9: consumer bankruptcy choice: chapter 7 or 13?; dismissal for abuse © charles tabb 2010 to pay or...

9: Consumer Bankruptcy Choice: Chapter 7 or 13?; Dismissal for Abuse

© Charles Tabb 2010

To pay or not to pay, that is the question

What is good about 7?

• Discharge debts NOW–Keep future earnings for yourself

• Keep all exempt assets

What is bad about chapter 7?

• Have to turn over all non-exempt assets

• Can’t cure defaults on secured debts (home, car) or get collateral back unless secured creditor agrees

What is good about 13?

• Basically, what’s good about 13 are the same things that are bad about 7

• Keep all your property–Even if non-exempt

• Can cure problems (defaults, repos) on secured debts

What is bad about 13?

• Again – mirror opposite of 7

• Do NOT get immediate discharge

• Instead have to pay creditors for years and years

Problem 2.4(a)

• In the following situations, would the debtor be likely to

prefer to file under chapter 7 or chapter 13? Explain. – Samantha Debtor owes $50,000 from

uninsured medical bills. –Assets of $60,000 (including her home and

car), all of which is exempt under state law. – Samantha has a job as a professor making

$50,000 a year.

Answer to 2.4(a)

• Samantha – prefer chapter 7–Keep all of her property (all exempt) –Discharge all of her debts–Not pay creditors a dime • Not required to pay future income• All current property exempt

–Of course, she’d have to stay current on her home mortgage and car payments, if any.

Comparison to 13

• If Samantha filed chapter 13:–Would NOT get an immediate discharge of

debts, like she would in 7 –would have to pay all of her “projected

disposable income” to creditors • For either three or five years• depends on whether her income is above the

state median

–Would get to keep her property, however

Is 7 open to Samantha?

• At a salary of $50,000, the means test of § 707(b)(2) might cause problems

• Whether is even subject to means test screening depends on her family size and the state median income for that family size

• If subject to means test, whether she passes it depends on her repayment capacity – Given her debt level – flunks means test if has

$182.50/mo. net (income – expenses)

Problem 2.4(b)• In the following situations, would the debtor be likely to prefer to file

under chapter 7 or chapter 13? Explain. • Same facts as in problem a., plus:

• Samantha is in default on payments of $800 on her car (a Volvo S60) to Auto Finance Co. (AFC), and last week her car was repossessed by AFC

• AFC has accelerated car loan; she owes $12,000 to AFC• Volvo is worth about $10,000

-> She really loves her car and very much wants to keep it. She bought it new three years ago

Answer to 2.4(b)

• Samantha might need to file chapter 13 to get her car back.

• Cure default• reverse acceleration • reinstate paymentsSee § 1322(b)(2), (3), (5)

-> Whether AFC likes it or not!

Strip down

• “Strip down” the principal amount of the car payments to the lower $10,000 value, rather than the $12,000 contract amount, and make the $2,000 balance unsecured. – Note: since the car was purchased more than 910 days

ago, she isn’t subject to the “hanging paragraph” following 1325(a)(5).

– If she were subject to the hanging paragraph, while she could still recover possession, cure defaults, and reverse the acceleration, she could not strip down the principal amount due.

Is chapter 7 possible?

• Samantha can try to work something out with AFC consensually in chapter 7 where:– AFC gets paid– Sam gets car back

• AFC knows that she can obtain the relief described in preceding slide in chapter 13, so might work with her if she filed chapter 7.

7 + Reaff

• AFC might be better off -- would not have to compete with other creditors in 7, b/c all other creditors (especially the big medical debt) would be discharged in chapter 7.

• Sam might file 7 (to discharge all other debt) AND propose a reaffirmation to AFC on similar terms to what they’d get in chapter 13– The proverbial “win-win”

problem 2.4(c)

• In the following situations, would the debtor be likely to prefer to file under chapter 7 or chapter 13? Explain.

• Same facts as in a, plus:

• Samantha also owes a debt for $9,000 on a credit card bill.

• She’s worried that she might not discharge the debt in a chapter 7 case due to fraud – she wasn’t entirely truthful when she filled out

the credit card application

Answer to 2.4(c)

• Prior to the 2005 amendments, Samantha might have considered filing under chapter 13 in order to take advantage of the “super” discharge of 1328(a)– Pre-2005, a fraud debt was dischargeable in ch 13

Super discharge not so super

• Now, however, fraud debts are excluded from discharge under chapter 13 as well (see § 1328(a)(2))

• so there’s nothing in chapter 13 for her

Problem 2.4(d)

• In the following situations, would the debtor be likely to prefer to file under chapter 7 or chapter 13? Explain.

• Samantha Debtor owes $50,000 from uninsured medical bills • Samantha has a job as a professor making $50,000 a year

• Assets of $60,000 – including her home and car

• Only $15,000 in assets are exempt

Answer to 2.4(d)

• The prospect of having to relinquish $45,000 of her $60,000 in assets to the chapter 7 bankruptcy trustee makes chapter 13 look a lot more attractive to Samantha

• Debtor would keep all of that property in chapter 13

Has to pay for it, though!

• under the “best interests” test of § 1325(a)(4), her unsecured creditors are entitled to get paid at least as much as they would in a chapter 7 liquidation – In ch 7 liquidation, the $45,000 in non-exempt

assets would be available for them. • So Sam would have to effectively “buy back”

her $45,000 non-exempt assets over the life of the chapter 13 plan

Other factors to consider

• (1) how much she’d have to pay to creditors under the “projected disposable income” (or “best efforts”) test of 1325(b), and

• (2) for how long – is she over or under the applicable state income median, which would dictate whether she has to pay for 3 years or 5?

-> If she has to pay too much to her creditors under the projected disposable income test, and for 5 years, at some point it makes sense just to throw in the towel and forget about the $45,000 in non-exempt assets.

Problem 2.4(e)

• Samantha just graduated from law school, and will be starting work in the fall for a major law firm, at a salary of $140,000.

• Samantha has $90,000 in student loan debt and $15,000 in credit card debt.

• She has no non-exempt assets.

Answer to 2.4(e)

• Samantha would of course love to file chapter 7 so that she could keep all of her substantial future earnings for herself, without having to give up any assets

• But if she filed chapter 13 she’d have to pay creditors a lot*

– * maybe – will revisit this when discuss Lanning

Chapter 7 discharge?

• Samantha likely would not be able to discharge her student loan debt in chapter 7, unless she could show an “undue hardship” (not likely). See § 523(a)(8).

• So that makes chapter 7 a lot less attractive– Only discharge the $15,000 in credit card debt– But that’s better than nothing!

Is 7 even an option?

• There is a substantial likelihood that Sam would not even be allowed to try chapter 7, because of the “abuse” test of § 707(b)(1) – Not likely to be subject to means test presumption– BUT still may be a chapter 7 “abuser” under “bad

faith” or “totality of the circumstances” test, see § 707(b)(3)• Classic case big salary coming up

Nifty ch 13 option for student loan debt?

• Dr MIGHT have a pretty cool option for handling her student loan debt in ch 13

• Put the student loan debt in a different class and pay it more under the plan– Leaves less of that non-dischargeable debt owing

after done with plan• Issue: “discriminate unfairly”? See § 1322(b)(1)– Gazillions of cases on point – hopelessly divided

But IS ch 13 an option? “Abuse” test:The issue (supposedly)

• Debtor has– No money now (i.e., no non-exempt assets)– Future earning potential

• If allowed to go under chapter 7– Discharge all debts– Pay nothing to creditors– Enjoy all future $ for himself– But COULD have paid Crs out of future earnings

The goal (of consumer credit industry)

• Close the chapter 7 door to these naughty “can-pay” debtors

• Make them pay future earnings to Crs in ch 13

Empirical question

• At bottom, is really an empirical question: how many of these “can-pay” abusers are really filing chapter 7?

Screening costs?

• Assume that some, but not all, of the ch 7 filers fall within the “can pay” category

• Q of how costly (in time and $) to screen out the can-pay debtors from no-can-pay debtors

-> at some point, the game is just not worth the candle

Policy Q: what is “can pay”?

• Along with the empirical Q, have the policy Q of what constitutes “can pay” ability?

Who decides?

• Also important issue is who decides what constitutes “can pay” ability– Congress?– Bankruptcy judge in a particular case

Rule or standard?

• Another important issue: screen for can-pay ability via a mechanical rule or a flexible standard?

History

• Creditors first sought a can-pay screening system in late 1920s– Bad timing!!

• Revisited in 1967 & ff.• Rejected in 1978 Code• 1984 – “substantial abuse” test

1984 “substantial abuse” test

• Congress compromised in 1984• Added 707(b) allowing dismissal of ch 7 case

filed by individual Dr with primarily consumer debts if the filing was a “substantial abuse”

• Did not define “substantial abuse”• Did NOT include a mechanical test that

payment ability = substantial abuse

1984

• The legislative compromise allowed both sides to declare victory

NO can-pay YES can-pay

Application of “substantial abuse”

“totality of circumstances” test-> multi-factor tests developed-> can-pay ability but one factor, not dispositive

spotty and inconsistent enforcement

Central Provision of 2005 Act

• Enactment of a mechanical, rule-based “means test” that kicked can-pay Drs out of Ch 7 was THE Holy Grail for consumer credit industry

• Got what they wanted in 2005 BAPCPA

New test: “abuse”

• Old “substantial abuse” test repealed

• New test only requires proof of “abuse”– § 707(b)(1)

Consequences of “abuse”

• Court must either–Dismiss the chapter 7Or–Convert to chapter 13• But only if DR “consents”

But Dr cannot stay in chapter 7

Scope of abuse test

ONLY applies to:1. Individual drs

2. With primarily consumer debts

Two ways to show “abuse”

1. Unrebutted presumption of abuse, 707(b)(2)A. i.e., flunk the means test

2. Bad faith or “totality of the circumstances,” 707(b)(3)

EITHER will suffice

Low-income safe harbor

• If DR’s income* is ≤ state median income for family size, immune from means test screening, 707(b)(7)

* Income is measured by “current monthly income,” which is a carefully (and confusingly) defined term, 101(10A)

Where find state medians?

On website maintained by Office of US Trustees http://

www.justice.gov/ust/eo/bapcpa/20100315/bci_data/median_income_table.htm

(applicable to cases filed on or after March 15, 2010; updated

periodically)

Huge variances

• Makes a big difference what state DR resides in

• For example, family 4, median income ranges from – Low of $27,434 in Puerto Rico– High of $102,894 in New Jersey

Process – file form

• DR has to file a very detailed form, Official Form B22A

http://www.uscourts.gov/rules/BK_Forms_08_Official/B_022A_0108f.pdf

Has means test calculation

Dr must file even if below state median

Presumption of abuse: the means test

Step 1: “Current monthly income” [101(10A)]

–Expenses [living expenses (IRS Collection Standards) + secured debts next 60 months + priority debts next 60 months + other allowed expenses, 707(b)(2)(A)]

= net monthly repayment capacity

Presumption, cont.

Step 2:• Multiply the net monthly repayment capacity

(from Step 1) by 60

• This gives the Dr’s total projected repayment capacity over a 5-year period– The amount of time would require an above-

median dr to be in Ch 13

Presumption, cont.

Step 3: compare total projected repayment capacity [Step 2 amount] with presumptive abuse amounts

-> if total projected repayment capacity is ≥ the statutory presumptive abuse $ amount, DR presumptively fails the means test

Formula

Statutory presumptive abuse repayment $ formula:

LESSER OF1. $7,025 or 25% of non-priority unsecured claims, whichever is greater

OR2. $11,725

shorthand

• If DR’s projected repayment capacity is < $117.09 per month– NEVER a presumptive abuser

• If DR’s projected repayment capacity is > $195.41 per month– ALWAYS a presumptive abuser

• If between $117.09 & $195.41, depends on whether ≥ 25% of unsecured debts

rebuttal

• Step 4If DR presumptively fails the means test, may try to rebut the presumption by showing “special circumstances”

Necessary for fairness to DRs, but detracts from purely mechanical test- introduces element of judicial discretion

Bad faith/totality

• EVEN IF Dr is not subject to the means test presumption at all, or passes the means test, is not necessarily home free

• STILL might have ch 7 case dismissed as “abuse” on ground was filed in bad faith or due to totality of the circumstances

Problem 2.5• Debtor and his spouse both work. Debtor is self-employed as a painting

contractor, and his spouse has a steady wage-earning job• “current monthly income” = $5,300 per month. • Illinois state median income for 2-person families is $59,838 per year (as

of March 15, 2010). • Nonpriority unsecured debts = $80,000.• Under means test, their deductible monthly expenses are:

– $2,800 (net of secured debt payments) under the IRS standards– $1,800 secured debts – $300 priority debts– $100 other deductible expenses of $100 total allowed expenses = $5,000.

They want to file chapter 7, and come to see you for advice

1st: even subject to “abuse” test?

• Threshold Q whether have “primarily consumer debts”

• If Debtor’s painting business debts predominate, then not subject to abuse test of 707(b)(1) at all– Whether under means test presumption

(subsection (b)(2)) or bad faith/totality (subsection (b)(3))

2nd – means test apply at all?

• Assuming that Dr and spouse do have “primarily consumer debts,” next Q is whether they are subjected to means test screening, or whether they fall within the low-income safe harbor of 707(b)(7)

Ask is their “current monthly income” (CMI) ≤ state median income for family size?

Safe harbor calculation

• DR + spouse CMI = $5,300 per monthSo, annualized (i.e., times 12) = $63,600

• Compare to applicable state median:Illinois, 2 persons, = $59,838

• DR/spouse CMI > state median, so YES, are subject to means test screening

means test calculation

• Dr/spouse CMI = $5,300 month• Total allowed expenses = $5,000 month– $2,800 IRS + $1,800 secured + $300 priority +

$100 other• Repayment capacity = $300 month– CMI $5,300 – Expenses $5,000

• Total repayment capacity = $18,000 – (over 60 months -- $300 x 60)

Statutory abuse $ amount

• Compare the DR’s projected repayment capacity withy the statutory abuse $ amount

• Formula (as of April 2010):Lesser of

1. $7,025 or 25% of nonpriority unsecured debts (25% of $80K = $20K), whichever is greater -> thus $20K

2. $11,725

- and of course $11,725 is < $20,000

Thus $11,725 is presumptive abuse amount

Flunks means test

• DR’s total projected repayment capacity = $18K

• Abuse trigger = $11,725• So Dr is presumptive abuser – Total projected repayment capacity > statutory

abuse trigger amount

Shorthand measure

• DR/spouse monthly repayment capacity = $300

• ALWAYS flunk means test if have at least $195.42 month in repayment capacity

Rebut?

• Dr/spouse could try to rebut the presumption of abuse

• No facts given• Must show “special circumstances”

What can Dr do?

After you explain means testing to them, Debtor asks if he should stop taking painting jobs for a few months before they file. What would you tell him?

• SURE• Why?– If reduce income for 6 month pre-bankruptcy CMI

period, might either:1. Not even be subjected to means test (fall under safe

harbor)2. Pass means test – less projected repayment capacity

Reduced income

• Safe harbor: in 2.5, if DR and spouse had monthly income of $4,986 a month (rather than $5,300), would fall below state median– Illinois median = $59,838/yr, or $4,986.50/mo

• Pass means test: in 2.5, pass means test if have $195.41 (or less) in monthly repayment capacity– So reduce income from $5,300 to $5,195– Only $105 less a month!

Increase expenses

• What if Debtor asks you if they should trade in their old Chevrolet, which is paid off, and buy a new BMW, with 60 monthly payments of $750 each?

↑ expenses, pass means test

• If DR were to increase secured debt expenses by $750 month, likely would pass means test

• Count all secured debt, no matter how high

Calculate if add secured debt

• Currently have $300 month net income over expenses– Note would lose some (or all) of $496 month ownership

expenses under IRS if add $750 secured• Worst case get $254 more in allowable expenses

($750 secured debt-$496 IRS transportation ownership)

• Reduces projected disposable income enough to pass means test– no more than $46 month ($300-$254)– Anything < $117.09 always passes means test

Risk of gaming: bad faith / totality

• As discussed, either ↓income or ↑ expenses might enable Dr to pass means test

• However, not home free • Still risk court would dismiss for bad faith or

totality of circumstances under 707(b)(3)

The take-on-secured-debt ploy in particular has been found a basis for abuse in many reported cases

Problem 2.6

• A debtor with a family of four currently resides in New Jersey and has “current monthly income” of $8,000 (for an annualized income of $96,000). The debtor is considering moving to New York

• For cases filed on or after March 15, 2010, the median income for a family of four in New York was $82,164 and in New Jersey was $102,894.

• She wants to file bankruptcy under chapter 7. • Would you advise this move?

Not move – lose safe harbor

• If move, lose low-income safe harbor of 707(b)(7), would be subjected to means test screening

• CMI = $96K/yr• State medians: NJ = $102K, NY = $82K

So obviously is now below the NJ median, if move to NY would be above