When an individual contemplates filing for bankruptcy protection, he or she has a few options. One is to file a Chapter 7 case, and another is to file a Chapter 13 case. In a Chapter 7, all of a debtor’s non-exempt assets are transferred to a bankruptcy estate to be liquidated and distributed to creditors. In a Chapter 13, the debtor retains assets and makes payments to creditors according to a court-approved plan.

In Harris v. Viegelahn,[1] the U.S. Supreme Court weighed in on an issue of consumer bankruptcy law that had created a split among the courts of appeal. Specifically, the Court considered the effect of the conversion of a Chapter 13 case to Chapter 7 on a debtor’s postpetition wages held by the Chapter 13 trustee. Do the funds go to the debtor (the position of the Third Circuit Court of Appeals) or do they go to creditors (the Fifth Circuit position)?

BACKGROUND

The debtor, Charles Harris III, filed a Chapter 13 bankruptcy case in February 2010. Harris confirmed a payment plan that provided that a certain amount of his postpetition wages would be transferred to the Chapter 13 trustee, Mary Viegelahn. Those funds were to be used to pay Harris’ mortgage debt, first, and then another secured lender. Once those priority debts were paid in full, funds would be distributed to unsecured creditors.

After falling behind on his mortgage, Harris’ lender foreclosed on his home (after obtaining permission from the bankruptcy court). The trustee stopped making payments to the lender after foreclosure despite continuing to receive postpetition wages from Harris that had been earmarked for mortgage payments. In November 2011, Harris converted his case to Chapter 7. At the time of conversion, Viegelahn had accumulated more than $5,000 in Harris’ postpetition wages. Ten days after conversion, Viegelahn distributed those funds to the other secured lender and administrative and unsecured creditors.

Harris moved the bankruptcy court to direct the refund of the accumulated postpetition wages, asserting that the trustee lacked the authority to distribute the funds once the case was converted to Chapter 7. The bankruptcy court ruled in favor of Harris, the district court affirmed on appeal, and the Fifth Circuit reversed. The Fifth Circuit held that “considerations of policy and equity” dictated that the funds go to the creditors.

THE SUPREME COURT DECISION

The Court reversed the Fifth Circuit. Justice Ginsberg, writing for a unanimous Court, began by explaining the difference in treatment of a debtor’s postpetition wages in Chapter 7 versus Chapter 13. In a Chapter 7 case, a debtor’s postpetition wages are not part of the estate, whereas a Chapter 13 estate includes wages and property acquired after the filing.

The Court looked to section 348(f) of the Bankruptcy Code, which provides that: “[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.” The Court concluded that while section 348(f) is clear that postpetition wages are excluded from a Chapter 7 case resulting from a Chapter 13 conversion, what is not made clear by the statute is how to treat postpetition wages held by a Chapter 13 trustee as of the time of conversion.

The Court concluded that, while the Bankruptcy Code does not “expressly” direct that “[o]n conversion, accumulated wages go to the debtor,” that interpretation “is the most sensible reading of what Congress did provide.”[2] The Court further bolstered its conclusion by referencing provisions of the Bankruptcy Code terminating the services of a Chapter 13 trustee (except for specified tasks) upon conversion of a case to Chapter 7. Finally, the Court rejected the Fifth Circuit’s concern that such a ruling would result in a windfall for the debtor. Rather, the money being returned to the debtor was money that the debtor would have kept had he filed a Chapter 7 case in the first place.