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Conversion from Chapter 11 to Chapter 7: What to do with Post-Petition Earnings?

In a case of first impression, in In re Markosian, 506 B.R. 273 (9th Cir.BAP Cal) 2014 WL 956475, the 9th Circuit Bankruptcy Appellate Panel (BAP) held that an individual debtor’s postpetition Chapter 11 earnings that are property of the debtor’s bankruptcy estate revert back to the debtor upon a subsequent conversion to Chapter 7. The court also notes in a footnote that there may be situations in which the court may have to separate earnings from personal services by an individual from the earnings of a business.

Facts and Procedural History
Mr. and Mrs. Markosian (Debtors) filed a chapter 7 petition. Debtors’ chapter 7 petition was subsequently converted to a chapter 11 bankruptcy and then re-converted to a chapter 7. When Debtors initially filed their chapter 7 petition, the U.S. Trustee moved to dismiss Debtors’ case based on the Debtors high income level and their ability to repay creditors. As a result, Debtors elected to convert their case to chapter 11. However, the Debtors were unable to confirm a chapter 11 plan because Mrs. Markosian lost her job. Thus, Debtors re-converted their case to a chapter 7.

Many of the issues discussed in the case arose from the fact that Mr. Markosian received a large bonus from his employer for services that were rendered while the chapter 11 case was pending. The Debtors turned Mr. Markosian’s bonus over to the Trustee, but after re-converting their case to a chapter 7, filed a motion to compel the trustee to return the bonus to them arguing that the post-petition earnings were no longer the property of the estate upon conversion. The bankruptcy court found that the bonus constituted earnings from personal services within the meaning of §1115(a)(2), but concluded that it ceased to be property of the estate upon conversion to chapter 7.

Analysis
The court began its analysis by defining what constitutes property of the estate. For Chapter 7 purposes, under §§541(a)(6) and (7), property of the bankruptcy estate is distinct from the debtor’s property. Under §541(a)(6) post petition earnings in a Chapter 7 bankruptcy are not included in the debtor’s bankruptcy estate. By contrast, in a Chapter 11 case, what constitutes property of the estate is modified by §1115, which expressly includes post petition earnings of the debtor under §1115(a)(2). Thus, the issue before the court was what to do with the post petition earnings once the case had been converted to a Chapter 7 from a Chapter 11 case given that §541(a)(6) and §1115(a)(2) appeared directly at odds. The court first held that section §348 governs conversion from one chapter to another.

Under section §348(f)(1)(A), a debtor’s postpetition earnings are expressly excluded from the Chapter 7 estate once converted from Chapter 13. However, there is no parallel provision in §348 for Chapter 11 debtors. Congress was silent on this issue. Thus, the Markosian court applied a plain meaning interpretation to section §348(a) and determined that it applies to all cases under Title 11, not just conversions from Chapter 13 to Chapter 7. Further, the court expressly stated that the date of the petition remains unchanged, thereby bringing all post petition but pre conversion earnings within the scope of §348. Accordingly, because §348(f)(1)(A) applies to cases converted from Chapter 11 to Chapter 7, a debtor’s post petition earnings are considered property of the debtor upon conversion.

According to the court in Markosian, other courts have struggled with this issue because of Congress’s failure to enact a parallel provision to §348(f)(1)(A) for chapter 11 debtors. However, in Markosian, the BAP disagreed with divining intent from congressional silence, which the court noted has been cautioned against by the Ninth Circuit Court of Appeals. Specifically, the court found that the fact that Congress did not enact a parallel provision to 348(f)(1)(A) for chapter 11 debtors when it enacted section 1115 had no significance, and thus a plain reading of the statutes involved compelled the determination that upon conversion from Chapter 11 or Chapter 13 to a Chapter 7, post petition earnings should not be considered property of the estate.

Finally, the court concluded that there is no reason to treat Chapter 11 debtors differently than Chapter 13 debtors in the context of determining property of the estate upon conversion from a Chapter 7 case. The court noted that the purpose of statute section 348(f) was to “avoid penalizing debtors who first attempt a repayment plan,” and the court determined that there was “no policy reason as to why the creditors should not be put back in the same position as they would have been in had the debtor never sought to repay his debts”.

Author’s Note
One practice pointer to take away from this case is buried within a footnote. The court states that if a case is filed under Chapter 11 and then converted to a Chapter 7, it may be necessary to distinguish personal earnings from business earnings for debtors who own a business (or multiple businesses). In other words, in cases converted from Chapter 11 to Chapter 7 bankruptcy practitioners may need to analyze where earnings are coming from, and how closely they related to the business itself (when there is a debtor who owns a business). If the earnings are from the personal services of the debtor, then they should revert back to the debtor upon conversion. However, if the earnings are from the distributions of the business or profits of the business, then they should be considered property of the estate. This makes the situation of a debtor who personally owns a business a complex factual determination of where the income to the debtor is primarily derived from.