The following is a case summary written by Kathleen A Cashman-Kramer analyzing Brown v Barclay (In re Brown), 953 F. 3d 627 (9th Cir. 2020).
The recent decision in Brown vs. Barclay (In re Brown), 953 F.3d 617 (9th Cir. 2020) concludes SIX years of litigation that started with a Chapter 13 case filed in San Diego in 2013. Here, the Ninth Circuit answered the following question in the affirmative: “The question we must answer here is whether the statutory provision, § 348(f)(1)(A), that defines property of the estate at the time of conversion, includes funds that were fraudulently transferred out of the voluntary estate in order to avoid creditors.” Id. at 12. To view the opinion, click here.
During a chapter 13 case, the debtor Jason Brown made unauthorized and fraudulent transfers to his three brothers, one of whom was the appellant, Kenneth Brown. The source of those funds was an inheritance received by the debtor several months after the chapter 13 was filed. When the chapter 13 trustee learned of the transfers of more than $37,000, he moved to convert the case to chapter 7; the motion was granted with a finding that debtor’s conduct had been in bad faith, and a chapter 7 trustee, Mr. Barclay, was appointed. The bankruptcy court also held that the transferred funds remained part of the converted estate and therefore the chapter 7 trustee could recover the funds for the chapter 7 estate as an avoidable transfer.
The bankruptcy court offered two different reasons why the funds remained part of the bankruptcy estate: (1) because the transfers were not for ordinary living expenses permitted by statute, but were made in bad faith to avoid creditors; and alternatively (2) because Jason’s estate had a claim to recover the funds from his brothers, the funds could be said to have remained within his possession or control within the meaning of 11 U.S.C. § 348 (f)(1)(A). Kenneth appealed the bankruptcy court’s order to the BAP, which agreed with the bankruptcy court’s first reason and affirmed.
On appeal to the Ninth Circuit, appellant Kenneth urged that 11 U.S.C. § 348(f)(1)(A) must be construed to mean that the post-conversion estate only contains property that “remains in the possession of or is under the control of the Debtor,” and did not include funds the debtor had transferred pre-conversion, regardless of whether the transfers were fraudulent. Id. at 11-12. The Ninth Circuit affirmed the BAP, but under a completely different rationale.
The Ninth Circuit first noted that the appellant never challenged the bad faith finding of the bankruptcy court, and his sole argument on appeal is that the funds would not be considered property of his brother Jason’s converted estate because the funds were not in Jason’s possession or control at the time of the transfer. As a result, 11 U.S.C. § 348(f)(1)(A) required a finding that the spent funds were not property of the converted estate. Id.. At 623.
The court then looked at the history of the application of section 348(f)(1)(A), including In re Salazar, 465 B.R. 875, 878–79 (B.A.P. 9th Cir. 2010). There, the debtors had received a tax refund after they filed for Chapter 13 and spent those funds “in the normal course of living.” In re Salazar, 465 B.R. at 882. After conversion to Chapter 7, the Salazar trustee sought recovery of the tax refunds that were acquired by the debtors post-petition and spent without court authorization. The BAP disagreed, on the basis that the debtors spent the tax refunds on ordinary living expenses and, as a result, were not recoverable. The Ninth Circuit in Brown then cited to a New York district court case which joined others in finding that funds a debtor had transferred fraudulently to avoid creditors and without authorization and notice to the trustee were recoverable. Specifically, there the debtor had transferred to his wife and brother-in-law funds realized from a truck sale. The New York court reasoned that, because those funds should have been used to repay the debtor’s creditors, and the transfer was without the Chapter 13 trustee’s knowledge, the funds were recoverable after conversion by the Chapter 7 trustee because the transfers were made in bad faith. In re Pisculli, 426 B.R. 52, 66 (E.D.N.Y. 2010). Brown, 953 F.3d at 621.
The Ninth Circuit then considered Kenneth’s argument that the BAP should have discussed the Supreme Court’s decision in Law v. Siegel, 571 U.S. 415 (2014), namely, that the Bankruptcy Court and BAP committed a similar error by using their equitable authority to override an express provision of the Bankruptcy Code. Id. at 12.
Specifically, Kenneth contended that the BAP majority did not even attempt to explain how its result could be reconciled with the text of § 348, and that they are in fact irreconcilable.
The question we must answer here is whether the statutory provision, § 348(f)(1)(A), that defines property of the estate at the time of conversion, includes funds that were fraudulently transferred out of the voluntary estate in order to avoid creditors. We do not agree with Appellant that the express provision of the Code provides a clear answer with respect to the issue of fraudulent transfers. To interpret what we view as ambiguous text, we begin by looking to the structure, object, and policies of the Bankruptcy Code. See Hawkins, 769 F.3d at 666.
The Code reflects a firm policy of not rewarding fraud or bad-faith debtors—which it realizes in numerous provisions, including the structural relationship between Chapter 13 and Chapter 7. In both Chapter 13 and Chapter 7 proceedings, unauthorized transfers of estate property by the debtor can be recovered by the trustee. See 11 U.S.C. § 549(a). Under both, a delay of discharge may be obtained where a debtor fraudulently transfers funds. See 11 U.S.C. § 523(a)(2)(A).
Id. at 623.
The Ninth Circuit ultimately concluded that, 1) because the Code permits the court to convert a chapter 13 to a chapter 7 when the debtor fraudulently transfers funds during the chapter 13 case; 2) had the case remained in Chapter 13, the trustee could have recovered those funds, or 3) had the case initially been filed as a Chapter 7, the trustee could have also recovered the funds, finding that “[t]here is thus no basis in the structure, policy, or purpose of the Bankruptcy Code for treating the fraudulent transfers as beyond the reach of the creditors merely because the estate was converted.” The Ninth Circuit then looked outside the Bankruptcy Code to reach its conclusion that the funds remained within the debtor’s constructive possession or control and hence should be considered property of the converted estate under 11 U.S.C. § 348(f)(1)(A). Id. at 623.
After its analysis, the Ninth Circuit added that the debtor’s transfer of funds out of his actual possession to a close family member, in an effort to avoid payment to his creditors that would have otherwise been required under the Bankruptcy Code, was analogous to criminal cases where defendants attempt to evade the operation of law by disguising ownership of fraudulently obtained funds or contraband. Hence, it gave rise to a rebuttable presumption that funds remained within the debtor’s possession or control – a presumption that the Debtor never challenged. Ultimately, the Ninth Circuit held that the funds remained within his constructive possession or control and should be considered property of the converted estate under § 348(f)(1)(A).
It seems clear that the Ninth Circuit searched for a well-reasoned argument to affirm the fraudulent transfer finding when it considered the applicability of and limitations on 11 U.S.C. § 348. This author has rarely seen any court – circuit or otherwise – go so far as to compare the provisions of the Code with specific federal criminal statutes. In this instance, the comparisons seemed well reasoned and likely reached the appropriate result.
These materials were authored by Kathleen A. Cashman-Kramer, Of Counsel at Sullivan Hill Rez & Engel (Cashman-Kramer@Sullivanhill.com), with editorial contributions from ILC members Summer Shaw and Hon. Meredith Jury (ret.).
 Prior to the Chapter 13 filing, the three non-debtor brothers, including Kenneth, abandoned their interest in the inheritance to the Debtor.
 In its analysis the Ninth Circuit looked at “statutes penalizing the possession of contraband and statutes penalizing laundering of money that has been in the defendant’s possession,” and where courts have 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. See, e.g., U.S. v. Vasquez, 654 F.3d 880, 885–86 (9th Cir. 2011), citing 21 U.S.C. § 841(a)(1), where courts rejected the argument that defendants could only be convicted if they had actual possession of the contraband; see also U.S. v. Disla, 805 F.2d 1340, 1350 (9th Cir. 1986) (observing that “[w]e have upheld many convictions [under § 841(a)(1)] under the theory of constructive possession”); and U.S. v. Ruiz, 462 F.3d 1082, 1088 (9th Cir. 2006) (defined possession as having actual or constructive control). It also looked at money laundering – 18 U.S.C. § 1957(f)(2) (defining “criminally derived property” as “any property constituting, or derived from, proceeds obtained from a criminal offense”) – and noted that courts have concluded 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. See U.S. v. Smith, 44 F.3d 1259, 1266; U.S. vs. Prince, 214 F.3d 740, 748 (6th Cir. 2000) (holding that the defendant “did not need to have physical possession of the money before it could be considered proceeds”); U.S. v. Howard, 271 F. Supp. 2d 79, 83 n.4 (D.D.C. 2002) (explaining that “the defendant need not be in actual possession of the proceeds of the funds derived from the specified unlawful activity; constructive control of the funds is sufficient”). Accordingly, the Ninth Circuit concluded that proceeds from money laundering may be within the defendant’s constructive control or possession, even though the funds were never placed in the defendant’s account. Smith, 44 F.3d at 1266.