Bankruptcy Reform Is Here
At one time a Chapter 7 filing let debtors off the hook—no more.
EXECUTIVE SUMMARY
LAWRENCE S. CLARK, JD, LLM, is dean of the Cameron School of Business at the University of North Carolina (UNC) in Wilmington and lead author of the McGraw-Hill Law and Business textbook series. His e-mail address is clarkl@uncw.edu . RANDALL HANSON, JD, LLM, chairman of the department of accountancy and business law at UNC, has practiced law and has written more than 70 articles. His e-mail address is hansonr@uncw.edu . JAMES K. SMITH, CPA, JD, PhD, is an associate professor of accounting at the University of San Diego. He has practiced as a tax attorney and CPA and has written more than 30 articles. His e-mail address is smithj@sandiego.edu .
he ease with which debtors have been able to walk away from debt has frustrated creditors for years. But all that changed last April when President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 into law. Most provisions became effective last month. The legislation—in the works for eight years—is the result of intense lobbying, mainly by banks and credit card companies. Now debtors with severe financial problems will find it harder to secure relief, and many consumer-protection groups fear that restricted access to Chapter 7 will unfairly hurt individuals whose impoverishment results from calamities like Katrina and Rita. CPAs need to understand the changes so they can advise clients. This article will bring them up to date.
THE KEY CHAPTERS
To grasp the impact of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, it helps to understand the characteristics of the three most common forms of bankruptcy: Chapter 7 (liquidations), Chapter 11 (reorganizations) and Chapter 13 (adjustments). Traditionally Chapter 7 discharged most debts completely, allowing debtors to secure a fresh start. Many creditors have viewed it as an invitation to abuse.
Chapters 11 and 13 essentially are unchanged under the new law. Chapter 11 lets a troubled business reorganize and develop a recovery plan; it holds off creditors while the plan is implemented. Chapter 13 lets wage earners develop a recovery plan but doesn’t discharge significant debts. The goal of 11 and 13, which are more creditor-friendly than Chapter 7, has been to help troubled debtors develop realistic payment plans, become financially stable and repay their debt.
| Too Easy? About 1.6 million debtors—representing 70% of all Source: American Bankruptcy Law Institute, www.abiworld.org . |
THE CHAPTER 7 PROCESS
The primary feature of the new legislation is that distressed individuals no longer have free access to Chapter 7’s easy discharge of debt. Now, debtors must undergo a “means test” and credit counseling to assess whether to permit them to choose Chapter 7 relief. As a result, many individual debtors likely will be funneled into Chapter 13, which requires them to repay their debt over time.
To obtain Chapter 7 relief, a debtor files a petition with the bankruptcy court. For eligible debtors (formerly both businesses and individuals, now businesses and some individuals) the process is not much changed. The court appoints a trustee to represent creditors and act as an independent party responsible to the court. The debtor is required to turn over all nonexempt assets to the trustee and to list all creditors so they can be notified of the bankruptcy filing (see “ No Privacy in Bankruptcy ”). The creditors have to file a claim for the amount they are owed.
Trustees have a number of powers to protect creditors. They can request the return of preferential payments to favored vendors and can set aside fraudulent transfers intended to hide assets. Trustees also can seize inheritances to which the debtor becomes entitled within 180 days of a Chapter 7 filing. After accumulating all assets, trustees distribute any monies obtained according to priority-distribution rules. Paid first are secured parties, administrative costs, unpaid wages and pension obligations, alimony and child support and taxes; finally, general unsecured parties are paid pro rata.
Debtors are allowed to keep exempt assets to help them start over. The exemptions vary from state to state, but generally include a homestead exemption and an exemption for a car, tools and specified personal property.
CHAPTER 11 RELIEF
Businesses undergoing hard times can file under Chapter 7 or 11. While Chapter 7 provides for a liquidation Chapter 11 is designed to protect businesses whose distress can be corrected. It assumes a business can be rehabilitated given a viable recovery plan and a modified payment schedule.
Once a business files for Chapter 11 with the bankruptcy court creditors must temporarily refrain from attempting to collect debts. For the first 120 days after filing, the business has the right to work out a viable recovery plan proposal. If it does not succeed, the creditors step in to submit one. The bankruptcy judge has the authority to approve a plan. Typically the court won’t appoint a trustee to manage the business, and the same people continue under the new plan except that the bankruptcy judge supervises and approves certain expenditures and business decisions. The judge has the power to convert to a Chapter 7 bankruptcy if there is no hope of saving the business. Many large entities have gone into Chapter 11 and come out strong vibrant businesses.
CHAPTER 13 RELIEF
Chapter 13 allows financially distressed individual debtors to create a court-supervised five-year repayment plan (formerly a three- to five-year program). During the specified period the debtor pays a portion of his or her disposable income to the trustee, who then pays the creditors. Payment schedules can be modified under Chapter 13, and some obligations can be fully discharged. Debtors get to keep some property rather than turning it all over to a trustee. Creditors have always preferred Chapter 13 since the debtor strives to repay a significant portion of his or her obligations. Chapter 13 is better for creditors than Chapter 7, but almost two out of three Chapter 13 filers ultimately fail to fulfill their plan according to the American Bankruptcy Institute.
NEW LEGISLATION: CONSUMER BANKRUPTCIES
The two most important changes to the U.S. Bankruptcy Code are the terms of access to Chapter 7 and changes to the homestead exemption provisions.
Access to Chapter 7. Under the new legislation businesses still can seek Chapter 7 relief without undergoing a means test; individual debtors must undergo a means test to qualify. People who don’t qualify go into Chapter 13 plans, and most will have a five-year period to repay debts. Only a limited group of debtors can obtain a discharge and a fresh start as easily as before.
A person in financial trouble now has to undergo financial counseling and a budget analysis from a court-approved nonprofit agency within six months of filing for bankruptcy protection. In some cases counseling may enable debtors to develop their own informal rehabilitation plan. If debtors still wish to proceed into bankruptcy court, the next step is determining whether their income exceeds the state median. Debtors with income below the median for their home state can proceed to Chapter 7 (assuming creditors don’t challenge and there are no existing issues or actions regarding potential fraud).
Previously debtors and bankruptcy judges could choose the chapter of the code under which to file. Now if a debtor has an above-median income, he or she must proceed to a means test. The law presumes “abuse” is likely if a debtor’s current monthly income (as determined by the previous six-month average) less secured payments divided by 60, less priority debts divided by 60, less the allowed expenses per region permitted by the IRS, less certain other allowed expenses is greater than $100 a month.
The means test, which takes place under the supervision of the debtor’s attorney, deducts standardized living and housing payments from the debtor’s monthly income; then transportation costs based on IRS tables; then monthly health insurance costs; then secured payments on automobiles over 60 months. If the gross monthly income minus those deductions leaves $100 or more, the debtor will be denied Chapter 7 relief. That is, if debtors can pay $6,000 over five years toward creditors’ claims they must set up a payment schedule under Chapter 13.
Debtors can rebut the presumption of abuse only by demonstrating special circumstances that justify expenditure or income adjustments. The legislation doesn’t define those special circumstances, so it isn’t clear how much latitude courts will give debtors to challenge a monthly income calculation that is skewed or in which ongoing catastrophic health expenses have in effect become “usual.”
In calculating a debtor’s secured debt obligations, bankruptcy courts formerly divided the debt so that only the fair value (generally the depreciated value) was considered secured; the remainder was considered unsecured. Under the new law, all loans secured by property within one year before bankruptcy and for vehicles in the 910 days before bankruptcy must be paid in their entirety. This may have the unintended consequence of leaving the debtor insufficient income to proceed under Chapter 13.
Before debtors can complete either a Chapter 7 or 13 bankruptcy action and receive a discharge, they have to complete a financial management course.
Homestead exemption changes. Exemptions are very important; under Chapter 7 debtors can keep exempt property but must turn over all nonexempt property to the trustee. Although bankruptcy law is federal, each state is allowed to specify exemptions. The most important exemption is the homestead because typically it is the debtor’s biggest asset. Debtors under Chapter 7 can keep their home, subject to the size of the state homestead exemption, which can vary dramatically. For example, the homestead exemption is $5,000 in Alabama, but it’s unlimited in Florida and Texas. A $5 million Florida home is fully protected from creditor claims, while an Alabama home is protected only up to $5,000. Debtors must keep mortgages on the homestead current or the lender will foreclose.
Under the new law debtors can’t evade obligations by moving to a state with a better homestead exemption. A person is eligible for a state homestead exemption only if he or she has lived in that state for at least two years before claiming bankruptcy; if not, the former state’s exemption likely will apply. If the debtor has engaged in specified criminal acts, the exemption will be capped at $125,000 even if the state homestead exemption is higher.
Longer Chapter 13 plans. Previously Chapter 13 debt-repayment plans ranged from a three-year minimum to five years; now they are a mandatory five years. Debtors prepare and submit their payment schedules to the judge, who reviews and approves them. The new system takes longer and is more cumbersome to administer. It may require significant new resources such as appointment of more bankruptcy judges to handle the increased caseload and additional supervision.
New documentation requirements. Debtors need to provide a certificate of credit counseling, evidence of recent wages, a statement of monthly net income and expenses, a tax return for the most recent year and a photo ID. A controversial new requirement of the act is that attorneys must verify debtor information is correct and “grounded in fact.” Because there are liability implications in this requirement, some practitioners think many attorneys will cease to represent individual debtors and that those who do will raise fees substantially. Attorneys also are required to generate additional notices to clients about bankruptcy procedures and recordkeeping responsibilities.
Longer Chapter 7 filing interval. Under the old law a person was permitted to file for Chapter 7 relief every six full years. The interval under the new act is eight.
More nondischargeable debts. The debts that could not be discharged formerly were child support/alimony, some tax obligations, debts incurred by fraud or malicious activities, most student loans, judgments incurred due to driving under the influence of alcohol and government fines. New provisions expand the list. Included are student loans from private as well as government bodies; last-minute debts incurred right before filing for bankruptcy; credit purchases of $500 or more for luxury goods or services made within 90 days of filing; and loans of more than $750 taken within 70 days before filing.
Evictions of residential tenants in bankruptcy. The new act affects clients who are landlords. Under the old law, a bankruptcy petition stopped eviction proceedings. Now a landlord may be able to evict tenants who are not in compliance with the rental agreement even if the tenant files for bankruptcy. Eviction proceedings can continue if the landlord obtained a judgment of eviction prior to the debtor’s bankruptcy filing. A landlord that doesn’t have a prior eviction judgment may evict if the property is endangered or if drug activities occurred on the premises within 30 days before the debtor filed for bankruptcy.
The new law also creates a number of changes for businesses seeking bankruptcy protection.
Nonresidential real property leases. Old rules gave businesses 60 days after commencing a bankruptcy to assume or reject nonresidential property leases. The new legislation changes the time limit for the debtor’s decision: Nonresidential property leases must be assumed or rejected within 120 days after commencement of the case. An extension of 90 days is permitted, but further extensions require the written consent of the landlord. The net result is that businesses have only 210 days to decide whether to retain leased nonresidential real property. Retail businesses will be severely affected by this change.
Exclusivity period. The new rules place a limit on the time period during which a debtor has exclusive rights to propose a Chapter 11 bankruptcy plan. Old rules had no limitations on the number of extensions a court could grant a debtor. Under the new rules the exclusivity period may not extend beyond 18 months from the date of the bankruptcy petition. After that any interested parties may propose a bankruptcy plan, which could give creditor committees more power to dictate terms as the 18-month time limit approaches.
Executive compensation. The new bankruptcy rules attempt to curtail a business debtor’s ability to pay key employees retention bonuses, severance payments and other payments that could be construed as unethical. Retention payments to insiders (officers and directors) of the debtor are subject to a number of constraints, including the requirement that they’re needed to retain people who have received a bona fide job offer. Businesses need to check the rules before committing to any payment promise to executives and other key insiders.
Utilities. The new rules increase the likelihood that utility companies will be paid for services provided after a business files for bankruptcy. The old rules prevented a utility from discontinuing service to a business in bankruptcy protection. The business had to provide only “adequate assurance” that it would pay utility bills, a phrase courts liberally interpreted in favor of the debtor. The new rules limit “adequate assurance” to cash deposits and letters of credit or a form of assurance upon which both the utility and debtor agree. Businesses will have to budget for their postpetition utility bills.
REMEDIAL ACTION
The new bankruptcy reform legislation changes the psychology of debt in addition to the law. About 1.6 million people filed for Chapter 7 relief last year, and it will be interesting to see whether legal reforms bring that number down when debtors no longer can easily access Chapter 7 and its discharge of debts. Consumer protection groups say the reform legislation is slanted in favor of the credit industry and doesn’t protect consumers. The credit industry shares blame, they say, for unsolicited marketing of preapproved credit that may lure people into living beyond their means. Many are concerned that vulnerable groups such as the poor, the elderly and the sick no longer will be able to obtain bankruptcy protection. Additional changes are likely if the reforms prove unjustly burdensome and the cure turns out to be worse than the condition it was meant to correct. 
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