trustee was powerless to take any action was an over-reading of the statute. The question, therefore, was not whether the trustee retained the power to dispose of funds, but to whom those funds must be delivered.

The court also disagreed with its sister court in Michael where the Third Circuit found that, under sections 1306(b) and 1327(b), until the trustee actually distributes the funds in accordance with the unconverted chapter 13 plan, the debtor retains a vested interest in them. The Harris court found that that holding ignored the limiting language of those provisions: “except as provided in a confirmed plan.”

The court rejected the debtor’s argument that permitting the trustee to distribute the funds to creditors would render section 348(f)(2) meaningless. Rather, the court found that that section, which establishes that in the event of bad faith conversion the chapter 7 estate consists of all property as of the date of conversion, would still impact property that could not otherwise be touched under the court’s ruling.

After rejecting the debtor’s statutorily-based arguments, the court likewise rejected those of the trustee. Specifically, the court rejected the trustee’s contention that the creditors had a vested right to funds paid into the plan under section 1326(a)(2). The court found that that section merely directs the trustee’s responsibilities and says nothing about creditor rights.

Having thus concluded that statutory directives were insufficient to resolve the issue, the court turned to policy considerations. The court began by rejecting the “disincentive” argument that other courts had found persuasive. It found that, as a practical matter, the debtor pays into the chapter 13 plan according to his own agreement and has no expectation that funds will not be distributed immediately. Therefore, the deterrence factor that would apply if all post-petition property acquired prior to conversion became part of the chapter 7 estate, would not apply to the funds at issue here.

Finally, the court reasoned that fairness dictated its decision. During the pendency of the chapter 13 plan the debtor received the benefit of the use of his home and vehicle which would otherwise have been lost. His payments during the plan were merely quid pro quo. In so holding, the court distinguished In re Stamm, 222 F.3d 216 (5th Cir. 2000), in which funds collected pursuant to an unconfirmed plan were returned to the debtor upon conversion. The decision in Stamm was required by section 1326(a)(2) which applies only pre-confirmation.

Harris opinion 5th Cir.

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