“I get knocked down / But I get up again / You’re never gonna keep me down.”

 – Chumbawumba

Do you stay up at night wondering about the effect the conversion of a chapter 13 case to chapter 7 has on a debtor’s postpetition wages held by the chapter 13 trustee?  Well, neither do we.  But when the United States Supreme Court issues a decision involving interpretation of the Bankruptcy Code, we at the Bankruptcy Blog get very excited — even if it does not deal with an issue so relevant to our everyday practice.  And so we read with great interest yesterday’s Supreme Court decision in Harris v. Viegelahn.  And while the particular Bankruptcy Code sections most implicated by that case are not ones corporate restructuring attorneys generally grapple with, any insight into the Supreme Court’s statutory interpretation framework is always useful to our practice.  In addition, there are broader lessons to be learned from this one, including the old adage that “if at first you don’t succeed, try, try again.”  

When considering whether to file for bankruptcy, one of the first questions a potential debtor confronts is which chapter to seek relief under.  Let’s say, for example, the debtor is an individual faced with mounting debts.  The debtor has options, including filing a chapter 7 case and transferring its prepetition assets to a bankruptcy estate to be liquidated and distributed to creditors, or filing a chapter 13 case and retaining assets during the bankruptcy subject to a court-approved plan for payment of debts.  Further still, once a debtor chooses a chapter under which to file, its decision is not set in stone.  That is, under certain circumstances, the Bankruptcy Code permits a debtor to convert its case to a different chapter.  See, e.g., 11 U.S.C. §1307(a) (permitting a debtor to convert a case under chapter 13 to a case under chapter 7 at any time).  What happens, then, if a debtor opts to convert its case to a different chapter with different rules concerning the treatment of the debtor’s assets?  Do the statutory provisions governing the original chapter under which the debtor sought relief apply or do the rules governing the new, converted chapter apply?  This was the question the Supreme Court confronted in Harris v. Viegelahn, where the provisions of chapter 13 and chapter 7 intersected.  The Supreme Court was called upon to resolve a circuit split concerning the treatment of the postpetition wages of a debtor who converts its bankruptcy case from chapter 13 to chapter 7 when such wages had been turned over to the chapter 13 trustee, but not disbursed to creditors prior to conversion.  The Supreme Court held that such wages were not property of the estate.

The Facts

In Harris v. Viegelahn, Charles Harris III filed a chapter 13 bankruptcy petition in February 2010.  At the time of the filing, Harris was indebted to multiple creditors, including his home mortgage lender Chase Manhattan, a consumer electronics store, and multiple unsecured creditors.  During his chapter 13 case, Harris confirmed a payment plan which provided that a certain amount of Harris’ postpetition wages would be remitted to the chapter 13 trustee, Mary Viegelahn, who would distribute a portion of the wages to Chase to pay down Harris’ mortgage debt and the remaining portion to Harris’ other secured lender, the consumer electronics store.  Once those creditors were paid in full, Viegelahn was to begin distributing funds to Harris’ unsecured creditors.

Harris fell behind on his mortgage payments and in November 2010 Chase foreclosed on Harris’ home.  Following the foreclosure, Viegelahn ceased making payments earmarked for Chase, but continued to receive the portion of Harris’ postpetition wages that had been used to pay down the mortgage.  Accordingly, funds formerly reserved for Chase accumulated in Viegelahn’s possession.  In November 2011, Harris exercised his statutory right to convert his chapter 13 case to a case under chapter 7.  By that time, Viegelahn had accumulated postpetition wages amounting to $5,519.22.  Ten days after the conversion, Viegelahn distributed those funds to the consumer electronics store and to Harris’ unsecured creditors.

Harris moved the Bankruptcy Court for an order directing refund of the accumulated wages, arguing that Viegelahn lacked authority to disburse the funds to creditors once the case was converted to chapter 7.  The Bankruptcy Court granted Harris’ motion and the District Court affirmed.  The Fifth Circuit reversed, concluding that considerations of equity and policy rendered the creditors’ claim to the undistributed funds superior to that of the debtor.  The Fifth Circuit acknowledged that its decision conflicted with the Third Circuit’s decision in In re Michael, which held that a debtor’s undistributed postpetition wages are to be returned to the debtor at the time a case is converted from a chapter 13 to a chapter 7.

Postpetition Wages Upon Conversion (Generally)

The Supreme Court began its opinion by recognizing that the Bankruptcy Code provides diverse courses debtors may pursue to gain discharge of their financial obligations and obtain a “fresh start.”  In describing the differences between chapter 13 and chapter 7, the Court noted a crucial distinction.  While a chapter 7 estate does not include the wages a debtor earns or the assets the debtor acquires after the bankruptcy filing (enabling the debtor to obtain a fresh start by shielding from creditors the debtor’s postpetition earnings and acquisitions), a chapter 13 estate includes both the debtor’s property at the time of the filing and any wages and property acquired after the filing.  Compare 11 U.S.C. §541(a)(1)with 11 U.S.C. §1306(a).

The Court further recognized that the law on the treatment of postpetition wages following conversion of a case from chapter 13 to chapter 7 was clarified in the Bankruptcy Reform Act of 1994, which added section 348(f) to the Bankruptcy Code.  That section provides:  “[P]roperty of the [chapter 7] estate in the converted case shall consist of property of the estate, as of the date of filing of the [initial chapter 13] petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  11 U.S.C. §348(f)(1)(A).   The Court also noted the exception to the foregoing set forth in section 348(f)(2), which states:  “If the debtor converts a case [initially filed] under chapter 13 … in bad faith, the property of the estate in the converted case shall consist of the property of the estate as of the date of the conversion.”

Accordingly, the Court concluded that absent a bad faith conversion, section 348(f) clearly limits a converted chapter 7 estate to property belonging to the debtor ‘as of the date’ the original chapter 13 petition was filed.  And, the Supreme Court noted, “[p]ostpetition wages, by definition, do not fit that bill.”  Thus, the statute was clear that postpetition wages are excluded from the chapter 7 estate created by conversion.  However, what was left unanswered by the language of the statute – and the very question presented to the Court – was what becomes of postpetition wages held in the hands of the chapter 13 trustee at the time a case is converted.  Are they returned to the debtor or distributed to creditors?  As noted above, there was a circuit court split on the issue.

Postpetition Wages Upon Conversion (When Held by the Chapter 13 Trustee)

In answering the question at hand, the Court recognized that section 348(f) does not expressly state that, on conversion, accumulated wages go to the debtor.  However, the Court determined that requiring delivery of postpetition wages in the hands of a chapter 13 trustee to the debtor – and not to the debtor’s creditors – is the “most sensible” reading of what Congress actually did provide.  The Court explained that by excluding postpetition wages from the converted chapter 7 estate, section 348(f)(1)(A) removes those earnings from the pool of assets that may be liquidated and distributed to creditors.  Allowing a terminated chapter 13 trustee to disburse the very same earnings to the very same creditors, the Court reasoned, would be incompatible with the statutory design of section 384(f).  Where the statute precluded postpetition wages from the pool of assets comprising the chapter 7 estate, the Court refused to place the debtor’s wages in the creditors’ hands another way (i.e., through distribution by a chapter 13 trustee).

To support its conclusion, the Court again looked to section 348(f)(2)’s exception for bad faith conversions.  That section penalizes bad faith debtors by making their postpetition wages available for liquidation and distribution to creditors.  But, when the conversion is made in good faith, the Supreme Court highlighted that no penalty is exacted.  Shielding a chapter 7 debtor’s postpetition earnings from creditors, the Supreme Court continued, “enables the ‘honest but unfortunate debtor’ to make the ‘fresh start’ the Bankruptcy Code aims to facilitate.”

Finally, the Court considered section 348(e) of the Bankruptcy Code, which provides that “Conversion [from chapter 13 to chapter 7] terminates the service of [the chapter 13] trustee.”  A core service of the chapter 13 trustee is the disbursement of payments to creditors, but the moment the case is converted, the chapter 13 trustee is stripped of the authority to provide that service.  11 U.S.C. §348(e).  For these reasons, the Court reversed the judgment of the Fifth Circuit and remanded for further proceedings.

Lessons Learned

Although the status of Mr. Harris’ $5,519.22 has now been settled, the Supreme Court’s decision is instructive to practitioners and creditors alike for a number of reasons.  First, while the decision may provide little comfort to creditors of a chapter 13 debtor who no doubt will be weary of the debtor’s ability to convert its case to chapter 7, these creditors are not without protection.  As the Supreme Court recognized, creditors may gain protection against the risk of excess accumulations in the hands of chapter 13 trustees by seeking to include in a chapter 13 plan a schedule or regular disbursement of funds the trustee collects.  Accordingly, to gain the utmost protection against a good faith conversion by a debtor, it would behoove a creditor to pay close attention to a debtor’s proposed payment schedule and to demand that regular payments be made.

Second, and more interesting to us in a broader sense, the case highlights that, where no uniform guiding precedent exists, even the most brilliant legal minds can disagree about the correct way to interpret a statute.  Remember that while the Supreme Court issued a unanimous decision on the issue at hand, a unanimous three judge panel of the Fifth Circuit read the Bankruptcy Code to require a different outcome entirely.  This reinforces the notion that a ruling can turn on a judge’s individual statutory construction and analysis and should serve as a reminder to all practitioners, in the spirit of Chumbawumba, not to give up when facing a loss at the lower court level, as it is very possible that a higher court will reach the opposite conclusion when presented with the exact same legal issue.