What Happens to Funds Being Held By a Chapter 13 Trustee When the Debtor Files a Voluntary Conversion to Chapter 7?

Many Chapter 13 bankruptcies fail to complete, often times because the debtor’s situation changes not allowing him to continue making plan payments. Oftentimes, the debtor will exercise his right to file a voluntary conversion to Chapter 7. Typically, when the debtor files his notice of conversion the Chapter 13 Trustee is holding funds collected from the debtor – waiting to be disbursed to the creditors.

The question becomes what happens to those funds? There are three likely answers. First, the Trustee could disburse the remaining funds to the creditors. Second, the Trustee could disburse the funds to the newly appointed Chapter 7 Trustee. Finally, the Trustee could release the funds back to the debtor. Until recently, Courts around the country were split on how to handle this situation.

The U.S. Supreme Court in the case Harris v. Viegelahn, Chapter 13 Trustee, 575 U.S. ___ (2015) ruled that the Chapter 13 Trustee must return the funds to the debtor upon conversion to Chapter 7. The Court reasoned that the conversion notice immediately “terminates the service” of the Chapter 13 Trustee, thereby relieving him of his duty to disburse funds to creditors.

Some lower courts had ruled that the funds held by the Chapter 13 trustee should be turned over to the Chapter 7 Trustee for distribution to creditors unless exempted. The Supreme Court rejected this reasoning on the grounds that the Chapter 7 estate is comprised of prepetition assets and the wages held by the Trustee are always a post petition asset. Meaning that the debtor voluntarily turns over his wages to the Chapter 13 Trustee, he is not required to turn over post petition wages to a Chapter 7 Trustee.

The bankruptcy code defines the bankruptcy estate of a converted case to be the assets in existence at the time of the original filing of the case – not the time of the conversion. Meaning, new assets that the debtor acquires after filing, but before conversion are not an asset of the new Chapter 7 estate. Since the wages were acquired after the filing of the Chapter 13, but before the conversion, they do not belong to the Chapter 7 Trustee and should be returned to the debtor.

There is an exception to this rule. If the debtor converts a case initially filed under Chapter 13 in bad faith, then the estate shall consist of assets as of the time of conversion. So in a case where the debtor files his conversion in bad faith, the post petition wages held by the Chapter 13 Trustee could be turned over to the Chapter 7 Trustee.