by Funds fraudulently transferred during a chapter 13 case remain in the debtor’s “constructive possession” and become part of the chapter 7 estate upon conversion. Brown v. Barclay, No. 18-60029 (9th Cir. March 23, 2020).
The chapter 13 debtor received an inheritance while in bankruptcy which he divided between himself and his three brothers without notifying the chapter 13 trustee. When the trustee learned of the unauthorized transfer, he moved the court to convert the debtor’s case to chapter 7 as a sanction. Finding the debtor had acted in bad faith, the bankruptcy court ordered the conversion. The chapter 7 trustee sought turnover of the funds from all the brothers. One of the brothers, the appellant in this case, fought turnover on the basis that because the debtor was not in control of the funds at the time of conversion, they did not become part of the chapter 7 estate. The bankruptcy court disagreed, and the bankruptcy appellate panel affirmed.
On appeal, the Ninth Circuit found that the case turned on interpretation of section 348(f)(1)(A) which defines an estate converted from chapter 13 to chapter 7 as including the property on the petition date for the original chapter 13 case that remains in the debtor’s possession or control at the time of conversion. This provision generally places the debtor in the same position he would be in had he filed under chapter 7 at the outset, except that, by limiting the chapter 7 estate to property in the debtor’s possession or control, the provision takes into account the chapter 13 debtor’s ability to use estate assets to pay ongoing expenses.
The question on appeal was what happens when the reduction in estate property is due to the debtor’s bad faith conduct. In In re Salazar, 465 B.R. 875, 878–79 (B.A.P. 9th Cir. 2010), the bankruptcy appellate panel found that where the debtors failed to inform the court of a tax refund and proceeded to spend the money on ordinary expenses, the trustee could not recover those funds when the case was converted to chapter 7. Salazar hinged on the debtors’ use of the funds for ordinary, albeit unauthorized, expenses.
On the other hand, courts such as In re Pisculli, 426 B.R. 52, 66 (E.D.N.Y. 2010), have allowed recovery of funds the debtor transferred post-petition but pre-conversion where the funds were not spent on the debtor’s ordinary expenses. In Pisculli, the debtor surreptitiously transferred truck sale proceeds to a family member. The court found he should not escape the consequences of his actions simply by converting the case to chapter 7.
The court here was persuaded that the reasoning in Pisculli applied with extra force where the debtor’s case was converted as a sanction for the unauthorized transfers.
The court noted that, on its way to the Ninth Circuit, the lower courts had offered three rationales for finding that the transferred funds were part of the chapter 7 estate. The bankruptcy court found that the chapter 13 estate had a claim against the debtor’s brothers which became part of the new chapter 7 estate. The BAP majority relied on Salazar to find that because the debtor did not spend the funds on ordinary expenses, they were recoverable by the chapter 7 trustee. The BAP concurrence opined that the chapter 13 trustee had a right to turnover of the funds that accrued to the chapter 7 trustee upon conversion.
The Ninth Circuit found that none of the foregoing rationales addressed the issue of how to include in the chapter 7 estate property that is no longer in the debtor’s possession or control. The court found the statute ambiguous as to its application to the circumstances here and, therefore, turned its attention to considerations beyond the text. It noted that the Code reflects a policy of not rewarding bad faith. The court considered other situations where a textual requirement of possession was interpreted broadly, such as in criminal cases like money laundering where courts have allowed “constructive” possession to establish the element of possession.
The court adapted this interpretation to the current circumstances, finding that where the debtor transferred property with the intention of evading his creditors, those funds remained within his “constructive possession” for purposes of section 348(f)(1)(A).
The court affirmed.