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Advocate: Using a Bazooka to Swat a Fly:
One Lawyer's Attempt to Hurdle the Broad, New Federal Bankruptcy Law

by Robert M. Bovarnick

Summer 2005, Vol. 68, No.2

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention, Consumer Protection Act. During the signing ceremony, the President stated that the new law “makes common sense reforms to our bankruptcy laws…[restores] integrity to the bankruptcy process…[makes] the system fairer for creditor and debtors..." The bulk of the law will go into effect on October 17, 2005 (certain provisions are immediately effective). While the current system is not free from abuse, the abuses come from a small minority of debtors. It appears, however, that Congress has taken the view that the abuses and abusers are the norm rather than the exception. The result is a very broad, and not particularly well conceived, law that creates more issues than it corrects. The cost associated with the new bankruptcy law will be very steep, both in monetary and non-monetary terms. The most common reaction to the changes is that they will increase the barriers to entry into the system and make the primary purpose of bankruptcy—the fresh start—far more difficult for the vast majority of debtors who use the system properly.

This is not to say that the new law is completely devoid of positive changes. Those changes do exist. The consensus among the bankruptcy bar, however, is that it creates more problems than it solves. This article will attempt to highlight some of the issues—both positive and negative.

The Positives
In reading through various analyses of the law, the first thing that struck me was the added protections relating to domestic support obligations. Section 507 of the Code establishes the priority scheme for repayment of debts. Under current law, payment of domestic support obligations (child and spousal support, alimony) are given a seventh priority. Now, they are elevated to a first priority. The significance is that since priority claims are paid in the stated order of priority, many more of these claims will now be paid. In addition, all other claims arising from property settlement agreement or court-ordered property division are made non-dischargeable, without any kind of balancing test or litigation in bankruptcy court, as is currently required.

The second positive change relates to preference cases. A basic premise of bankruptcy is equal treatment for all similarly situated creditors. Under the law, a payment by a debtor to a creditor within ninety days of the bankruptcy is presumed to be a preferential transfer, subject to recovery by the debtor. This is true even if the debtor owes the creditor money when the bankruptcy is filed. So if a company is owed $100,000 and is paid $25,000 just before the bankruptcy, the debtor can sue to recover the payment. Of course, there are defenses to the preferential transfers. One of the most common is the ordinary course of business defense, which exists to protect creditors who continued to deal with the debtor in the normal fashion in the period leading up to the bankruptcy. Previously, to prevail under the ordinary course of business defense required proof under what were referred to as the “subjective” and “objective” tests. The new law expands the defense such that transfers in payment of a debt incurred in the ordinary course of business may either be made in the ordinary course of business or made according to ordinary business terms. Finally, payments made for domestic support obligations will not be preferences.

The law also changes the venue provisions relating to suits of less than $10,000. Under the current law, such lawsuits can be brought in the jurisdiction where the bankruptcy has been filed. The new law will require that claims of less than $10,000 must be brought in the district where the defendant resides.

This new law also increases the wage priority to $10,000 for wages earned within 180 days prior to bankruptcy and clarifies the priorities regarding contributions to benefit plans.

The Negatives
The linchpin of the legislation is to curtail the abuses “where deadbeats can get out of paying their debt scot-free while honest Americans who play by the rules have to foot the bill.” This assumption, which is based in part on the sheer number of filings, is inconsistent with the facts. While there are abusers in the system, they represent the minority of filers. Harvard Professor Elizabeth Warren noted that more than ninety percent of debtors file due to unemployment or underemployment, an illness, accident or divorce, or a combination of those causes.

In order to attempt to curb the abuses, the new law makes it harder for individuals to file Chapter 7 and receive a discharge of all unsecured debt. If an individual files under the wrong chapter (should file under Chapter 13 and files under Chapter 7), the court can dismiss the case, finding that the individual has “abused” the system. The first test to determine whether the petition was filed under the “correct” chapter is to determine where the individual’s income falls within the state’s median income. In essence, this test looks to see if an individual is better off than half of the individuals in the state. If the individual’s income falls below the median, a Chapter 7 can be filed and there will be no finding of abuse of the system. Each state’s median income is based on the U.S. Census Bureau's latest figures. Pennsylvania's medican income is $43,577.

The second test is referred to as the “means test.” This can be viewed as the “means to pay.” The debtor’s income is defined as the debtor’s current average monthly income over a six-month period reduced by allowed expenses. The definition of income includes money contributed by the debtor’s spouse, even in a non-jointly filed case. Current monthly income is an average of all income received by the debtor, including regular contributions to household expenses made by other persons. The expenses, which then offset the income, are based on the IRS National Standards for clothing, personal care and entertainment (subject to certain exceptions if demonstrated by the debtor). Certain other expenses are calculated using other standards (local, county and regional). The deductions are categorized as follows:

  1. living expenses specified under the IRS standards;
  2. the actual expenses of the debtor in categories recognized by the IRS but to which no specific allowance has been specified;
  3. expenses for protection from family violence;
  4. continued contributions to care for nondependent family members;
  5. actual costs of administering a Chapter 13 plan;
  6. expenses for grade and high school;
  7. additional home energy costs;
  8. 1/60th of all secured debt that will become due in the five years after filing;
  9. 1/60th of all priority debt; and
    continued contributions to tax-exempt charities, up to fifteen percent of gross income.

If the debtor has at least $166.67 in current monthly income available after the allowed deductions, abuse is presumed regardless of the amount of the general unsecured debt. If the debtor has at least $100 of such income, abuse is presumed if the income is sufficient to pay at least twenty-five percent of the debtor’s general unsecured debt over five years.

Earlier this year, ninety-two bankruptcy and commercial law professors authored a letter to Senators Arlen Specter and Patrick Leahy regarding the proposed legislation. The professors posited that the means test “is unnecessary, over-inclusive, painfully inflexible and costly in both financial terms and judicial resources.”

The professors correctly note that the current law permits proper action, including denial of a discharge, to prevent substantial abuse. Over the past few years, the Office of the United States Trustee, including the Office of the Standing Chapter 13 Trustee, have taken a more active and aggressive role in dealing with debtors who abuse the system.

The professors also note that a second problem with the means test is that it will “replace a judicially supervised, flexible process for ferreting out abusive filings with a cumbersome, inflexible standard that can be used by creditors to impose costs on overburdened families, and deprive them of access to a bankruptcy discharge. Any time middle-income debtors have $100/month more income that the IRS would allow a delinquent taxpayer to keep, they must submit themselves to a 60-month repayment plan. Such a plan would yield a mere $6,000 for creditors over 5 years, less costs of administration.”

A third problem is that certain of the amounts allowed for deductions are unrealistic. By way of example is the means test limit of $1,500 for private or parochial school tuition. Since the tuition at most parochial schools exceeds $1,500, the bill would force many struggling families to remove their children from parochial school in order to confirm a Chapter 13 plan.

So while the concept may make some sense, the manner in which it is being accomplished is problematic.

Credit Counseling
The law also provides that no individual may be a debtor unless, within 180 days prior to the filing, he or she received credit counseling from an “approved nonprofit budget and credit counseling agency.” Credit counseling agencies must provide adequate counseling with respect to a client’s credit problems that includes analysis of the client’s current financial condition, factors that caused such financial condition, and how the client can develop a plan to respond to the problems. While the theory of having individuals learn more about dealing with credit prior to filing for bankruptcy sounds good, in practice it is no panacea. First, while there are some legitimate credit counseling agencies, a 2004 Senate subcommittee noted numerous abusive practices. In fact, earlier this year the Federal Trade Commission announced a settlement where three “consumer debt service companies” agreed to pay more than $6 million in consumer referrals for falsely promising “easy debt relief.” While the credit counseling agency must be “approved,” it is not entirely clear how an agency becomes approved. Many credit counseling agencies are set up by the creditors. Does it make sense for those agencies to be approved when the result could be a self-fulfilling prophecy?

At the other end of the spectrum, all Chapter 7 and 13 debtors must complete a financial management course before they receive a discharge. In theory, this course is to assist the individuals in determining why they ended up in bankruptcy and to prevent the problem from recurring. If the fall into bankruptcy was as a result of extraordinary medical costs, a loss of a job or a divorce, it is unclear how the course will address those concerns.

Other Notable Changes
The bankruptcy legislation makes a significant change to the extension of time to assume or reject nonresidential lease of real property. Simply put, upon filing the bankruptcy, a new legal entity is formed, known as “ABC, Debtor in Possession.” One of the opportunities this new legal entity has is to look at all of the existing contracts and decide those it likes, those it does not like and those where it is not yet sure. The contracts the debtor likes are “assumed” and the name of the new legal entity “replaces” the prepetition debtor as the contracting party. The contracts the debtor does not like are “rejected.” The rest temporarily go into the “I don’t know yet” pile. For most contracts, the debtor has until the end of the case to decide in which pile to place the contracts. There is a different rule for leases of nonresidential real property, where, under the current law, a debtor has sixty days to make the decision or there is an automatic rejection. The time frame can be extended upon motion prior to the expiration of the sixty days. Under the new law, there is a 120-day period to assume, which may be extended for an additional ninety days one time for cause. Any additional extensions can be granted only upon written consent of the landlord.

Debts owed to a single creditor totaling more than $500 for luxury goods incurred within ninety days of the filing and cash advances of $750 within seventy days of filing are not discharged. Presumably, someone who takes a $750 cash advance to buy groceries and gas for his car will find that such advances are not discharged.

Another area receiving significant attention (but not in Pennnsylvania) is the reduction of the homestead exemption. An individual Chapter 7 debtor has the right to exempt certain property from the bankruptcy estate. The debtor can elect either the federal exemptions or the state exemptions. Certain states, such as Florida, permit an unlimited homestead exemption. Former baseball commissioner Bowie Kuhn, who also was a name partner in Myerson & Kuhn, moved to Florida after his firm dissolved in 1989. After creditors seized his home in the Hamptons and were about to attach his house in New Jersey, Kuhn acquired a multi-million-dollar home in Florida and protected it from his creditors due to that state’s unlimited homestead exemption. The new law will severely curtail such an action by both requiring the debtor to have lived in the jurisdiction for 730 days and limiting the exemption to $125,000 in a homestead that was acquired within the 1,215 days prior to the filing (subject to certain exceptions and exclusions).

New Duties for Lawyers
The law has many other potential issues. There are additional duties and penalties for attorneys. First, attorneys who represent a consumer debtor may be classified as “Debt Relief Agencies.” If so, a debtor’s counsel may be subject to various types of actions for damages due to failure to comply with the disclosure and record keeping, failure to comply with the advertising requirements, failure to perform any stated services, or filing a document that, with the exercise of reasonable care he or she should have known was untrue and misleading. The types of sanctions include actual damages, injunctive relief, disciplinary actions, loss of fees and payment of costs.

The new law will require a debtor’s attorney to certify as to the accuracy of all factual allegations in the petition and the schedules and statement of financial affairs, subjecting the attorney to sanctions to the extent any factual inaccuracies result in the dismissal of the chapter or its conversion to Chapter 13. This is found in Section 707(b) and references Rule 9011 (the bankruptcy counterpart to Rule 11). This signifies a significant expansion of Rule 9011. Previously, similar to Rule 11, the sanctions were only applicable to a pleading signed by an attorney. The schedules and statement of financial affairs are attested to by the debtor and not the attorney. The petition and schedules are prepared with information supplied by the debtor and the debtor is currently alone responsible for the truthfulness and accuracy of the information. By holding the attorney liable, the bill would force the attorney to independently verify the information contained in the petition and schedules. This could result in the attorney being required to engage in time-consuming and expensive investigations to verify the items listed on the schedules, together with their stated appraised values

It is clear that the new legislation will have two immediate consequences on the consumer debtor bar. First, many attorneys will not want to take the risk of the imposition of sanctions and will stop representing debtors. Second, those attorneys who continue to represent debtors will have to increase their fees to cover the additional obligations.

On March 2, 2005, the Philadelphia Bar Association passed a resolution opposing the law. The resolution states, in part, “Whereas, the certifications that would be required [under the new law] go far beyond the requirements of current Bankruptcy Rule 9011 [and] the certification of client statements provisions…would require the debtor’s attorney to personally certify the accuracy of the client’s bankruptcy schedules, and would hold the attorney personally liable for any inaccuracies in the…schedules that result in the dismissal of a Chapter 7 petition or its conversion to Chapter 13 status…[and]…both the certification of client statements and reaffirmation certification provisions…would force the attorney to hire private investigators and appraisers to independently verify the existence and value of all of the client’s assets…”

The bankruptcy law also dramatically changes the landscape for “small businesses.” Under the current law, a small business (defined as a person engaged in business activities whose aggregate non-contingent liquidated secured and unsecured debts do not exceed $2 million) may elect to be treated under the slightly different provisions of the Code. It appears that this “election” is no longer possible and that all businesses that meet the definition will come under the small business provisions. Among the problems this creates are the possibility that a case could shift from being considered small business back to a regular case and back again to a small business case; numerous reporting requirements, including setting out the profitability, reasonable approximations of the projected cash receipts and disbursements and comparisons of projections to actual receipts; filing financial statements and tax returns within seven days of starting the case; and new deadlines for the exclusive right to file a plan, together with a hard deadline of 300 days to file a plan (unless an order is entered prior to the expiration of the period).

The new bankruptcy law reaches far and wide. This short article doesn’t even touch on healthcare issues, changes in the automatic stay and many other changes that are best described as “inside baseball.” One thing is certain: Over the next six months a cottage industry of lectures and seminars on the new law will sprout and flourish.