Supreme Court Rules Debtor Entitled to Funds Remaining Upon Conversion of Chapter 13 Case

Acknowledging that the statutory language "does not say expressly" what should happen, the Supreme Court nevertheless ruled that undistributed funds held by the Chapter 13 trustee should be returned to the debtor following a conversion.   The Court described its result as "the most sensible reading of what Congress did provide."   Justice Ginsberg wrote the opinion for an unanimous Court.   Harris v. Viegelahn, No. 14-400 (5/18/15).

What Happened

Charles Harris, III began his trip to the Supreme Court when he filed a chapter 13 petition in San Antonio, Texas in February 2010.   He was trying to save his home after defaulting upon his mortgage.    However, by November 2010, the Court had lifted the stay to allow the lender to foreclose.   A year later, he converted his case to chapter 7.   At that time, the Chapter 13 Trustee had over $5,500 on hand.  Rather than returning these funds to the debtor or paying them to the Chapter 7 trustee, she paid them to debtor's counsel and the unsecured creditors.   The Debtor filed a motion for return of the funds.   The Bankruptcy Court granted this motion and the trustee appealed.   The Fifth Circuit reversed, finding that the Bankruptcy Court's order would allow the Debtor to receive a "windfall."    In re Harris, 757 F.3d 468 (5th Cir. 2014).   The Supreme Court granted cert to reconcile a conflict with the Third Circuit.

The Ruling

The Court noted that prior to 1994, there was a split of authority over whether the debtor's post-petition earnings vested in the chapter 7 estate upon conversion.    This problem was solved when section 348(f) was added to the Code.   It provides that absent bad faith, property of the chapter 7 estate following conversion from chapter 13 consists of property which was originally part of the chapter 13 estate which remained "in the possession . . . or control" of the debtor on the date of conversion.  Thus, the funds held by the chapter 13 trustee would not become property of the chapter 7 estate.   

However, this did not answer the question of what the chapter 13 trustee could do with the funds upon conversion.   The court noted that under section 348(e), the chapter 13 trustee's "services" are terminated upon conversion.   The Court concluded that paying money to creditors was one of the "services" provided by the trustee and therefore something that could not be done after conversion.   The Court also concluded that paying money to creditors was not part of the trustee's duty to "wind up" the chapter 13 estate and that a chapter 13 plan did not vest funds in creditors until they were paid out.

The Court rejected the policy arguments that were relied upon by the Fifth Circuit.  It was not a "windfall" for the debtor to receive the undistributed funds for the reason that those funds would have belonged to the debtor if he had initially filed under chapter 7.    The Supreme Court agreed that it was a fortuity that some trustees had lots of money on hand when a case converted and others didn't.   However, the Court suggested that creditors "seek() to include in a Chapter 13 plan a schedule for regular disbursement of funds the trustee collects."   Opinion, p. 11.  The fact that creditors could protect themselves showed that the Court did not need to bend the statute to arrive at a reasonable result.

What Does It Mean?

In this case, the Supreme Court followed the text and structure of the statute rather than relying on easily manipulated policy arguments like the Fifth Circuit did.    The Supreme Court showed that it was willing to look at how the Bankruptcy Code functions to resolve a question that was not completely obvious.   While no statute expressly said that the debtor gets to keep funds in the hands of the chapter 13 trustee, the Court noted that other provisions, such as those revesting post-petition property in the debtor and terminating the services of the trustee, pointed to the correct answer.   This is a functional, pragmatic approach toward interpreting the law and will be useful to practicing lawyers.

The case will likely also encourage Chapter 13 trustees to seek authority to make interim distributions.   The ruling only applies to funds held by the Chapter 13 trustee on the date of conversion.   Had the Trustee received permission for interim distributions, there would have been a much smaller amount on hand and the Trustee would have received commissions on the funds which were distributed.   As the Court pointed out, there is nothing wrong with encouraging Trustees to make distributions early and often.    

Because Trustees will likely modify their procedures to address the ruling, the practical effect of the opinion will likely be minimal.   However, any time that the Supreme Court interprets the Bankruptcy Code, it provides valuable guidance as to how they might rule in other cases.    That will be the lasting impact of this case beyond the relatively small sum that Trustee Viegelahn will be required to pay.

Note:  The Bankruptcy Court order was entered by then-Bankruptcy Judge Leif M. Clark.   Over the years, Judge Clark has been a fertile source of material for this blog.   Congratulations to Judge Clark on being affirmed by the Supreme Court.    Congratulations also to local attorney Steven Cenammo who filed the motion which set this in motion.