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Bankruptcy conversion question settled by Supreme Court

The U.S. Supreme Court has handed down a decision that will, according to bankruptcy professionals, settle a long-standing question about conversions and undistributed funds. We wrote about the case when the court agreed to hear it in January (see our Jan. 10, 2015, post).

The case involved a man who declared Chapter 13 bankruptcy and, after some time, opted to convert the Chapter 13 repayment plan to a Chapter 7 liquidation. Even though the debtor had not made payments on his mortgage, he had made regular monthly payments to the Chapter 13 bankruptcy trustee. At the time of the conversion, the trustee had a balance of more than $5,500 of the debtor's funds.

With that cash, the trustee paid a handful of unsecured creditors and kept a small amount for herself as commission. The debtor believed the money should have been refunded to him.

The trial court agreed with him, but the appeals court did not. The Supreme Court unanimously agreed with the debtor: The money should be refunded.

The 1994 amendments to the Bankruptcy Code clarified the issue, the court said, by allowing debtors to retain earnings and other assets acquired after the petition to convert from Chapter 13 to Chapter 7 has been filed. Again, those assets are not part of the Chapter 7 bankruptcy estate; they are not subject to liquidation to pay off creditors.

The only exception to the rule is in cases of bad faith. Had this conversion been done in bad faith, the trustee's actions would have been appropriate. However, the court found no evidence of bad faith, no evidence that the debtor wanted anything more than a fresh start.

We'll discuss the trustee's arguments in our next post.

Source: Courthouse News Service, "Bankruptcy Leftovers Go to Debtor, SCOTUS Says," William Dotinga, May 18, 2015

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