NINTH CIRCUIT FINDS FUNDS FRAUDULENTLY TRANSFERRED BY DEBTOR TO BE PART OF CONVERTED CHAPTER 7 ESTATE

Earlier this year the Bankruptcy Appellate Panel for the Ninth Circuit found that assets fraudulently transferred by a debtor during his Chapter 13 bankruptcy proceedings constituted assets of the bankruptcy estate despite a forced conversion of the proceedings from Chapter 13 to Chapter 7. In re Brown. In Brown, the Court explained “[t]he problem…began when the debtor [Jason Brown] made unauthorized and fraudulent transfers” to his brothers during his Chapter 13 bankruptcy proceedings. Jason Brown’s father died in July 2012 leaving a modest estate to four sons, including Jason Brown (“Jason” or “the debtor”). The three brothers abandoned their interest in their father’s estate to Jason.

After the Browns’ father died, but before distribution of the probate estate’s assets, Jason petitioned for debt relief under Chapter 13 of the bankruptcy code. In his bankruptcy schedules he noted an anticipated inheritance of $2,500; however, a few months later the trustee of his father’s estate distributed over $55,000 to Jason. “[A]lmost immediately, and without the approval of the Chapter 13 trustee,” Jason transferred in excess of $12,000 to each of his three brothers. As a sanction for these unapproved transfers, the trustee successfully sought conversion of Jason’s Chapter 13 proceedings to Chapter 7.

The trustee’s request was in furtherance of 11 U.S.C. § 1307(c), which provides for forced conversion of a Chapter 13 plan to a Chapter 7 plan “for cause.” The bankruptcy court expressly found Jason acted in bad faith and that “the transfers were made to avoid payments to creditors.”

The Chapter 7 trustee moved to recover all the inherited funds from the brothers. One of Jason’s brothers, Kenneth Brown appealed asserting the funds he received “were not part of the bankruptcy estate after the conversion because they were no longer in the possession or control of the debtor, as required by § 348(f)(1)(A).” The pertinent portion of this provisions reads:

…[W]hen a case under chapter 13 of this title is converted to a case under another chapter under this title–(A) 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…

The Court considered § 348 in the context of “property of the estate” and fraudulent transfers. In its analysis of this issue, the Court explained the different treatment of assets in a Chapter 13 proceeding and a Chapter 7 proceeding. The Court noted in the former the debtor’s debts are discharged over time via a repayment plan and “the property accumulated during the repayment period becomes part of the bankruptcy estate and is used to repay creditors.” Comparatively, in a Chapter 7 proceeding the debtor’s debts are immediately discharged. In exchange for the immediate debt relief, the debtor is required to liquidate all existing assets, but “assets acquired by the debtor post-petition are not property of the estate…” It was this latter rule Kenneth relied upon in his appeal of the Chapter 7 trustee’s suit to recover the funds Jason fraudulently transferred to him. Kenneth argued at the time Jason filed his Chapter 13 petition and at the time of the forced conversion to Chapter 7, the inherited funds were not physically in Jason’s possession or control so they could not be considered property of the bankruptcy estate.

The Trustee countered that even if Jason did not maintain physical possession of the fraudulently transferred funds they must be considered as part of the estate “to prevent abuse of the system.” The Court agreed noting § 348 has become problematic for bankruptcy courts in the context of determining the status of funds that are out of the physical possession of the debtor, but only because they were unlawfully transferred out during the Chapter 13 proceedings prior to conversion. The Court explained in cases where the “for cause” conversion provisions of § 348 were employed as a sanction against a debtor who fraudulently transferred funds to avoid creditors, “literal application of § 348(f)(1)(A)” would “lead to an absurd result, one rewarding bad faith.”

The Court classified the language of § 348 as “ambiguous” and looked to several criminal cases for guidance on interpreting the intended meaning of “actual possession” and determining under what conditions, other than literal possession, the “possession or control” requirement would be met. The Court considered cases dealing with the laundering of money and possession of contraband, both of which “utilized the concept of ‘constructive’ control or possession, whereby an individual is deemed to possess items even when the individual does not actually have immediate physical possession of the item.” The Court agreed with the conclusions drawn in the analogous criminal cases “that constructive control of fraudulently obtained funds is sufficient and may be inferred where transfers are made pursuant to a scheme of fraud that the defendant participated in or directed.”

The Court explained “…courts have consistently rejected efforts to evade the operation of the law by disguising ownership of fraudulently obtained funds or contraband.” The Court concluded that it was undisputed Jason tried to avoid paying his creditors by transferring funds to his brothers so the fraudulently transferred funds “remained in his constructive possession or control” and therefore “should be considered property of the converted estate under § 348(f)(1)(A). This decision is well-reasoned and supports the bankruptcy code’s “firm policy of not rewarding bad-faith debtors.”