Bankruptcy: A Fresh Start ?

Federal Law codifies three (3) types of bankruptcy relief:

  1. Chapter 7 - Liquidation;
  2. Chapter 11 - Debt Reorganization; and
  3. Chapter 13 - Small Debt Reorganization for the Debtor with Regular Income (11. U.S.C.A. §§ 701 et seq., 1101 et seq., and 1301 et seq., respectively).

All would agree that Chapter 7 is the preferable remedy for someone who's broke. Creditors get the non-exempt assets, and that's the end of it. So, consider these questions:

  1. Assume Lawyer A has non-exempt assets of $10,000.00 and consumer debts of $40,000.00 (Christmas presents). Further, assume that Lawyer A has current income of $10,000.00 and essential expenses of $5,000.00, leaving disposable net income of $5,000.00. Most members of the bar would assume that Chapter 7 relief is available to Lawyer A irrespective of his current disposable net income.
  2. Assume Lawyer A has the same assets, debts and disposable net income, but assume that one-half the debt represents income taxes owed to the IRS. Change these assumed facts so that this debt is owed on six (6) VISA accounts used to borrow the money to pay the income taxes. Most members of the bar would opine that there is a different result in the two scenarios because in one instance the income tax obligation is non-dischargable if owed to the IRS for current taxes but dischargeable if owed to VISA even though the money was used to pay the taxes.
  3. Lastly, assume that Lawyer A's debts represent investment losses in the stock market. Most of the membership would conclude that Chapter 7 relief is available to extinguish this type of loss.

The answers to this quiz are:

  1. Wrong assumption in the 8th and 9th Circuits. Maybe right, maybe wrong elsewhere.
  2. Wrong assumption, but this is a trick question.
  3. Right assumption in the 5th Circuit.

Given the simplicity of the statutes it is difficult to understand just how the courts reach differing results. A little history is helpful, at least to a point. Prior to 1984, Chapter 7 relief was available without current income restrictions. Code amendments in that year, however, permitted a bankruptcy court , on its own motion or on the motion of the trustee (as of 1986), to dismiss a Chapter 7 petition if substantial abuse existed and the debts were "primarily consumer debts". See Bankruptcy Code, 11 U.S.C.A. § 707(b). The two (2) key statutory issues are:

  1. the absence of a definition of "substantial abuse", and
  2. the minimal definition of "primary consumer debts".

At the time of adoption of § 707(b), another bill was pending in the Senate designated S. 2000, 97th Cong. 2d Sess. (1982). This Senate Bill provided a formula for the dismissal of Chapter 7 proceeding if the debtor had sufficient current income to fund a Chapter 13 plan (§ 707 (b) was actually carved from a Senate Bill which contained provisions similar to S. 2000. See S. 445, 98th Cong. 1st Sess. (1983)). Both pieces of legislation were advocated by the credit card industry which at that time was taking a licking. The adoption of § 707(b) and the rejection of S. 2000, as well as the pertinent portions of S. 465, which provided for mandatory Chapter 13 application, provide strong evidence that the ability to fund a Chapter 13 plan, standing alone, is insufficient to constitute "substantial abuse".

Substantial Abuse

While there are judicial interpretations to the contrary, See U.S. Trustee v. Harris, 960 F.2d 74 (8th Cir. 1992); In re Kelly, 841 F.2d 908, 913 (9th Cir. 1988), an equal number of courts have rejected the "ability to fund" test as the yard-mark for "substantial abuse". See e.g., In re Green, 934 F. 2d 568 (4th Cir. 1991). In general the bankruptcy court will examine the circumstances giving rise to the inability to pay the debt. If that inability relates to an illness, loss of employment, or other type of calamity, "substantial abuse" will not be found. See Green, supra, 934 F. 2d at 572; In re Heasley, 217 B.R. 82 (Bkrptsy, N.D. Texas 1998); In re Herbst, 95 B.R. 98 (W.D. Wisc. 1988); In re Kress, 57 B.R. 874 (Bkrptcy, D.N.D. 1985).

In a curious attempt to divine legislative intent, those courts opting for the harsher approach have looked for guidance at legislative history and floor debates relating to legislation which was not adopted. In re Pilgram, 135 B.R. 314 (C.D. III 1992), is such a case. The court observed:

"Although the term "substantial abuse" is not defined in the Bankruptcy Code, and is not dealt with expressly in the legislative history, the Trustee reviews the events leading up to the enactment of § 707(b) which lend support to his interpretation of this provision. Before final passage in *317 1984, the proposed amendments contained a "future income threshold test" and a consumer counseling system which were removed from the final version of the bill. These amendments were aimed specifically at debtors who could repay a reasonable portion of their debts. See Trustee's brief p. 4. Although these particular proposals failed to carry sufficient support to be included in the final bill, the Trustee reminds the court that the impetus behind these proposals remains relevant." Id at 317.

I can think of no other situation where the legislative rejection of a provision was found to constitute proof that Congress intended the rejected principles to apply in any event. Similarly, the Kelly court used inverted logic to define substantial abuse by referring to language from a Senate Committee Report on S. 445, that it would a substantial abuse of Chapter 7 if the debtor could pay his debts without difficulty. Kelly, supra, 841 F.2d at 914. But it is clear that Congress rejected the provision being discussed by the committee. And there appears to be no justification for the assumption that a definition of substantial abuse can materialize from this Report by simply switching the order of the words. On balance, Kelly, Harris, and Pilgram seem wrongly decided.

Of course the debtor's obligations must be primarily consumer debts to permit dismissal under the statute. The Fifth Circuit, at least, has provided a working definition for "primarily". That court requires that the consumer debts both in number and amount account for more than 50% of the debt. See In re Booth, 858 F. 2d 1051, 1055 (5th Cir. 1988). That same court also determined that the nature of the underlying debt would be determined by the use of the funds, not the source of the funds. Id at 1055. Thus, a cash advance on a credit card to pay a business debt is treated as a business debt not a consumer debt in this circuit. Elsewhere the issue is unresolved.

Consumer Debt

But what is a "consumer debt"? Under the statute, 11 U.S.C.A. § 101(7), and the legislative history, consumer debt is defined as a debt incurred primarily for personal, family or household use. Interpretation of the term has led to many diverse results. For example, state and local taxes, income taxes and tax penalties are considered to be non-consumer debts, and money borrowed to invest in market index options has also been determined to be a non-consumer debt. On the other hand, any debt created in the divorce court which reflects a spouse's interest in the other spouse's business is said to be a consumer debt. See In re Shands, 63 B.R. 121 (Bkrptcy, E.D. Mich. 1985); See also In re Stewart, 215 B.R. 456 (Bkrptsy Panel, 10th Cir. 1997). A rather startling interpretation of "consumer debt" is found in In re Berndt, 127 B.R. 222 (Bkrptsy, D.N.D. 1991). There the issue was whether investments in the stock market should be classified as consumer debt. Because the investments were not in furtherance of "ongoing business requirements" the court found them to be a consumer debt like any resulting from "gambling, hobby or whim". Id at 224. The court attempted to characterize In re Booth, supra, as an example of non-consumer debts having been incurred in "furtherance of business requirements".

The fact is that much of the debt characterized as non-consumer by the Fifth Circuit was incurred to PURCHASE a marina not operate an existing marina. Id at 1053. Indeed the bankrupts in Booth were physicians and there was no suggestion that they were even involved in the ongoing operation of the marina. Booth says that a debt created in a transaction entered into for profit will not be classified a consumer debt. Id at 1054-55. Berndt is inconsistent with Booth as well as In re Alemendinger, 56 B.R. 97 (Bkrptcy, N.D. Ohio 1985), and In re Costantina, 72 B.R. 189 (Bkrptcy, D.S.C. 1986). While it is true that the bankrupt in Alemendinger was a stockbroker, his losses occurred from his personal investments in the market not the operation of his brokerage business. And in Costantina the market-index option investor was a business manager of a hospital, and the court nevertheless found the debt to be non-consumer. Constantina, supra, at 192. The ultimate resolution of the issue awaits Supreme Court action, although the dearth of decided case doesn't bode well for early resolution. See Anno, 101 A.L.R. Fed. 771 (1991).

Unresolved Issues

There remain a number of other issues also unresolved. For example:

  1. Is the fact that unsecured debt exceeds $250,000.00 mean that dismissal is improper since this amount exceeds the maximum permitted in Chapter 13 proceedings? In re Wegner, 91 B.R. 854 (Bkrptcy, D. Minn. 1988), suggests that it is. Wegner, however was predicated on Wamsganz v. Boatmen's Bank of DeSoto, 804 F.2d 503 (8th Cir. 1986), which erroneously held that Chapter 11 was available only to those in business.
  2. Is the expense of a Chapter 11 proceeding a deterrent to a consumer debtor's invocation of this Chapter which protects both disposable income as well as non-exempt assets? Certainly an interesting question for a high-income consumer.

One last caveat. Consumer debt for luxury goods or services or extensions of credit under an open-ended credit plan in excess of $1,000.00 and incurred within sixty (60) days of the bankruptcy filing are "presumed" to be non-dischargeable. See 11 U.S.C.A. § 523 (a)(2)(C). The creditor, however, will file such a protest at his peril. The Code provides recoupment of fees and expenses by the debtor if the challenge fails. 11 U.S.C.A. § 523(d).