1 9: Consumer Bankruptcy Choice: Chapter 7 or 13?; Dismissal for Abuse © Charles Tabb 2010 To pay or not to pay, that is the question

2 What is good about 7? Discharge debts NOW – Keep future earnings for yourself Keep all exempt assets

3 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

4 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

5 What is bad about 13? Again – mirror opposite of 7 Do NOT get immediate discharge Instead have to pay creditors for years and years

6 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.

7 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.

8 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

9 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)

10 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

11 Answer to 2.4(b) Samantha might need to file chapter 13 to get her car back. Cure default reverse acceleration reinstate payments See § 1322(b)(2), (3), (5) -> Whether AFC likes it or not!

12 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.

13 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.

14 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”

15 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

16 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

17 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

18 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

19 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

20 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

21 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.

22 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.

23 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

24 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!

25 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

26 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

27 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

28 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

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

30 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

31 Policy Q: what is “can pay”? Along with the empirical Q, have the policy Q of what constitutes “can pay” ability?

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

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

34 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

35 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

36 1984 The legislative compromise allowed both sides to declare victory NO can-payYES can-pay

37 Application of “substantial abuse” “totality of circumstances” test -> multi-factor tests developed -> can-pay ability but one factor, not dispositive spotty and inconsistent enforcement

38 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

39 New test: “abuse” Old “substantial abuse” test repealed New test only requires proof of “abuse” – § 707(b)(1)

40 Consequences of “abuse” Court must either – Dismiss the chapter 7 Or – Convert to chapter 13 But only if DR “consents”  But Dr cannot stay in chapter 7

41 Scope of abuse test ONLY applies to: 1.Individual drs 2. With primarily consumer debts

42 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

43 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)

44 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)

45 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

46 Process – file form DR has to file a very detailed form, Official Form B22A http://www.uscourts.gov/rules/BK_Forms_08_O fficial/B_022A_0108f.pdf Has means test calculation Dr must file even if below state median

47 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

48 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

49 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

50 Formula Statutory presumptive abuse repayment $ formula: LESSER OF 1.$7,025 or 25% of non-priority unsecured claims, whichever is greater OR 2.$11,725

51 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

52 rebuttal Step 4  If 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

53 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

54 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

55 1 st : 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))

56 2 nd – 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?

57 Safe harbor calculation DR + spouse CMI = $5,300 per month So, 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

58 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)

59 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

60 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

61 Shorthand measure DR/spouse monthly repayment capacity = $300 ALWAYS flunk means test if have at least $195.42 month in repayment capacity

62 Rebut? Dr/spouse could try to rebut the presumption of abuse No facts given Must show “special circumstances”

63 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

64 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!

65 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?

66 ↑ 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

67 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

68 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

69 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?

70 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