Debtor's Earnings Must Be Turned Over to Ch. 7 Trustee

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By Diane Davis

March 17 — Money that a debtor earned after he filed for Chapter 11 bankruptcy but then converted to a case under Chapter 7 belongs to the Chapter 7 bankruptcy estate, a district court in Illinois held March 11.

Affirming the judgment of the bankruptcy court, Judge John Z. Lee concluded that debtor Robert J. Meier must turn over the funds deposited into a debtor in possession (DIP) account to Chapter 7 trustee Robert B. Katz.

The result in this case “is very unfortunate and, in my opinion, wrong, albeit understandable, given the statute,” Prof. Charles J. Tabb, Mildred Van Voorhis Jones Chair in Law, University of Illinois, told Bloomberg BNA March 16.

The issue of what happens to post-petition earnings when a debtor first files a petition under Chapter 11, which is for businesses or individuals whose debts exceed the statutory thresholds for Chapter 13, and later converts the case to one under Chapter 7 in which a debtor's nonexempt assets are liquidated and the proceeds are distributed to creditors has never been addressed by a circuit court. The lower courts that have addressed the issue are split, the court said.

Bankruptcy Code Section 348(a) provides that a “conversion of a case from a case under one chapter of this title to a case under another chapter of this title constitutes an order for relief under the chapter to which the case is converted, but … does not effect a change in the date of the filing of the petition.” In 2005, Congress added Section 348(f), which provides that when a bankruptcy case is converted from Chapter 13 to Chapter 7, the Chapter 7 estate doesn't include earnings made by the debtor after the commencement of the case.

The district court took the approach of the statutory construction tool “expressio unius est exclusio alterius” (“to express or include one thing implies the exclusion of the other”) and found it significant that Section 348(f) mentions only cases converted from Chapter 13 and doesn't include conversions from Chapters 11 or 12.

Disincentivizes Ch. 11 Debtors

“At first blush, one certainly can understand why a court would limit the special protective rule of § 348(f) to Chapter 13 cases, since it refers only to Chapter 13 cases,” Tabb told Bloomberg BNA. “But there is little reason to think that when Congress in 2005 added the post-petition property rules to Chapter 11 cases (in § 1115) it thought to revisit the conversion rule of § 348(f), which had been enacted 11 years earlier to address exactly this problem — and did so in a way favorable to the debtor,” Tabb said.

This is “yet another of a very long laundry list of illustrations of the careless and inept drafting of the draconian 2005 law,” Tabb told Bloomberg BNA. “All Congress was trying to do in 2005 regarding individual Chapter 11 debtors was to mimic the Chapter 13 approach, but as Meier illustrates, an individual debtor can be worse off under Chapter 11 than under Chapter 13,” he said.

“The Meier outcome disincentivizes an individual debtor from trying to pay his creditors in a Chapter 11 case. Even worse, an individual can be thrown into Chapter 11 involuntarily (unlike in Chapter 13), and thus, could be exposed to the risk of post-petition wages being brought into his estate even though he’s never voluntarily chosen anything other than to liquidate,” said Tabb, who is an editor of Bloomberg Law: Bankruptcy Treatise.

Case Is Converted

Meier filed for Chapter 11 bankruptcy relief and while the case was proceeding, he continued working and deposited his earnings into a DIP account. When he wasn't able to reorganize under Chapter 11, he converted his case to Chapter 7.

One of Meier's creditors moved to compel him to turn over the funds deposited into the DIP account. The Chapter 7 trustee joined the creditor's motion.

The debtor argued that the earnings weren't property of the Chapter 7 estate because they arose after he had filed his original bankruptcy petition.

The bankruptcy court ruled in favor of the creditor/trustee and ordered the funds to be turned over to the trustee. The debtor appealed to the district court.

Two Avenues to Create Estate

Chapters 11 and 7 offer “two different avenues for individuals seeking to avail themselves of the bankruptcy process,” the district court said. Whichever chapter a debtor chooses, the commencement of a bankruptcy case creates an “estate” consisting of property of the debtor.

Under Section 1115(a)(2), a Chapter 11 estate includes property owned by the debtor at the time the case is commenced, and any income earned by the debtor after the petition is filed, the court said. Under Chapter 7, a trustee sells the assets of the estate and the proceeds are distributed to the debtor's creditors. The estate under Chapter 7 excludes “earnings from services performed by an individual debtor after the commencement of the case,” the court said, citing Section 541(a)(6).

Split in Circuits

When Congress added subsection (f) to Section 348 in 1994, there was a split among circuit courts as to what property remains part of the estate after a bankruptcy case is converted from Chapter 13 to Chapter 7, the court said. The Seventh Circuit in In re Lybrook, 951 F.2d 136 (7th Cir. 1991), held that once a debtor's earnings became part of the Chapter 13 estate, they remained so even after a conversion to Chapter 7, but the Third Circuit in In re Bobroff, 766 F.2d 797 (3d Cir. 1985), came to the opposite result.

Look at Legislative History

The legislative analysis of Section 348(f) states that the amendment overrules the holding in In re Lybrook and adopts the reasoning of , but gives the court discretion in a case in which the debtor has abused the right to convert and converted in bad faith, the court said.

The legislative history demonstrates that Congress was aware of the same issue with Chapter 12, but still limited the application of Section 348(f) to Chapter 13, the court said. Then in 2005, the court noted, Congress simplified Chapter 11 by adding Section 1115(a)(2), which made post-petition earnings part of the estate in Chapter 11 cases, but didn't bring Chapter 11 or Chapter 12 within the scope of Section 348(f).

The debtor questioned why Chapters 11 and 12 should be treated any differently than Chapter 13.

There are many procedural and substantive differences between Chapters 11 and 13, the court said. “The differences between Chapter 13 and Chapter 11 are replete with policy considerations, and Congress is better equipped at making these policy choices than the court,” the court said.

Appellant Robert J. Meier, Arlington Heights, Ill., represented himself, pro se; Elizabeth A. Bates, Springer Brown, LLC, Wheaton, Ill., represented defendant/trustee Robert B. Katz; Jack B. Schmetterer, United States Bankruptcy Court, Chicago, Ill., represented defendant service list: U.S. Bankruptcy Court, Clerk, U.S. Bankruptcy Court, Chicago; United States Trustee, Office of the United States Trustee, Chicago.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com