Is it or is it not property of the estate? That is, perhaps, the most fundamental issue in bankruptcy law, and yet it is a question that even the most seasoned insolvency professionals can discuss at length and still not be entirely sure of their conclusion. Such is the situation when attempting to identify the bankruptcy estate when a case is converted from chapter 13 to chapter 7. With the ever-increasing number of consumer filings, converted cases are being encountered more frequently, and it is more important than ever that chapter 7 trustees be fully equipped to identify all of the assets that should be liquidated for the benefit of creditors. And, while informative articles have recently been published about §348(f),¹ there is still room for a more focused look at the practical impact of §348(f) and the ways trustees and the courts can insure that assets are properly preserved for the benefit of creditors.

The General Rule

By way of review, §348(f)(1)(A) states that "property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion...." Subsection (f)(1)(A) was added to §348 by the Bankruptcy Reform Act of 1994 to "clarify the Code to resolve a split in the law about what property is in the bankruptcy estate when a debtor converts from chapter 13 to chapter 7...by [overruling] the holding in cases such as Matter of Lybrook, 951 F.2d 136 (7th Cir. 1991) and [adopting] the reasoning of In re Bobroff, 766 F.2d 797 (3d Cir. 1985)."²

Essentially, the 1994 amendment made it clear that, as a general rule, property acquired by the debtor during the chapter 13 case is not property of the estate in the chapter 7 case. Therefore, the debtor's personal services earnings during the chapter 13, although property of the estate in the chapter 13 case,³ would not be property of the estate in the converted chapter 7 case because they would not have been property of the estate on the petition filing date.⁴ Likewise, other property acquired by the debtor during the chapter 13 case would not be property of the estate in the converted case.

Under this rule, determining whether property is property of the estate in the converted case initially involves a two-part analysis: (1) was it property of the estate as of the original petition date, and (2) was it in the debtor's possession or control as of the conversion date?

Property of the Estate

Property of the estate is broadly defined by §541(a) to include virtually all property interests of the debtor as of the petition date and even some interests acquired post-petition.⁵ The exceptions spelled out in §§541(b) and (c)(2) are narrow, generally well-defined and uniformly interpreted. The issue, therefore, is determining just how far §348(f)(1)(A) goes, if at all, in removing from the chapter 7 estate what otherwise would have been considered property of the estate had the case not been converted from chapter 13 but initially filed as a chapter 7.

For instance, §348(f)(1)(A) could be read to mean that only the categories of property existing on the petition filing date would be included in the estate upon conversion. Therefore, any property acquired after the petition date (either by the debtor or by the estate) would not be property of the estate in the converted case. The drafters of §348(f)(1), however, clearly did not contemplate such a result. Their expressed intent was to avoid creating a disincentive to chapter 13 filings caused by debtors' fears that property acquired during the chapter 13 (including equity resulting from the pay-down of secured claims) could be lost if the case were converted to chapter 7.⁶ The objective, therefore, was to remove from the estate in the converted case property that would not otherwise have been property of the estate had the case been initially filed as a chapter 7, namely the debtor's personal services income and property acquired by the debtor after the filing of the case. That objective appears consistent with the generally accepted policy of promoting chapter 13 cases and ensuring that debtors are at least no worse off for having made a good-faith attempt at a chapter 13.

An interesting question, then, is whether any property can be acquired by the estate (as opposed to the debtor) during the chapter 13 case that would then be property of the estate in the converted case by virtue of §541(a)(7). If §348(f)(1)(A) is narrowly interpreted, property acquired by the chapter 13 estate would properly be considered property of the chapter 7 estate after conversion.

For instance, proceeds, product, offspring, rents or profits of or from property of the estate may be considered property of the estate in the converted case. Consider the chapter 13 debtors who own residential rental property that generates rental income listed on Schedule I. While it is fairly well-settled that plan payments made to the chapter 13 trustee are returned to the debtor rather than distributed to the chapter 7 trustee (a.k.a. "chapter 13 severance pay"),⁷ there may be an exception to the extent that plan payments came from rental income. If the income was generated by property of the chapter 13 estate (rather than by the debtor), the chapter 7 trustee should not assume that the debtor is entitled to the funds. A careful look should be given to the Schedule I filed in the chapter 13. It also bears mentioning that the chapter 7 trustee should do this review quickly. The chapter 13 trustee is under no obligation to wait for a chapter 7 trustee to assert an interest in pre-conversion plan payments and, as a result, the funds may be returned to the debtor and dissipated before the chapter 7 trustee realizes what has happened.⁸ In these situations, it would also be appropriate for the chapter 13 trustee to give a head's-up to the chapter 7 trustee.

Another circumstance to consider is the operation of the debtor's business during the chapter 13 case. Whether operating as a sole proprietor or as a separate legal entity, the business could accumulate tax attributes during the chapter 13 that might be of benefit to the chapter 7 estate. Again, if §348(f)(1)(A) is narrowly interpreted, such tax attributes may belong to the chapter 7 trustee.

While this may seem like a remote issue, its practical application can be significant depending on the dollars involved in the operation.⁹ Consider the chapter 13 debtors who operate a business as a separate legal entity and list themselves as employees. During the pendency of the chapter 13, they may by paying themselves wages. The business may also contribute, or accrue contributions, to a pension plan on behalf of the debtors. By so doing, they convert to personal wage funds that would otherwise constitute business income that would add to the value of the estate's interest in the business. In so doing, the business may also generate a net operating loss that could be valuable in the hands of a chapter 7 trustee (either to offset estate income if the loss flows through or to increase the value of the stock or membership interest). However, the tax attributes cannot be recovered for the creditors if the trustee is not aware of the potential assets and/or does not take steps to claim the tax attributes are utilized by the debtor. Thus, chapter 7 trustees should look very carefully at the tax returns of the debtor and/or the business when cases are converted from chapter 13 to insure that tax attributes are not overlooked.

Post-petition appreciation in property may also be a source of recovery in chapter 7. With the combination of an appreciating real estate market and a bankruptcy court that confirms after the bar date, it is possible that recoverable equity may have developed while the debtors sat in chapter 13 enjoying the shelter of the automatic stay. However, great care must be taken in this area. If the property was valued in the chapter 13, subsequently accruing appreciate is not part of the chapter 7 estate. But it is not always clear whether the property has been "valued."¹⁰ Depending on the jurisdiction, valuation might occur merely by being scheduled, upon plan confirmation or in connection with a stay relief action.¹¹ Thus, the chapter 7 trustee should be mindful of both the relevant law and the valuation events that may have occurred in the chapter 13.

Another area of potentially fertile inquiry is the order confirming the chapter 13 plan. Pursuant to §1327(b): "except as otherwise provided in the plan or the order confirming the plan, the confirmation of a plan vests all of the property of the estate in the debtor." In other words, the existence or non-existence of property of the estate post-confirmation may be determined by a single paragraph in the order confirming the plan. In a growing number of communities, the order confirming the plan routinely includes language vesting property of the estate in the debtor upon completion of the plan. There are numerous reasons for this approach, but one of the clearest illustrations comes from City of Chicago v. Fisher.¹² In Fisher, the debtor received multiple parking citations post-confirmation and ultimately her car was impounded and crushed by the city of Chicago. The debtor argued that her vehicle was protected by the automatic stay, but the court found that §362 did not extend to property of the debtor with respect to post-petition claims and that the city of Chicago had not violated the stay.¹³ Arguably, the result would have been different if the order confirming had delayed vesting until completion of the plan. Thus, some bankruptcy courts refuse to confirm unless vesting is delayed until completion of the plan in order to continue the protection of the automatic stay. This same analysis may also determine whether property remains in the estate post-conversion. If assets remain property of the estate after confirmation, they may become part of the chapter 7 estate upon confirmation. As a consequence, chapter 13 creditors may want to encourage the delayed vesting language when the plan is confirmed, and chapter 7 trustees may want to check the order confirming for the vesting date.

Debtor's Possession or Control

To the extent that the chapter 7 trustee identifies property of the estate, the second part of the §348(f) analysis is whether the property is in the debtor's possession or control as of the conversion date. On its face this appears to be a fairly straightforward determination. Indeed, as a general matter, the debtor is considered to be in possession or control of all pre-confirmation plan payments even though some assets (such as plan payments) are in the chapter 13 trustee's physical possession. As discussed above, if those payments were made from the debtor's post-petition personal services income, they would not have been property of the estate as of the petition filing date and, therefore, not property of the chapter 7 estate.

A question arises concerning property that is no longer in the debtor's physical possession because it was transferred during the pendency of the chapter 13 case and is technically, but not actually, out of the debtor's control. For instance, transfers of property to adult children or businesses (in which the debtor owns no more than 50 percent) may be worth investigating. If the transfer was superficial, the chapter 7 trustee may be successful in arguing that the asset remains in the possession of the debtor. Alternatively, the trustee may find assistance in §348(f)(2).

The Bad-faith Exception

Section 348(f)(2) provides an exception to the general rule as follows: "If the debtor converts a case under chapter 13 of this title to a case under another chapter under this title in bad faith, the property in the converted case shall consist of the property of the estate as of the date of conversion (emphasis added)." In other words, bad faith brings into the chapter 7 estate property acquired post-petition, but pre-conversion. For instance, if the debtor wins the lottery while in chapter 13, the winnings would not be property of the chapter 7 estate under the general rule of §348(f). However, the winnings would be available for distribution to the chapter 7 creditors if the trustee can demonstrate that the case was converted in bad faith.

Unfortunately, there is a paucity of published opinions interpreting §348(f)(2). However, in In re Siegfried,¹⁴ the court took a fairly comprehensive approach in its attempt to define the "amorphous standard" of bad faith.¹⁵ The court applied a familiar totality-of-the-circumstances test frequently used in the confirmation process:¹⁶ (1) the amount of the proposed payments and the amounts of the debtor's surplus; (2) the debtor's employment history, ability to earn and likelihood of future increases in income; (3) the probable or expected duration of the plan; (4) the accuracy of the plan's statements of the debts, expenses and percentage of repayment of unsecured debt, and whether any inaccuracies are an attempt to mislead the court; (5) the extent of preferential treatment between classes of creditors; (6) the extent to which secured claims are modified; (7) the type of debt sought to be discharged and whether any such debt is non-dischargeable in chapter 7; (8) the existence of special circumstances such as inordinate medical expenses; (9) the frequency with which the debtor has sought bankruptcy relief; (10) the motivation and sincerity of the debtor in seeking chapter 13 relief; and (11) the burden that the plan's administration would place upon the trustee.¹⁷

While these factors are certainly helpful in guiding the court's consideration of the facts, they are far from a bright-line standard. The factors are so subjective that courts can reach different conclusions based on similar facts. Moreover, using such a potpourri of factors has led to a very practical reality: Attempting to invoke the bad-faith exception under §348(f) is expensive, time-consuming and highly unpredictable.¹⁸ Thus, unless a very large asset is at stake, odds are that the chapter 7 trustee will not pursue the issue because the cost benefit analysis so strongly favors the debtor.

This inequity could easily be reduced by adding an additional factor to the court's analysis: whether the debtor, the trustee or a creditor sought conversion. Presumably, there is a greater likelihood of bad faith if the debtor sought conversion.¹⁹ Indeed, in the lottery scenario, neither the trustee nor a creditor would seek conversion. Instead, they would attempt to have the lottery winnings disbursed through the chapter 13 plan. The debtor on the other hand, would prefer to pocket the windfall in a chapter 7. Hence, looking at the identity of the movant would reveal volumes about the debtor's motivation.

The authors propose, however, that the entire process would benefit by going one step further. Bad-faith converters would quite naturally and efficiently be culled out if a presumption of bad faith was triggered when a debtor (rather than the trustee or a creditor) moves to convert. This would dramatically shift the burden of protecting assets. In the case of the lottery-winning debtor, if the debtor filed the motion to convert, the chapter 7 trustee could automatically claim the winnings unless the debtor demonstrated that the conversion was not in bad faith. The debtor would retain all of the rights and protections under §348(f), but the price for bad faith would go up. Strategically opportunistic debtors could no longer bet on avoiding detection or winning the war of attrition against the chapter 7 trustee. With burgeoning caseloads and ever-decreasing administrative resources, such a simple change in the approach to §348(f)(2) deserves serious consideration.

Conclusion

Because the case law interpreting §384(f) is still very much in its infancy, there will undoubtedly be much more activity in the area, and there is opportunity for creative lawyering on behalf of debtors, creditors, trustees and other parties in interest. However, because the line between creative lawyering and manipulation of the system is still rather blurry, it is important that all parties, including the bench, remain vigilant and take advantage of strategies discussed herein to guard against manipulation and abuse that can lie just below the radar.

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Footnotes

¹ See Smith, Blanche D., "Property of the Estate‹To Be or Not to Be? That Is the Question the Trustee Asks of Thee," ABI Journal, Vol. XXI, No. 10 at 28 (2003); see, also, Koffman, Erin, "Note & Comment: What Is a Bad-faith Conversion? The Need for a Uniform Method of Determination," 18 Bank. Dev. J. 425 (2002). Return to article

² See §311 in Section-by-section Description of H.R. 5116, 140 Cong. Rec. H10,770 (daily ed. Oct. 4, 1994), reprinted in App. Pt. 9(b) at 9-98, Collier on Bankruptcy (15th Ed. Rev.). Return to article

³ See §1306(a)(2). Return to article

⁴ See §541(a). Return to article

⁵ Such as avoided liens and subordinated interests preserved for the benefit of the estate (§541(a)(4)), property received by bequest, devise or inheritance within 180 days after the petition date (§541(a)(5)), proceeds, product, offspring, rents or profits of or from property of the estate (§541(a)(6)), and any interest in property the estate acquires after the commencement of the case (§541(a)(7)). Return to article

⁶ See Section-by-section Description of H.R. 5116, supra at n. 2; H.R. Rep. No. 835, 103d Cong., 2d Sess. 57 (1994). Return to article

⁷ See In re Stamm, 222 F.3d 216 (5th Cir. 2000); see, also, In re Bobroff, 766 F.2d F.2d 797 (3d Cir. 1985); In re Luna, 73 B.R. 999 (N.D. Ill. 1987); In re de Vos, 76 B.R. 157 (N.D. Cal. 1987); In the Matter of Gorski, 85 B.R. 155 (Bankr. M.D. Fla. 1988); In re Marshall, 79 B.R. 147 (Bankr. N.D.N.Y. 1987); In re Lepper, 58 B.R. 896 (Bankr. D. Md. 1986); In re Bullock, 41 B.R. 637 (Bankr. E.D. Pa. 1984); In re McFadden, 37 B.R. 520 (Bankr. M.D. Pa. 1984); In re Peters, 44 B.R. 68 (Bankr. M.D. Tenn. 1984); In re Hannan, 24 B.R. 691 (Bankr. E.D.N.Y. 1982); In re Richardson, 20 B.R. 490 (Bankr. W.D.N.Y. 1982). Return to article

⁸ See, e.g., In re Zamora, 274 B.R. 268 (Bankr. W.D. Tex. 2002). Return to article

⁹ For an example of a significant dispute over tax attributes that can arise between chapter 7 trustees and shareholders of corporation, see In re Formann Enterprises Inc., 281 B.R. 600 (Bankr. W.D. Pa. 2002) (the court held that the carryback of an S corportion's net operating loss by its shareholders was not a voidable post-bankruptcy petition transfer because the NOL was not the property of the S corporation's bankruptcy estate). Return to article

¹⁰ See §541(a)(6); In re Kuhlman, 254 B.R. 755 (Bankr. N.D. Ca. 2000) (where there was no explicit valuation during the chapter 13 case, appreciation in debtor's homestead included in property of the chapter 7 estate); In re Wegner, 243 B.R. 731 (Bankr. D. Minn. 2000) (valuation in debtor's schedules sufficient for purposes of §348(f)(1)(B) so that pre-conversion appreciation in homestead belonged to debtor and not chapter 7 estate). Note that the chapter 7 estate's interest in such property would be subject to valid exemptions claimed by the debtor, such as in the proceeds from the sale of the debtor's homestead during the chapter 13 case. Return to article

¹¹ Id. Return to article

¹² In re Fisher, 198 B.R. 721 (Bankr. N.D. Ill. 1996), rev'd. on other grounds, sub nom, City of Chicago v. Fisher (In re Fisher), 203 B.R. 958 (Bankr. N.D. Ill. 1997). Return to article

¹³ Id. Return to article

¹⁴ In re Siegfried, 219 B.R. 581 (Bankr. D. Colo. 1998). Return to article

¹⁵ Id. at 584. Return to article

¹⁶ See, e.g., In re Warren, 89 B.R. 87 (Bankr. 9th Cir. 1988). Return to article

¹⁷ In re Siegfried, supra at 584. Return to article

¹⁸ As pointed out by Erin Koffman in her recent Note and Comment, the reported decisions on this topic strongly suggest identical facts could create different results depending on which court heard the case. "For example, it seems logical that if the In re Siegfried court had decided the Taco Bell case, it likely would have decided that the plaintiffs had, in fact, sought conversion of their case in bad faith... Similarly, one could logically speculate that if the Siegfried court had decided the In re Kuntz case, a different outcome likely would have resulted." N. 1 at 448-49. Return to article

¹⁹ A similar proposal was recently made by Keith Rucinski. Rucinski, Keith, "The Chapter 13 Trustee's Pursuit of Post Petition Assets vs. The Debtors Absolute Right to Dismiss: Why the New Bankruptcy," NACTT Quarterly, October/November/December 2003. However, Mr. Rucinski suggested that §348(f) be amended to implement his proposed change. The authors do not believe that a statutory amendment is realistic, and instead encourage change through case law. Return to article