Undisbursed Funds Returned to Debtor Upon Conversion

Posted by NCBRC - May 18, 2015

In a unanimous decision, the Supreme Court today found that funds paid into a confirmed chapter 13 plan that are undisbursed when the case is converted to chapter 7 should be returned to the debtor. Harris v. Viegelahn, 575 U.S. ___, No. 14-400 (May 18, 2015).

After Harris failed to maintain his mortgage payments in accordance with his chapter 13 plan, the mortgagee foreclosed and the trustee stopped distributing the funds earmarked for that debt. As a result, when Harris converted to chapter 7, the trustee held over $5,500 in accumulated but undistributed funds. Ten days after the conversion, the trustee used the funds to pay attorney and administrative fees and then distributed what was left to the remaining secured and unsecured creditors. The bankruptcy court ordered the trustee to refund the money to the debtor and the district court affirmed. The Fifth Circuit reversed, In re Harris, 757 F. 3d 468 (2014), creating a conflict with the Third Circuit case of In re Michael, 699 F. 3d 305 (2012).

The Supreme Court began its discussion with section 348(f) which provides that, upon conversion, the chapter 7 estate consists of the debtor’s property as of the original chapter 13 petition date unless the case is converted in bad faith. Where this section is intended to shield post-petition assets from chapter 7 creditors, permitting the trustee to distribute those funds via chapter 13 would be contrary to congressional intent. Permitting post-conversion distribution would also declaw section 348(f)(2) under which a debtor converting in bad faith loses the benefit of returning to the original petition date to establish the chapter 7 estate. The Court concluded: “In sum, §348(f) does not say, expressly: On conversion, accumulated wages go to the debtor. But that is the most sensible reading of what Congress did provide.”

Other considerations also supported this finding. Section 348(e) specifies that upon conversion, the services of the trustee are terminated. Where the primary service the trustee performs is making distributions to creditors, permitting the trustee to make such distributions post-conversion would be contrary to this section. Returning the funds to the debtor, on the other hand, is not among the “services” provided by the chapter 13 trustee.

Neither section 1327(a), which makes the confirmed plan binding on debtors and creditors, nor section 1326(a)(2), which mandates that the trustee make payments according to the confirmed plan, alters this conclusion. Once a debtor converts to chapter 7, those sections cease to apply and the trustee has no authority to distribute funds. Finding no basis in the Code to support it, the Court also rejected the argument that the creditors’ right to the funds “vested” once they were paid into the plan. Likewise, the trustee’s obligation to “wind up” the closed chapter 13 case does not include a requirement that she distribute funds. Federal Rules of Bankruptcy Procedure, Rule 1019, enumerates the trustee’s “wind up” duties and does not include distribution of remaining funds.

Finally, the Court rejected the trustee’s argument that the plan itself mandated that she distribute the funds. The unique language of the plan provided that upon confirmation the property remained property of the estate instead of vesting in the debtor as contemplated by section 1327(b). The Court found that property remaining in the estate does not become the creditors’ property until it is distributed to them. In fact, the plan itself provided that upon conversion, “[s]uch property as may revest in the debtor shall so revest.”

While the Court acknowledged that the debtor’s receipt of the money was dependent upon the happenstance that the trustee had not distributed it at the time of conversion, that factual scenario did not alter the legal analysis. The statutory construct shielding post-conversion funds and giving the debtor nearly unlimited right to convert leads to this result reached by the Court. Creditors can protect their interests by seeking a provision in the plan for frequent, regular, distributions. The Court added that it did not “regard as a ‘windfall’ a debtor’s receipt of a fraction of the wages he earned and would have kept had he filed under Chapter 7 in the first place.”

Harris v. Viegelahn opinion



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