§ 143.5 — Bad-Faith Conversion

Revised: June 17, 2004

[1]

In cases filed after October 22, 1994, if conversion from Chapter 13 to another chapter is “in bad faith,” § 348(f)(2) further redefines property of the estate in the converted case to “consist of the property of the estate as of the date of conversion.” It seems to have been the intent of Congress to penalize debtors for bad-faith conversion by including in the estate in the converted case different property than would come into that estate at a good-faith conversion.

[2]

Once again, the definition of property of the estate is fundamental to application of this new section but not illuminated by the 1994 Act. If “property of the estate as of the date of conversion” means “property of the estate defined by § 541,” then the Chapter 7 estate in a bad-faith conversion from Chapter 13 would include all of the property described in § 541 that was acquired by the debtor (but not disposed of?) between the filing of the Chapter 13 case and the conversion. This approach might capture for the Chapter 7 estate appreciation in property that occurred during the Chapter 13 case, before conversion. This interpretation might be disrupted by disintegration of the Chapter 13 estate at confirmation under § 1327(b).1 In one reported decision discussing a bad-faith conversion from Chapter 13 to Chapter 7, the bankruptcy court explained the difference between the good-faith estate and a bad-faith estate as follows:

Section 348(f)(1)(A) was added to clarify 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. . . . [I]n the typical preconfirmation conversion from Chapter 13 to Chapter 7, any property in the hands of the Chapter 13 Trustee will be returned to the debtor and the debtor will be entitled to retain most, if not all, property acquired during the pendency of the Chapter 13 case. An important exception, however, was added to this rule by Section 348(f)(2). If the debtor converts a case under Chapter 13 to a case under Chapter 7 or another chapter under Title 11 in bad faith, the property in the converted case shall be extended to include property of the estate as of the date of conversion. . . . [I]f the bad faith conversion is done prior to confirmation, any property in the hands of the Chapter 13 Trustee and, potentially, any property acquired by debtor during the pendency of the Chapter 13, will become property of the Chapter 7 estate.2
[3]

What does “bad faith” mean in § 348(f)(2)? Will this be the same bad faith that bars confirmation under § 1325(a)(3)?3 Will it be the same bad faith that has inspired some courts to dismiss Chapter 13 cases under § 1307 both before and after confirmation of a plan?4 Arguably, bad faith for purposes of § 348(f)(2) should focus on the conversion from Chapter 13, not on circumstances before confirmation or before the filing of the case. Misconduct by the debtor during the Chapter 13 case might appropriately be considered, but only if it affected the rights of creditors at conversion. Could default under a confirmed plan be bad faith for purposes of conversion to Chapter 7? Would it be bad faith for a debtor to transfer property during the Chapter 13 case to avoid “possession . . . or . . . control” of property at conversion?5 Does the content of bad faith change if all property of the estate vested in the debtor at confirmation under § 1327(b)?6

[4]

One bankruptcy court has reported a decision defining bad faith at conversion for § 348(f) purposes with much borrowing from good-faith analysis under § 1325(a)(3). In In re Seigfried,7 the debtor was in a Chapter 13 case for approximately nine months and paid $4,600 to the trustee. On the eve of the hearing on confirmation, the debtor voluntarily converted to Chapter 7. Evidence indicated that the debtor had failed to disclose assets, debts were not scheduled accurately and the debtor had been generally dishonest and not forthright. A creditor moved that the funds held by the Chapter 13 trustee at conversion be turned over to the Chapter 7 trustee. The bankruptcy court agreed, explaining bad faith at conversion as follows:

[T]he statutory language does not define “bad faith” . . . . [C]ase law dealing with standards applicable to lack of “good faith” under Section 1325(a)(3) is helpful . . . . Bad faith, by implication or nuance, is something more than lack of good faith. Bad faith is more extreme . . . . Bad faith is more severe, more flagrant . . . . A court must apply broad standards and general definitions of bad faith to the specific facts of the case to determine if there is fraud, deception, dishonesty, lack of disclosure of financial acts or an abuse of the provisions, purpose or spirit of the Bankruptcy Code. . . . Debtor’s conduct . . . evidences a pattern of dissembling, failure to fully or accurately disclose financial affairs, disingenuous explanations of wrongful conduct and unfair manipulation of the bankruptcy system to the detriment of his creditors. . . . Considering Debtor’s pattern of deception and dishonesty in revealing assets and disclosing debts, the Court finds that the proper disposition of funds in the hands of the Chapter 13 Trustee and funds potentially received by Debtor during the pendency of the Chapter 13 case is to have them turned over [to] the Chapter 7 Trustee for distribution to creditors.8
[5]

What about the Chapter 13 debtor who converts to Chapter 7 (on the advice of counsel) precisely to take advantage of the different definition of the estate? For example, is it “bad faith” for a Chapter 13 debtor involved in a car accident to convert to Chapter 7 to prevent creditors from grabbing any nonexempt recovery from the accident? On almost exactly these facts one bankruptcy court used statutory construction to find that conversion was not in bad faith.

[6]

In In re Bejarano,9 the Chapter 13 case was filed in December of 2001 and converted to Chapter 7 in September of 2002. During those 10 months the debtor was in an automobile accident and became entitled to a tax refund for 2002. After conversion, bad faith was argued as a ground for including the lawsuit and the tax refund in the Chapter 7 estate. The bankruptcy court explained that the debtor should not be penalized for exercising the rights that Congress granted in § 348(f):

[N]o inference of “bad faith” arises solely because a debtor acquires a postpetition, but preconversion asset, and thereafter elects to convert their case on account of the protection afforded by § 348(f)(1). . . . To hold otherwise would clearly go against the principle that a person should not be penalized solely for exercising a statutory right. . . . [T]o penalize a debtor for merely exercising their right under § 348(f)(1) goes against the Congressional policy of encouraging debtors to seek bankruptcy relief under Chapter 13 and not Chapter 7. . . . “[B]ad faith” means “not simply bad judgment or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; . . . it contemplates a state of mind affirmatively operating with furtive design or ill will.” [United States v. True, 250 F.3d 410, 423 (6th Cir. 2001)]. . . . [I]mplicit in the meaning of “bad faith,” under § 348(f)(2) is the notion that some sort of nefarious planning was involved.10
[7]

Under some circumstances, bad-faith conversion under § 348(f)(2) may be more favorable to debtors than conversion not in bad faith. Section 348(f)(2) determines property of the estate after a bad-faith conversion “as of the date of conversion.” There is no reference back to the date of the petition in § 348(f)(2) as there is in § 348(f)(1)(A), nor is there any consideration of “possession . . . or . . . control” when the conversion is in bad faith.11 From the words used in § 348(f)(2), it is arguable that property of the estate in the converted case is determined by applying § 541 to the facts at the date of conversion, without regard to what may have been property of the estate at the filing of the Chapter 13 petition. Changes in property of the estate during the Chapter 13 case before the bad-faith conversion would be irrelevant except to the extent that postpetition acquisitions remain in the estate at conversion. For example, appreciation in property during the Chapter 13 case would benefit creditors only if the debtor does not dispose of the appreciated property before conversion. Property transferred by the debtor to a family member during the Chapter 13 case might be excluded from the estate at a bad-faith conversion; that same property might be captured for the estate by § 348(f)(1)(A) at a good-faith conversion if the debtor retained control after the transfer. Section 348(f)(2) could be an invitation to preconversion planning by debtors. Ironically, transfers of property during a Chapter 13 case that might lead to a finding of bad faith at conversion to Chapter 7 might also provide the debtor with a more favorable definition of property of the estate in the converted case.

[8]

On facts out of a law school final exam, one bankruptcy court revoked a Chapter 7 debtor’s discharge based on the disposition of property during the Chapter 13 case before conversion. In Wyss v. Fobber (In re Fobber),12 the debtors originally filed a Chapter 7 case that was converted to Chapter 13. During the Chapter 13 phase, the debtors sold a $35,000 unencumbered tractor and spent the proceeds. Debtors then reconverted to Chapter 7 and received a discharge. When the Chapter 7 trustee learned of the sale of the tractor, the trustee filed a complaint to revoke the Chapter 7 discharge. The debtors moved to dismiss, arguing that neither the tractor nor the proceeds from its sale were property of the estate under § 348(f)(1) because neither was in the debtors’ possession or control when the Chapter 13 case converted to Chapter 7. The bankruptcy court found this technically accurate application of § 348(f)(1) was just too good to be true:

If this is a correct statement of the law, then § 348(f) gives debtors carte blanche to commit fraud. A chapter 7 debtor who decides that he does not want to surrender to the trustee an asset which is property of the estate can convert to chapter 13 long enough to dispose of the asset, and then reconvert to chapter 7 and obtain a discharge with impunity. . . . By adopting [Bobroff v. Continental Bank (In re Bobroff), 766 F.2d 797 (3d Cir. 1985),] in its enactment of § 348(f)(1), Congress intended to avoid penalizing debtors for their chapter 13 efforts by placing them in the same economic position they would have occupied if they had filed chapter 7 originally. . . . In other words, § 348(f)(1) was designed to mitigate the effect of § 1306(a) in cases converted from chapter 13 by excluding from property of the estate in the converted case property brought into the estate under § 1306(a). In the instant case, however, the property acquired by the debtors during the chapter 13, i.e., the sale proceeds, became property of the estate, not because of the chapter 13 and its expanded definition of property of the estate but because it was proceeds of property held by the debtors at the bankruptcy case’s commencement. Under § 541(a)(6), the sale proceeds would have been property of the estate regardless of whether the debtors had stayed in chapter 7 as originally filed or converted to chapter 13. . . . In light of § 348(f)’s purpose as stated in its legislative history, it is unclear to this court why Congress, in enacting that provision, limited property of the estate in the converted case to property which “remains” in the possession or under the control of the debtor on the date of conversion. . . . [T]his court is convinced that § 348(f) was never designed to be a safe harbor for debtors who fraudulently and surreptitiously dispose of property of the estate while in chapter 13. As such, this court holds that § 348(f) is inapplicable to the facts of the present case. In other words, notwithstanding § 348(f), a chapter 7 trustee in a case originally filed under chapter 7, converted to chapter 13, and then reconverted to chapter 7, may seek to revoke the discharge of a debtor who in the chapter 13 phase of the case disposed of property which was property of the estate in the original chapter 7. To hold otherwise would lead to an absurdity and would not further the legislative intent of § 348(f).13

 

1  See §§ 230.1 [ 11 U.S.C. § 1327(b): Vesting Effect on Property of Estate ] § 120.3  11 U.S.C. § 1327(b): Vesting Effect on Property of Estate and 315.1 [ In Cases Filed before October 22, 1994 ] § 143.1  In Cases Filed before October 22, 1994.

 

2  In re Siegfried, 219 B.R. 581, 584 (Bankr. D. Colo. 1998).

 

3  See discussion beginning at  § 103.1  In General.

 

4  See § 152.2  Cause for Dismissal—In General§ 152.3  Cause for Dismissal Added or Changed by BAPCPA and § 152.4  Cause for Dismissal, Including Bad-Faith, Multiple and Abusive Filings.

 

5  See § 316.1 [ In Cases Filed after October 22, 1994 ] § 143.2  In Cases Filed after October 22, 1994.

 

6  See § 120.3  11 U.S.C. § 1327(b): Vesting Effect on Property of Estate§ 143.1  In Cases Filed before October 22, 1994 and § 143.2  In Cases Filed after October 22, 1994.

 

7  219 B.R. 581 (Bankr. D. Colo. 1998).

 

8  219 B.R. at 584–86.

 

9  302 B.R. 559 (Bankr. N.D. Ohio 2003).

 

10  302 B.R. at 562–63.

 

11  See above in this section.

 

12  256 B.R. 268 (Bankr. E.D. Tenn. 2000).

 

13  256 B.R. at 276–79. See also Hazlett v. Gorshe (In re Gorshe), 269 B.R. 744 (Bankr. S.D. Ohio 2001) (After conversion from Chapter 13, discharge in Chapter 7 case is revoked based on debtor’s failure to comply with court order to turn over a portion of insurance proceeds received when debtor’s house burned during the Chapter 13 case.).