When a Chapter 13 bankruptcy is no longer feasible due to a permanent loss in household income or under other circumstances, a debtor may convert the case to a Chapter 7 bankruptcy.
In the Eastern District of Michigan Bankruptcy Court jurisdiction, this is accomplished by the simple filing of a one-page “Notice of Conversion.”
Upon filing, the case almost immediately becomes a Chapter 7 case—once the court enters the accompanying Order of Conversion, anyway.
The Bankruptcy Court then treats the case as a newly filed Chapter 7, scheduling a new (Chapter 7) 341 Meeting of Creditors and assigning—a Chapter 7 Trustee.
The Role of the Chapter 7 Trustee Upon Conversion to Chapter 7 from Chapter 13
It is important to bear in mind one of the most crucial differences between the two primary forms of personal bankruptcy:
In a Chapter 13 bankruptcy, assets are not liquidated for the benefit of your creditors.
In a Chapter 7 bankruptcy, they are.
The primary duty of the Chapter 13 Trustee is to accept your Chapter 13 Plan payment each month and then to disburse those funds out to your attorney and your creditors in the priority order established by your Chapter 13 Plan and by the Order Confirming the Plan.
The primary duty of the Chapter 7 Trustee is to seize your non-exempt assets, liquidate them, and to then disburse that pool of cash to your creditors—after paying him- or herself a fee, as well as the fees of any “professionals” retained by the Trustee to accomplish all of this.
One of the most common reasons, in fact, that people choose to file Chapter 13 when otherwise income-eligible for Chapter 7 is to preserve assets or property that would be seized by a Chapter 7 Trustee.
So what happens to those assets if you lose your job and convert to Chapter 7 Bankruptcy?
Assets Upon Conversion to Chapter 7: What the Bankruptcy Code Says
Section 348(f) of the US Bankruptcy Code states, in short, that, after conversion to Chapter 7, property of the Bankruptcy Estate over which the Trustee has authority is the property that the debtor had when the case was originally filed and which the Debtor still possesses or controls.
If the case is converted to Chapter 7 “in bad faith,” however, this Code provision holds that the property of the converted case shall then consist of the property of the estate as of the date of conversion.
What would an example of that be?
It could be many things, but, for instance, if you won millions of dollars in the lottery while in a Chapter 13 bankruptcy proceeding and converted to Chapter 7 to try and avoid turning the funds over to the Chapter 13 Trustee for disbursement to your creditors, you could expect the Chapter 7 Trustee to fight to the Nth degree to get that money from you.
That aside, what does this Code provision mean?
Generally speaking, it means that whatever assets you had the day that you originally filed the Chapter 13 and which you still control or own is subject to seizure by the Chapter 7 Trustee after conversion if they are not fully exempted.
What about assets you didn’t have on the day that you filed the original Chapter 13? What about new property you have come to own since filing?
Assets Obtained after the Original Bankruptcy Filing Date
As with every court in the United States, new law is made in the bankruptcy context by way of decisions issued by the judges of both the Bankruptcy and Federal appellate courts—and the U.S. Supreme Court.
In Michigan, which lies within the jurisdiction of the 6th Circuit Court of Appeals, the courts have primarily adhered to the plain language of the Code provision above in determining whether or not a Chapter 7 Trustee could or could not liquidate property obtained by the Debtor after the filing date of the original Chapter 13.
The courts of the Sixth Circuit have primarily allowed liquidation of property obtained by a debtor after the original Chapter 13 filing date where bad faith was found—or when the property was transferred by the debtor to a third party.
Any asset transfer by a debtor within certain timeframes relative to a filing (or conversion) date is liable to be scrutinized by a Chapter 7 Trustee as a possible fraudulent transfer.
A Chapter 7 Trustee can “avoid” or unwind fraudulent transactions and recover property from third parties.
Thus, Trustees have attempted to recover attorney fee payments made by Debtors post-filing, tuition payments, and other such transfers of cash.
These attempts have been allowed where the Debtor retains some equitable interest. In the case of an attorney fee payment, this was found where the funds may not have been fully earned by the receiving attorney, leaving the debtor with the right to a partial refund upon demand.
Equity in Real and Personal Property in Chapter 7 Conversions
What about increased or new equity in real estate or other personal property that may not have existed on the date of the original Chapter 13 filing?
Another common reason that people choose to file a Chapter 13 is, as noted, that the Chapter 13 process allows for the curing of a mortgage arrearage through the Chapter 13 plan.
Even where there is no arrearage in mortgage or in vehicle payments upon initial Chapter 13 filing, the Chapter 13 process is 3-5 years long. That means 36-60 ongoing mortgage or vehicle payments made post-filing—and quite a lot of potential post-filing equity.
Courts in the Sixth Circuit have largely considered the question of whether or not such equity enters the converting debtor’s bankruptcy estate as they would any other asset and in keeping with the Bankruptcy Code provision, above.
That is, where there is no bad faith in conversion, the equity does not enter the estate—and it belongs to the debtor.
Assets and Property When Converting to Chapter 7: The Bottom Line
The bottom line is that, just as you can expect a fish to swim, you can expect a Chapter 7 Trustee to try and take your stuff.
The United States Bankruptcy Code states that property of the Chapter 7 Bankruptcy Estate consists of all of the property of the Chapter 13 Estate at the time of filing the petition that still remains in the possession or control of the Debtor. 11 U.S.C. §348(f)(1)(A). However, it is important to note that in the rare case in which the Bankruptcy Court finds that the conversion to Chapter 7 was done in “bad faith,” the property of the new estate will also include property of the Debtor that the debtor held on the date of conversion, which would include post-petition or property the debtor acquired after the original Chapter 13 case was initially filed. 11 U.S.C. §348(f)(2).
The “bad faith” test utilized in the Sixth Circuit is a “totality of the circumstances” test that will examine your motivation for filing your case, the types of debt you are seeking to discharge, your motivation for converting to Chapter 7, and a number of other factual points. If the circumstantial evidence indicates that your conversion is indeed in bad faith, you will discover that only after you’ve converted and exposed your assets to the Chapter 7 Trustee.
If you are in a Chapter 13 proceeding without legal representation and are considering converting to Chapter 7, it is essential that you speak with an experienced bankruptcy attorney prior to filing that short, simple Notice.
Attorney Walter Metzen has represented thousands of Detroit-areas consumers in Chapter 7 and Chapter 13 bankruptcy for over 28 years and is a Board Certified Bankruptcy Expert.
Contact us to schedule a free consultation to discuss your bankruptcy concerns.