National Adequate Protection Debate and the 1½ Percent Solution? Three Principles and Two Cases
Author’s Note: A famous Holmes book—Sherlock, not Oliver Wendell—is titled The 7% Solution. In this piece, we have borrowed from that title to point out that some recent case law under 11 U.S.C. §1326 seems inclined to a rather Holmesian solution to adequate protection—”The 1 ½ Percent Solution.” This article points out that such neatly crafted mathematical solutions for adequate protection do not work, or at least do not work fairly—for, as Holmes stated—Oliver Wendell, not Sherlock—”The life of the law has not been logic; it has been experience.”
Pursuant to 11 U.S.C. §§1325(a)(5)(B)(iii)(I), added by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), for a chapter 13 plan to be confirmed, adequate protection payments are required “in equal monthly amounts” for claims secured by personal property. Pursuant to new §1326(a)(1)(C), payments must commence within 30 days of the order for relief.
This article reviews two decisions related to the amount and timing of adequate protection payments post-BAPCPA; Fin. Md. LLC v Smith (In re Smith), 355 B.R. 519 (Bankr. D. Md. 2006), and In re Desardi, 340 B.R. 790 (Bankr. S.D. Tex., 2006). These cases form the current “polar extremes.” This author suggests that Smith is the more correct interpretation of the statute, and bases this position on three concepts closely related to adequate protection.
Three Principles of Adequate Protection
1. Depreciation is happening daily and at different rates.
2. With BAPCPA, Congress has enacted a “no leap-frogging” statute, 11 U.S.C. §1326, meaning that no class of creditor may be paid ahead of a subordinate class, and therefore the priority system for administrative expenses may not jump ahead of secured claims.
3. In adequate protection, “timing is everything.” Specifically, a dollar next month is not the same as a dollar today. (i.e., the concept of present value).[1]
It is axiomatic that personal property collateral depreciates over time, though at different rates depending on the property itself and economic conditions. Because of the concept of the time value of money, creditors have long lamented that adequate protection payments that do not commence at or near the petition date do not adequately protect their interest, in particular considering the dismal success rate of chapter 13 cases.[2] Thus, the timing of adequate protection is a crucial feature to its effectiveness at neutralizing depreciation, i.e., being adequate.
In Smith, supra, a creditor moved to dismiss the debtor’s case for failure to commence making adequate protection payments. The debtor argued that because the creditor had obtained a judgment against the debtor pre-petition, the creditor was not entitled to adequate-protection payments. The court ruled that when the creditor obtained a judgment pre-petition, the entire amount of the claim became due before the petition date. Thus, the creditor was not entitled to receive adequate-protection payments for any “portion of the obligation that becomes due after the order for relief … under §1326(a)(1)(C).”
In its discussion, the court reviews the statutory language of §1325 and §1326 (post-BAPCPA) and, as is usual in statutory interpretation, tries to directly apply the language of the statute. In doing so, the court interprets §1326 to direct that for adequate protection to be “adequate,” it must be consistent and ongoing. In doing so, it stated, “The secured claim is proposed to be dealt with in a manner permitted under §1325(a)(5)(B) and (C). These provisions allow a debtor to pay the entire secured claim by a plan funded in equal installments over the duration of the plan with periodic distribution by the trustee to claimants. Where the claim is secured by personal property, the amount of such periodic distribution must be sufficient to provide the holder of the claim adequate protection during the period of the plan. 11 U.S.C. §1325(a)(5)(B)(iii)(II). Thus, a creditor in the situation of the movant in this case can also enforce adequate protection by objecting to a plan that does not provide a level of payments which would constitute adequate protection.” Smith, supra at 524-525 (Emphasis added).
To the author, this does not seem like a revolutionary principle but rather one that is intuitive. Based on the very dictionary definition of the words “adequate” and “protection,” consistent, fair payment is required to counter depreciation. However, more than keeping up with depreciation is required. In the face of depreciating collateral, if protection is not immediate and ongoing, it can hardly be “adequate.” In furthering this goal, Congress also mandated prompt confirmation of chapter 13 plans. See 11 U.S.C. §1324(b).
The Smith court notes that a plan that does not propose to pay a timely, adequate amount to a creditor is not subject to confirmation under §1325 in the first instance, and further, a plan that fails to commence payments in a timely manner is now subject to dismissal under §1307(c)(4).[3]
How Adequate Is Adequate?
Prior to BAPCPA, adequate protection for personal property had, to quote Judge Isgur’s term, “failed.” (i.e., arguably; payments had not fully protected the creditor’s contractual property rights.) However, this lack of protection was not universal. In the real estate mortgage arena, adequate protection on residences rarely “failed” because of the protection Congress has given under §1322 to first mortgage liens. Yet other creditors, specifically those secured by personal property, have not been as lucky. For instance, it was not unusual pre-BAPCPA to have a proposed adequate-protection payment (on, say, a late-model high-end truck) be a small fraction of the amount due under state law on the vehicle. The contrast with monthly real estate mortgage payments here is a stark one. The small (and late) payments received by personal property lenders did not adequately protect them. This was particularly so for a vehicle, such as our truck, that is more subject to either high use or abuse, or perhaps both.
The Smith court held that the provisions of §1325 and, under the right circumstances, §1326, though not always easy to discern under BAPCPA, were clearly discernable here. It was intended that if collateral were to be kept by debtors in chapter 13, they would pay adequate funds not only to meet depreciation, but also to adequately protect creditors who suffer from chapter 13’s ill effects. Otherwise, the property was to be returned to allow realization on the collateral security.
Enter Desardi
In Desardi, supra, the court took on the issues of both timing and priority of adequate-protection payments, as well as the appropriate interest rate for 910 car claims. Unfortunately, Desardi completely ignores the second principle, i.e., the “no leap-frogging” rules that Congress placed throughout BAPCPA, specifically in §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C) (e.g., where DSO obligations are now ahead of all other claims to address prior concerns about unpaid support[4]).
Section 1326(a)(1)(C) makes it clear that irrespective of the plan administrative expense regime, somebody (debtor or trustee) has to immediately begin meaningful adequate protection or the debtor faces dismissal or relief. Nevertheless, the Texas court in Desardi has rejected this process; rather, there, the court found that Congress did not say anything about when payments to secured creditors need start. Desardi further advocates a 1½ percent “solution” as adequate for protection in all cases.[5] Apparently, the Desardi court believed that all vehicles depreciate at the amount of 1½ percent per month. Local rule or not, it would therefore appear that the Desardi court believes that there is no time value to money, or not much anyway, because its holding allowed adequate protection to commence later in the case, forcing the secured creditor to bear the entire risk of nonpayment.
The 1½ percent solution is arbitrary and not rooted to a fair system of repayment; even its math is questionable.[6] Such an analysis seems to ignore the fact that there is a time value to money and that the personal property being used is depreciating, although at varying rates, as is suggested herein. Further, this depreciation can only fairly be met through timely payments of adequate protection. This is what Congress seemed to be saying in §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C).
The U.S. Supreme Court analyzed this adequacy issue, although in a different framework, and hit the nail right on the head. In the case of Till v. SCS Credit Corp., 124 S. Ct. 1951, 158 L. Ed. 2d 787, 541 U.S. 465 (S.Ct. 2004), the court struggled with setting a fair discount rate for payments by a debtor in chapter 13 on an under secured claim. As will be recalled in Till, the court set the “prime rate plus the risk factor” and reiterated that the reason for the payment stream, after all, is grounded in a constitutional property rights analysis. Adequate protection, and the income stream it supports, is a substitute for the creditor’s property that is being kept from them during the pendency of the case. Because the creditor is entitled to either the property or payment, the Till court reached a compromise, allowing an adjustment factor for risk and allowed the parties to prove up that risk. Desardi’s analysis ignores variable risk.[7]
With BAPCPA, the concept of adequate protection drastically changed, from a prior–to-confirmation analysis (all risk on the secured creditor) to the Till-oriented analysis of spreading the default risk to all parties in the case throughout the pendency of the plan. To pass constitutional muster now, adequate protection must not only be adequate until the time of confirmation, it must be adequate throughout the entire term of the plan.
As appeared to be the case in Desardi, in many cases it is no secret that the reason adequate protection payments are withheld decreased or “stair-stepped” is to pay attorney’s fees, although an accelerated mortgage cure or a tax claim could just as easily be present. While it is certainly understandable that the debtors’ counsel, or any creditor, might want to “front load” the plans and be paid as quickly as possible, it is a real policy concern as to whether or not that is appropriate or equitable. For instance, why shouldn’t the itinerant mortgage creditor or debtor’s attorney share the risk of default along with all the other parties as Till seems to dictate?[8] In a Desardi front-loaded plan, there is considerably less risk to the debtor’s counsel being paid than a plan where debtor’s counsel and all secured creditors get a substantial level payment over time. However, §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C) contain a clear policy of “no leap-frogging” and will lead to equitable treatment.
Yet Desardi clearly comes down on the side of withholding payments to the secured creditor, resulting in a front-loaded plan paying debtor’s counsel or other special parties first. Frequently, the creditor loses in this depreciation equation. If one looks at the other changes with regard to priority that were also passed with BAPCPA, such as the revised administrative expense treatment for unpaid alimony and child support (DSO), it would seem that the existence of these legislative exceptions could also, by their very nature, demand consistent monthly payments. Congress has mandated that child support and alimony are priorities and therefore must be paid first. It seems inconsistent to suggest that these important payments can be retarded, for example, six, eight or more months, while tax claimants or debtor’s counsel or other preferred claims might get paid in full. There are certainly other reasons the debtor might want to retard payment to unsecured or secured creditors- i.e., there could be nondischargeable debts, or the debtor may wish to cure a mortgage on real estate or pay taxes. There are literally as many reasons for the delayed payment as there are types of debt. However, Congress, in changing the law and requiring prompt payment in §1326(a)(1)(C), has made a clear policy decision. The Desardi ruling with its form of analysis seems to have either given this policy less importance, or ignored it completely. The Desardi court holds that car creditors are to be paid before debtor’s counsel, but this is cold comfort if all payments are held until confirmation and then disbursed on the 1½ percent basis.
The Smith Solution
In Smith on the other hand, the court attempts to apply amended §§1325 and 1326 language and states that adequate protection must be paid every month for it to be adequate and consistent. Smith also reiterates a secured creditor’s right to relief in the absence of such payments. It held that although a dismissal motion was denied, in chapter 13 plans, adequate protection payments must begin within the 30 days after filing, and continue, for any creditor with a right to receive adequate protection payments that became due after the relief order. Otherwise, the debtor may face relief or dismissal under 11 U.S.C. §1307(c)(4).[9]
The Desardi court finds nothing in 11 U.S.C. §1326 mandating when secured creditors must be paid adequate protection. It holds that other claims may be paid before adequate protection per 11 U.S.C. §§507 and 503(b), allowing some claims not mandated by Congress to be paid first, to the prejudice of all other creditors. Smith holds that this violates 11 U.S.C. §§1326 and 1307(c)(4), and will lead to unnecessary relief motions.[10]The Desardi 1½ percent solution to balance these payments is no “solution” at all but rather a “watering down” of 11 U.S.C. §1326’s new requirement. It is an attempt to put “old wine in new bottles” and return to the pre-Code status that Congress rejected. Smith upholds the concept of immediate level payment to provide adequate protection, or risk dismissal. This is consistent with the Code and the legislative intent of 11 U.S.C. §§1325 and 1326, under the BAPCPA changes.
Should Adequate Protection Be an Administrative Expense?
One recent commentator, when discussing DeSardi, indicated that an argument exists that delayed §1326(a) adequate protection payments may qualify as administrative expenses. And why not? As Carlson puts it:
… His justification is that car lenders can be paid immediately upon confirmation because adequate protection is an administrative expense of the bankruptcy estate. “Debtors in chapter 13 often need their vehicles to drive to work, which in turn allows for preservation of the estate.” [n. omitted].
…According to Judge Isgur, not only is depreciation an administrative expense but a superpriority administrative expense, thanks to §507(b)[n. omitted]. On this premise, the car lender should outrank the other administrative creditors and should receive the first distributions from the chapter 13 trustee’s funds.
…But in chapter 13, all we learn is that the administrative creditors can be paid over time (but must be paid in full). [n. omitted]. This rule does not mention §507(b), but presumably it too can be paid over time. Meanwhile there is no reason to suppose other creditors cannot be paid before the §507(b) claim is fully paid. [n. omitted].
…Yet §1326(b) requires that administrative creditors be paid before the ex-spouse. [n. omitted]. If this is so, it is hard to see how the invocation of §507(b) justifies senior adequate protection payments for car lenders. [n. omitted].
Judge Isgur’s conclusion requires the view that, if depreciation exceeds the secured claim at any time, adequate protection has “failed,” thereby triggering the remedy of the §507(b) superpriority. [n. omitted].
…Sometimes, attorneys and other professionals are given provisional payments under Bankruptcy Code §330, but later it turns out the bankruptcy estate is not large enough to pay all the administrative creditors. In such cases, at least some courts are prepared to call back the interim compensation so that the professionals have to share the loss pro rata with the other administrative creditors. [n. omitted]. But, if adequate protection payments are administrative claims, then these too would have to be called back, in case of shortfall. No one would dream of requiring this, yet it is the consequence of terming adequate protection an administrative expense of the bankruptcy estate. Per this reductio ad absurdum, adequate protection cannot be founded on administrative priority. [n. omitted].
Carlson, David G., "Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code," 14 Number 2 Am. Bankr. Inst. L. Rev. 301, pp. 327-330, (Winter 2006).
This article argues that all pat formulae such as the 1½ percent solution are suspect, if not patently unconstitutional. However, for those who need a formula to approach the adequate protection issue, this author suggests the following one as more tied to the depreciation experienced:
Adequate Protection = Claim Principal x Discount Rate ÷ Applicable Commitment Period.
This formula reflects the principle that depreciation happens at different rates. This formula has much to recommend it. First, it is simple. Second, it reflects the statute. Third, it lends itself to plan completion. It is based on the repayment of the income stream in the amount of the claim over time. It is not based on an arbitrary number; but rather on the amount required to be repaid at an agreed interest or discount rate per Till. It also subsumes the amount required to repay the creditor for the collateral over time per §1325(a)(5) in a confirmable plan. This is not new; it is textbook chapter 11 fare. The collateral’s value, paid at a fair discount rate for the time value of money. It need be no more complicated than this.
Conclusion
Smith and Desardi each provide a lens through which to view adequate protection. Although not harmonizing with the new Code, the comparison with an administrative expense analysis focuses the issue. Congress did not wish to give secured creditors too favorable treatment, as an administrative expense might provide, but did require “fair” treatment as set out by Smith.
BAPCPA and experience dictate that the amount of the monthly payment to the plan should start immediately, and in an amount that will compensate for depreciation over the entire plan. The 1½ percent solution is arbitrary and does not reflect the experience of chapter 13 cases.
The national adequate protection debate must be solved in a fair but practical manner. To find some way to “frontload” the plan for any creditor for any reason is, per se, prejudicial to others unless Congress has approved the discrimination such as with the treatment of domestic support obligations. If anyone is being paid first, or at a more rapid rate than the plan can amortize, chapter 13 nationally will not harmonize the rights of all parties and may continue to experience its current completion rate, one that we all believe can and should be better.
[1] For those who need formulae: present value is PV=FV/(l+r)n, where PV is the present value, FV is the value at time “n,” r is the rate to be compounded each period and n is the number of periods.
[2] Carlson, David G.,"Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code," 14 Number 2 Am. Bankr. Inst. L. Rev. 301, (Winter 2006), see page 381, n. 494, (37-60%).
[3] See, Smith, supra at 521, 523.
[4] 11 U.S.C. §507(a)(1).
[5] As the opinion recites, the 1½ percent figure followed by the Desardi court is ordained by local rule 4001. The Fifth Circuit invalidated a similar formula rule in In re Smithwick, 121 F.3d 211 (5th Cir. 1997).
[6] See Carlson, supra, at note 356, which states in applying the Desardi rule, which is now part of the Local Rule: “Actually, the $300 straight-line depreciation is 1.5 percent only for the first month. In the second month, it is 15.22 percent, because the numerator of $300 stays constant while the denominator decreases to $19,700. The local rule in question does require payments of 1.5 percent per month, which, if taken literally, would constitute $300 only in the first month and lesser amounts thereafter. Under the local rule read literally, the car never loses all its value.”
[7] The local rule also contains a 10-day notice provision of the setting of this adequate protection, but the 1½ percent figure is the basis of the amount applied.
[8] This risk sharing also requires debtors’ counsel to take a closer look at cases she is filing choosing those with a chance to complete, not just a chance to go five months to pay fees, or a preferred creditor.
[9] In Smith, under the facts 11 U.S.C. §1326(a)(1)(C) did not apply because a judgment had been obtained pre-petition and it was not being decelerated. Thus, although Smith explains the proper application of 11 U.S.C. §§1325 and 1326, its explanation of §1326’s broader effect is arguably obiter dictum.
[10] 11 U.S.C. §1307(c)(4) itself was not new law. Failure to make payments is a historic ground for dismissal.
Hit the Road Jack! Is It Easier to Evict a Residential Tenant after BAPCPA?
Almost two years after the implementation of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), it would appear that some of its provisions are meeting their objectives better than others. In the case of residential tenancy issues, the number of new disclosure requirements, coupled with submissions required to overcome the exceptions to the automatic stay, have had their intended effect. In reviewing this particular area of BAPCPA, the number of reported cases is scant, reflecting the limited issues subject to challenge.
With regard to the treatment accorded residential tenancy issues, where a judgment for possession has not been entered pre-petition, the state of the law remains unchanged. With regard to cases where the judgment for possession in the debtor’s residence has been entered pre-petition, the amendments and modifications brought about by BAPCPA have had a marked impact on the number of cases filed with the principal goal of retaining an interest in a residential lease.[1]
Residential Tenancy—Interplay between BAPCPA and State Law
It is generally accepted that the automatic stay applies to a debtor’s possessory interest in a tenancy. State law determines whether or not a debtor has an interest in real property. Courts have examined the outer bounds of such interest and have held that mere physical possession without more is insufficient to trigger the automatic stay. See Culver v. Boozer, 285 B.R. 163, 167 (D. Md. 2002). Likewise, “mere possessory interest (for instance, a ‘squatter’ or tenant at sufferance) in an expired lease at the time of filing has been held insufficient to sustain the protections of the automatic stay.” In re Turner, 326 B.R. 563, 573 (Bankr. W.D. Pa. 2005). Further, under many states’ laws, the tenant whose lease has expired retains no property interest in the tenancy that could ever become property of the estate. It follows that if the tenancy is not property of the estate, the automatic stay does not apply. However, it seems clear that in all jurisdictions a debtor/lessee’s belongings are “property of the estate.” See Ahart, Alan M., “The Inefficiency of the New Eviction Exceptions to the Automatic Stay,” 80 Am. Bankr. L.J. 125, 140 (2006). See also United States v. Whiting Pools Inc., 103 S. Ct. 2309, 2313 (1983); In re Atlantic Business Community Corp., 901 F. 2d. 325, 328 (3d. Cir. 1990).
Residential Leases: The State of the Law—No Judgment in Place
The automatic stay will protect debtors from a lessor’s quest for possession, eviction or unlawful detainer once a case has been filed if no judgment for possession has been entered. Moreover, attempts to collect rent, notice a default or nonrenewal of a lease could be construed as violations of the stay. See In re Lansaw, 358 B. R. 666 (Bankr. W.D. Pa. 2006) (as to a nonresidential lease). Relief from the stay is required to evict a debtor based on a post-petition default. In light of the existing provisions of the law, debtors may still propose to cure residential pre-petition rent arrears and assume residential leases in a chapter 13 plan.
Residential Leases: The New Exceptions to the Stay
Substantive changes arose in the area of residential tenancy issues with the enactment of BAPCPA. Provisions in 11 U.S.C. §362(b)(22) and 11 U.S.C. §362(b)(23) have created two notable exceptions to the automatic stay. Other provisions under 11 U.S.C. §362 (l)(5)(A) require that the debtor disclose the judgment of possession in the petition together with the landlord’s name and address (referred to as “lessor” in §362(d)(5)(A) and as “landlord” in the Official Voluntary Petition form). The debtor must also file a certification with the petition, in effect setting forth why the exception to the stay should not apply.
The exception set out in §362(b)(22) applies only where the lessor has obtained a judgment for possession pre-petition on a property in which debtor resides under a lease or rental agreement.[2] This exception to the stay takes effect 30 days after the commencement of a chapter 13 case, provided that the debtor meets the conditions set out in 11 U.S.C. §362(l). To salvage the tenancy for at least 30 days, the debtor must file a certification with the petition asserting that nonbankruptcy law permits a cure of the entire monetary default that gave rise to the judgment. Also, the debtor or his dependent deposits (pre-pays) one month’s rent with the clerk of the court. BAPCPA does not address the lessor’s right to object to the debtor’s initial certification, and presumably a lessor is not precluded from doing so (i.e., to challenge the truthfulness asserted in debtor’s certification). The debtor may extend the stay beyond 30 days under §362(l)(2) by filing an additional certification attesting that the pre-petition default that gave rise to the judgment has been cured in its entirety. If the lessor objects to this second certification, a hearing is required within 10 days to consider the merits. If the court rules in favor of the lessor, pursuant to §362(b)(22), the exception to the automatic stay applies.
Recent Reported Opinions
Few cases addressing residential tenancies have been published since the enactment of BAPCPA, the most colorful being In re Baird out of the Eastern District of Tennessee. This case, with some egregious facts and unsavory characters, serves as a good analysis of the applicability of §362(b)(22). In Baird, debtors filed for chapter 7 protection after the lessor obtained a judgment for possession. The debtors failed to comply with the provisions of §362(l). As a consequence, the court found that §362(b)(22) excepted the judgment from the automatic stay. However, the debtors sought the bankruptcy court’s assistance in retrieving their personal property from the residential property. The court held that the lessor had an affirmative duty to turn over the property pursuant to 11 U.S.C. §542(a). The court also found that the lessor had willfully violated the automatic stay in denying debtors access to their personal property and awarded damages to the debtors. In re Baird, 2006 WL 3922527 (Bankr. E.D. Tenn. 2006).
Are There Exceptions to the §362(b)(22) Exception to the Stay?
Judge Alan M. Ahart, a U.S. Bankruptcy Judge for the Central District of California, contends that if “¼ of a lessor has a pre-petition judgment against the debtor for possession, [he] would be barred from taking any further acts to obtain possession of the property (or from disposing of the debtor’s personal belongings) by both §362(a)(1) and §362(a)(2).” See Ahart, Alan M., “The Inefficacy of the New Eviction Exceptions to the Automatic Stay,” 80 Am. Bankr. L. J. 125, 142 (2006). Since the enactment of BAPCPA, bankruptcy courts have held that the §362(b)(22) exception may not apply in the case of a public housing tenant as the tenant is entitled to remain in the premises under 11 U.S.C. §525(a), even if the debtor discharges rather than cures the pre-petition rent default. In re Kelly, 356 B.R. 899 (Bankr. S.D. Fla. 2006). Additionally, a bankruptcy court in the District of Columbia held that §362(b)(22) did not apply where the foreclosure purchaser sought the eviction of a serial filer. There, the purchaser at foreclosure failed to assert that the debtor was a lessee or had a lease or rental agreement. Consequently, §362(b)(22) did not apply. In re McCray, 342 B.R.668 (Bankr. D.C. 2006). (The court vacated the stay on other grounds.)
As a practical matter, the 11 U.S.C. §362(b)(22) exception to the stay has plugged the dike in chapter 13 cases seeking to salvage a tenancy where the lessor obtained a judgment for possession pre-petition. Most debtors who would have the financial ability to cure pre-petition rent arrears within 30 days of filing would not be motivated to file for bankruptcy for the principal purpose of salvaging the tenancy.
BAPCPA does not direct that a lease or contract is rejected or ceases to be property of the estate if a judgment for possession has been entered pre-petition. Judge Lundin, in his treatise on chapter 13 practice, presumes that a bankruptcy court order allowing the assumption of a residential lease and specifying how a debtor will cure rental default would be a complete defense to the lessor’s action for possession. The provisions of §362(b)(22) will accelerate the assumption processes, but they do not denigrate a chapter 13 debtor’s rights under §§365 and 1322(b)(7). See Lundin, Keith, Chapter 13 Practice, 3d. Ed. Vol. 5 §382.1 (2006).
11 U.S.C. §362(b)(23): When Did Jack Clean Up His Act?
The second exception to the stay impacting residential tenancies is found in 11 U.S.C. §362(b)(23). This section provides that the automatic stay under §362(a)(3) (which applies exclusively to property of the estate), subject to the provisions of §362(m), will not apply to the eviction or similar proceeding involving residential property in which the debtor resides, under the circumstances described below. The exception acts to terminate the automatic stay upon the filing of a certification by lessor that during the 30 days preceding the filing of the certification the debtor endangered the property or used or allowed to be used a controlled substance on the property. Section 362(m)(1) provides for the application of the exception within 15 days of the filing of the certification. Unlike the provisions under §362(b)(22), this section does not prevent the automatic stay from taking effect upon filing. Additionally, §362(a)(1) would seem to enjoin a lessor from continuing any judicial action that was filed or served pre-petition against the debtor.
The debtor may file and serve an objection to lessor’s certification. If the debtor objects, the court must hold a hearing within 10 days to determine the merits of the objection. The objection keeps the automatic stay in place until the court enters its ruling. At the hearing, the debtor may argue that the lessor’s certification is inaccurate or demonstrate that the situation set forth in the certification has been remedied.
Section 362(m)(2)(C) does not specify a timeframe for the cure of the situation that gave rise to the certification. Thus, it is possible for the debtor to remedy the improper activity at any time before the hearing. If the court rules against the debtor or the debtor fails to object in a timely manner, the lessor may proceed with eviction. Since the exception is limited to §362(a)(3), the lessor may not proceed with enforcement against the debtor for pre-petition claims pertaining to such things as damages to the property without first moving for stay relief under §362(a)(1) and (a)(6).
Conclusion
Case law remains to be developed with respect to residential tenancy issues that will arise as a result of BAPCPA. At present the changes that have been enacted, coupled with the judicial opinions, suggest that the new residential tenancy provisions have been of greatest benefit to lessors. Until further decisions are published, it would be prudent for lessors to proceed with caution with regard to the limits of the automatic stay and for debtor/tenants to do likewise as it pertains to the cumbersome mandates required for compliance and ensuring protections.
[1] BAPCPA also amended a number of provisions pertaining to the assumption and rejection of nonresidential leases. However, these are not addressed here.
[2] The legislative history indicates that this exception extends to manufactured housing communities where the debtor pays rent for the lot.
Garnishee Liability for Failure to Answer a Writ of Garnishment and the Automatic Stay
Court rules for some states, such as Michigan, allow for a judgment creditor to seek judgment against a garnishee for failure to answer a writ of garnishment. Grounds for liability are based on contempt of court and damages incurred by the judgment creditor due to the garnishee’s failure to respond to the garnishment. (See M.C.R. 3.101). In the context of bankruptcy, an issue has arisen in some jurisdictions as to whether enforcement of a judgment against a garnishee is a violation of the automatic stay as to a judgment debtor who files for bankruptcy.
There is a split of authority on this matter. Some jurisdictions hold that an action against the garnishee is an action against the debtor in violation of the automatic stay. However, the majority opinion is that there is no violation of the automatic stay to enforce a judgment against a garnishee that fails to respond to a writ of garnishment.
Enforcement of Judgment against Garnishee as a Violation of the Automatic Stay
In In re Feldman, 303 B.R. 137 (Bankr. E.D. Mich. 2003), the creditor served a garnishment on the debtor’s employer. The employer failed to answer the garnishment, and soon after the garnishment was served, the debtor filed bankruptcy. The judgment creditor then sought and obtained a judgment against the employer for its failure to answer the garnishment. The court held that where a creditor seeks a post-petition judgment against an employer, the creditor violates the automatic stay for the reason that the garnishment of the employer satisfies the debt owed by the bankrupt debtor.
The Feldman court reviewed Kanipe v. First Tenn. Bank (In re Kanipe), 293 B.R. 750 (Bankr. E.D. Tenn. 2002), which held that enforcement of a judgment against the employer who does not answer a writ of garnishment does not violate the automatic stay. Kanipe reasoned that enforcement of the judgment was not a collection action against the debtor since the employer’s failure to timely respond to the garnishment gave rise to separate liability under Tennessee law.[1]
Feldman rejected the reasoning in Kanipe, finding that the majority rulings among the cases that have addressed this issue “focus on the wrong question.” “[I]it is simply irrelevant whether the creditor's post-petition act to obtain a judgment against the employer is an act to collect on the employer’s liability. The relevant question under §362(a) is whether that act is an act to collect on the debtor’s liability. Surely the answer to that question is yes, that act is an act to collect on the debtor’s pre-petition debt.” Id. at 140.[2]
The Feldman court identified three bases for its holding. First, it ascertained “that there would be no garnishment judgment against the employer absent the underlying debt.” Second, under the Michigan court rules, the debtor becomes liable to the employer for the amount of the garnishment. Finally, Feldman determined that “the employer's payment on the garnishment judgment requires the creditor to file a satisfaction of the judgment against the debtor.”
Timing of the Garnishee Judgment May Affect Whether There Is a Violation of the Automatic Stay
It should be noted that the Feldman court addresses the §362 issue in the context of a creditor who seeks judgment against the employer post-petition. The result may be different where the judgment is obtained pre-petition and enforced post-petition. For example, the state court opinion of Kenosha Hosp. & Med. Ctr. v. Garcia, 2004 WI 105 (Wis. 2004), found no violation of the automatic stay. In that case, the garnishment was served on the debtor’s employer, the employer did not respond, and judgment was entered against the employer accordingly. After the garnishment proceedings and entry of judgment against the employer, the debtor filed for bankruptcy.
Liability for the Entire Judgment Amount Despite Bankruptcy Filing in the Midst of a Garnishment Proceeding
In Bour v. Johnson, et al., 122 Wn.2d 829; 864 P.2d 380 (1993), the Washington Supreme Court addressed the issue of garnishee liability where the debtor filed for bankruptcy between two payment periods that were both subject to the garnishment proceedings. The garnishee, Deep Pacific Fishing Co., failed to respond to the writ of garnishment on the first pay period. Thereafter, the judgment creditor obtained default judgment against the garnishee for the entire judgment amount. The debtor then filed for bankruptcy.
On appeal, Deep Pacific sought to reduce the judgment to the amount of the debtor’s pre-petition wages that were subject to garnishment. It argued that the purpose of garnishee liability was to put the judgment creditor in the position it would have been in had the garnishee answered the writ. Since the debtor filed bankruptcy before the second pay period that was subject to the garnishment proceedings, the garnishment would have been released by operation of the automatic stay. For that reason, Deep Pacific contended that by operation of the automatic stay it would only be liable for the pre-petition portion of the garnishment judgment.
The Bour court rejected the garnishee’s argument based on the Washington statute, which prescribed triggering events for early termination of a garnishee’s liability on a garnishment. (RCW 6.27.350). Such events included termination of employment, where the underlying judgment is vacated, modified or satisfied or if the writ is dismissed. The court found that the legislature did not include bankruptcy as a basis for authorizing early termination of the garnishment. For that reason, the court held that Deep Pacific remained liable for the entire judgment amount due to its failure to respond to the writ of garnishment.
Section 362 May Have All the Answers with Regard to Garnishee Liability
Courts that have addressed the issue of garnishee liability rely on state law garnishment proceedings in conjunction with §362. Nonetheless, the timing of judgment against a garnishee is a key factual issue that courts have not yet closely reviewed. It seems that there would be a clear violation of the automatic stay where a judgment creditor seeks judgment against a garnishee post-petition, and where the judgment creditor obtains judgment pre-petition, §362 would not be implicated.
Where courts have not looked at timing, the majority opinion has at least allowed for the protection of a bankrupt debtor in a garnishment conundrum. While debtors’ employers may be subject to liability for not responding to a writ of garnishment, debtors are still protected by the automatic stay. Outside of bankruptcy, an employer may withhold an employee’s wages to satisfy a garnishment debt. By contrast, if in bankruptcy, “an employer held personally liable for failing to comply with the garnishment statutes attempted to collect from the debtor on that debt, or retaliate in some other way, it might be liable for violating a bankruptcy stay or discharge as well as the Consumer Credit Protection Act.” Kanipe at 369.
Conclusion
The majority opinion holds that liability of a garnishee that does not answer a writ of garnishment is the garnishee’s liability alone. The minority opinion, on the other hand, holds that enforcement of such a judgment is an indirect attempt to collect a debt of the bankrupt debtor and therefore implicates §362.
[1] In re Schneiderman, 254 B.R. 296 (Bankr. D. D.C. 2000); In re Sowers, 164 B.R. 256 (Bankr. E.D. Va. 1994); In re Waltjen, 150 B.R. 419 (Bankr. N.D. Ill. 1993); In re Gray, 97 B.R. 930 (Bankr. N.D. Ill. 1989); and United Guar. Residential Ins. Co. v. Dimmick, 916 P.2d 638 (Colo. Ct. App. 1996), have all held that there is no violation of the stay since the employer’s liability arose separately from the debtor.
[2] The Feldman holding was previously reached in O'Connor v. Methodist Hosp. of Jonesboro, Inc. (In re O'Connor), 42 B.R. 390 (Bankr. E.D. Ark. 1984); Univ. of Alabama Hosps. v. Warren (Matter of Warren), 7 B.R. 201 (Bankr. N.D. Ala. 1980).
The Blind Leading the Blind: Section 1329 and Chapter 13 Modifications
The more I look at the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the more I am beginning to think that we have all been misled by those who either did not know or did not care to know any better. During the past 20 months, we have been bombarded with questions about whether “projected disposable income” (PDI) is an historic fact or a future prediction. We have been puzzled and perplexed by Form B22C and disposable income (DI). We have wondered what Congress really intended when it adopted the IRS expense standards, which the IRS created solely for determining how much a taxpayer could pay in working out offers of compromise for tax debts. Compare In re Hardacre, 338 B.R. 718 (Bankr. N.D. Tex. 2006) (applies both PDI and DI), and In re Jass, 340 B.R. 411 (Bankr. D. Utah 2006) (ignored B22C for substantial drop in income by AMI debtors), with In re Alexander, 344 B.R. 742 (Bank. E.D.N.C. 2006) (the concept of DI as we knew it has changed), and In re Barr, 341 B.R. 181 (Bankr. M.D.N.C. 2006) (an above-median income (AMI) debtor with negative DI on Form B22C could file a good-faith plan paying less than the surplus net monthly income shown on Schedule J).
We have struggled with questions about “current monthly income” to the extent that it is not current, not monthly, and in some cases not even income. We have wondered whether the “applicable commitment period” is a device for measuring the duration of a plan or a mathematical number to determine the total amount a debtor must repay under the plan.
For all of us who have been sleep walking through this fog of new terms and strange concepts, hold on, because relief may be on the way and the relief may be right in front of us. In fact, it may just be hiding in §§1329(a)(1), (a)(2) and (a)(3). It is extremely important to note that not one of these sections was modified or amended by BAPCPA with the sole exception of deleting the “or” at the end of the former subsection (a)(2). To further compound the matter, since these sections were not amended, not one single provision of the new §1325(b) is incorporated in §1329. In fact, the only reference to §1325(b) is to subsection (1)(B) in §1329(c). This section simply provides that if a plan is modified under subsections (a) and (b), then the modified plan may not make payments beyond “the applicable commitment period under §1325(b)(1)(B)” unless the court, for cause, approves a longer period, provided that the court may not approve a period that expires more than five years after the time the first payment was due.
Disequilibrium and status quo “disturbances” arise from §1325(b)(4). This section provides that in order to determine how a debtor’s projected disposable income is to be disbursed to the unsecured creditors, the court must determine the “applicable commitment period.” If the debtor’s current monthly income (CMI) is less than the median income, then the commitment period is not less than three years. If the debtor’s CMI is more than the median family income, then the applicable commitment period is not less than five years. This section then provides that the applicable commitment period may only be less than three or five years if the plan provides for payment in full of all allowed unsecured claims. In short, if one wants to pay off a three-year plan in two years, then this section appears to require payment of 100 percent of all allowed unsecured claims.
Does this consequently mean that a chapter 13 debtor must either pay a 100 percent dividend or stay in a plan for not less than 36 or 60 months? Well (and this is where the smoke and mirrors come in), this is not necessarily what it means. Under the pre-BAPCPA Code, §1325(b)(1)(B) required that the debtor commit his “disposable income” received for three years to the plan. Under the old Code, however, there was no specific prohibition against modifying the plan to shorten the three-year period by way of an early pay-off without having to pay 100 percent to the unsecured creditors. See In re Anderson, 21 F.3d 355 (9th Cir. 1994).
The issues of how long a debtor must stay committed to a chapter 13 plan is not a new issue; in fact, it has been extensively litigated in numerous pre-BAPCPA cases. One of the first significant cases was In re McKinney, 191 B.R. 866 (Bankr. D. Or. 1966). The debtor’s confirmed plan in McKinney provided for a 0 percent dividend to the unsecured creditors and the payment of scheduled priority debt of approximately $10,000 to be paid over 36 months. Id. at 867. The actual priority claims filed and allowed totaled substantially less than $10,000, and as a result, the debtor was able to complete all plan payments in 12 months. The trustee responded by filing a §1329 motion to modify the plan to increase the percentage to the unsecured creditors and to require the debtor to continue paying all projected disposable income to the trustee for at least 36 months, as provided by §1325(b)(1). The bankruptcy judge granted the trustee’s motion and held that the modification of a confirmed plan had occurred because of the initial underestimation of priority claims, and that, upon the objection of the trustee by way of the motion to modify, the court had to look at §1325(b). More importantly, the court reasoned that while §1325(b) was not directly incorporated into §1329(b), it was “indirectly incorporated therein via its reference in §1325(a).”
The first signs of serious doubts about this so-called “incorporation” theory arose in Max Recovery Inc. v. Than, 215 B.R. 430 (9th Cir. BAP 1997). The plan in Than was confirmed, without objection, with terms providing monthly payments of $300 for 38 months or until the plan achieved an 11 percent dividend on those claims. The plan therefore appears to have been a hybrid pot plan. When filed claims proved to be lower than scheduled, the plan would pay the 11 percent dividend in 32 months instead of 38. Max Recovery, an unsecured debt buyer, moved under §1325(b) to increase the term of the plan to not less than 36 months. The bankruptcy court held that §1325(b) was inapplicable and denied the motion. Id. at 436. In affirming, the BAP stated that “the Code does not prohibit a plan that is less than 36 months in duration in the absence of any objection by the trustee or a creditor to ‘the confirmation of the plan.’” Id. at 437, citing §1325(b)(1). The BAP also noted in passing that §1329(b) does not expressly incorporate §1325(b). Id. at 434.
The next case-important modification was In re Sounakhene, 249 B.R. 801 (Bankr. S.D. Cal. 2000). In Sounakhene, the debtors, prior to the expiration of a 37-month plan, refinanced their home mortgage and made a single lump-sum payment to the trustee equal to the aggregate amount of their disposable income over the remaining life of the plan. The trustee moved to modify the plan to require that payments nonetheless be made for at least 36 months. The court denied the motion on the ground that the plan was complete when the trustee received the amount required under the plan. Id. at 804. The court also specifically held, however, that §1325(b) was not incorporated into §1329 based on a “plain interpretation of the statute.” Id. at 803. Rather than applying the so-called disposable-income test, the court determined that the better approach would be to utilize the analysis underlying the disposable-income test in exercising the court’s judgment and discretion. Id. at 805. Citing Than, the court stated that “the only limits on modification are those set forth in the language of the Code itself, coupled with the bankruptcy judge’s discretion and good judgment in reviewing the motion to modify.” Id. The court also noted that even if §1325(b)(1)(B) did apply, nothing in §1325(b) prohibited a lump-sum payment where no pre-payment discount was requested.
The next significant case was In re Casper, 154 B.R. 243 (N.D. Ill. 1993). In Casper, as a result of priority claims being allowed in amounts significantly less than scheduled, the debtors were able to complete their 60-month plan in 24 months. The confirmed plan paid a 10 percent dividend. The trustee filed a motion to modify the plan to a 60-month term and to increase the dividend from 10 percent to 80 percent. The bankruptcy court granted the trustee’s motion. On appeal, the district court reversed, holding that §1325(b)(1)(B) only required the debtors to commit the amount representing their projected disposable-income over three years to the plan. The district court also clearly stated that §1325(b) does not prohibit the payment of such an amount in less than the prescribed term of the plan. Id. at 245-46.
Casper was quickly followed by In re Phelps, 149 B.R. 534 (Bankr. N.D. Ill. 1993). The confirmed plan in Phelps provided for a payment of secured claims in full with a 10 percent dividend to unsecured creditors and monthly payments of $282 for a projected term of 43 months. Because allowed unsecured claims amounted to significantly less than those scheduled, the plan could be completed in 37 months. The trustee filed a motion to modify the plan to require a full 43 months of payments. The court rejected this motion, finding that plan completion occurs when the debtor has paid the percentage owed to each class of creditors as provided for in the confirmed plan. Id. at 537. While Phelps did not address the particular issue of §1325(b)’s disposable-income test and the mandatory minimum term of 36 months, its reasoning is instructive in that it interprets “completion of payments” as it is used in §1329(a), i.e., focusing on payment of the required percentage owed rather than on the duration of the plan.
Sections 1329 and 1325 were indirectly addressed by the court in In re Easley, 334 (Bankr. M.D. Fla. 1996). In Easley, several months after confirmation of a 60-month plan, the debtor filed a §1329 motion to modify the plan by paying the entire amount due from a loan received from his parents. The trustee objected and argued that any loan proceeds should be used to increase the plan payments and not to modify the plan. The court agreed with the debtor and granted the motion to modify. The court held that nothing in §1329 prohibited the debtor from borrowing money to pay his existing creditors early. The court reasoned that the debtor was merely “substituting one set of creditors, his parents, for his former set of creditors addressed in the plan.” Id. at 335.
The court in Forbes, 215 B.R. 183 (8th Cir. BAP 1997) directly addressed the §§1325 and 1329 issue. After 36 months of a 60-month plan, the debtor in Forbes received settlement proceeds that would enable him to reduce the plan term from 60 to 40 months. The debtor filed a §1329 motion to so modify the plan. The trustee and an unsecured creditor objected to the proposed modification on the ground that settlement constituted a windfall, enabling the debtor to pay all of his creditors in full. The bankruptcy court overruled both of the objections and approved the plan as modified by the debtor. The trustee and the creditor appealed. The issue before the BAP was whether the bankruptcy court erred by failing to consider the settlement funds as disposable-income under §1325(b). In affirming the bankruptcy court, the BAP held that Congress clearly did not include §1325(b) in the requirements for post-confirmation modification of plans under §1329, and the court would not read the statute to hold otherwise. Id. at 191. The panel also noted that its conclusion was supported by the absurd result that would have been obtained had the disposable-income test applied: “Mathematically, no proposed modified plan can satisfy both the disposable-income test in §1325(b) and the five-year limitation in §1329(c) if the proposed modification is filed after two years after the commencement of payments under the original plan.” Id. at 192.
In the case of In re Smith, 237 B.R. 621 (Bankr. E.D. Tex. 1999), aff’d, 252 B.R. 107 (E.D. Tex. 2000), the debtor had proposed a 56-month plan, which was confirmed over objections. After making payment number 26, the debtor paid the trustee the total amount due under the remainder of the plan. The trustee then distributed the funds with a notice of plan completion. An unsecured creditor objected and argued that the debtor had failed to submit her income to the plan for the full 36-month period as required by §1325(b)(1). The court overruled the objection and held that the creditor’s reliance on §1325(b)(1) was misplaced because that section only applied to plan confirmations. Id. at 625 n. 5.
The next significant holding was In re Golek, 308 B.R. 332 (Bankr. N.D. Ill. 2004). In this case, the debtor filed a motion in month 20 of his plan to sell real property. The court granted the motion and directed the debtor to pay the proceeds of the sale to the trustee in an amount sufficient to pay off the plan. The debtor then filed a motion to modify the plan to the amount of payments made. The trustee objected on the ground that the debtor was proposing to terminate his plan before its 36-month term had expired. Id. at 334. The court rejected the trustee’s position and argument that §1325(b) was incorporated into §1329. The court stated that when “Congress wants to say something, it knows how to say it, and in this instance, Congress did not say it. Indeed, §1329(b)(1) goes out of its way to include both §§1322(a) and 1322(b) in its list of restrictions. While §1325(a) is expressly listed, however, §1325(b) is not.” Id. at 337.
This issue was also recently addressed in two significant pre-BAPCPA cases, both of which were decided in 2005. In the first case, In re Sunahara, 326 B.R. 697 (9th Cir. BAP 2005), the court held that the debtor could seek to modify a plan under §1329 without having to pay a 100 percent dividend to the unsecured creditors. The debtor’s plan in this case provided for a total payment of $41,000 over a term of 60 months, with an estimated dividend of 50 percent to the unsecured creditors. One day prior to the hearing on confirmation of the debtor’s third amended plan, the debtor filed a motion to refinance real estate pay off the plan and terminate the case. The plan was confirmed without objection prior to the hearing on the motion. The bankruptcy court sustained the objection to the debtor’s motion, and on appeal the BAP reversed. The BAP pointed to Lamie v. U.S. Trustee, 540 U.S. 526 (2004) in holding that the “plain language of §1329(b) does not mandate satisfaction of the disposable income test of §1325(b)(1)(B) with respect to modified plans.” The court went on to emphasize that had “Congress intended to impose such a requirement, it could have easily done so by making the appropriate incorporating reference. If the absence of the reference to §1325(b) was indeed an oversight, it is the province of the legislature, and not the judiciary, to make the correction.”
The Sunahara court also specifically held that the so-called “best-efforts” test of §1325(b) did not apply to a §1329 motion. This holding was based on an unambiguous finding that the confirmation standards of §1325(b) were “not explicitly incorporated into §1329.” Specifically, the Sunahara court held: “Section 1329(b) expressly applies certain specific Code sections to plan modifications, but does not apply §1325(b). Period. The incorporation of §1325(a) is not, as has been posed by some courts, the functional equivalent of an indirect incorporation of §1325(b).” On remand, the BAP ordered the trial court to consider the current Schedules I & J, the likelihood of any future increases in net monthly income, the time period between confirmation and modification, and the risk of a plan failure over the remaining term versus the certainty of immediate payments to creditors.
The second important 2005 case was In re Keller, 329 B.R. 697 (Bankr. E.D. Cal. 2005). In Keller, the debtor filed a motion to modify a 36-month plan by reducing the term, by paying the base amount with a mortgage refinance, but without paying a 100 percent dividend. The court held that the debtor could pay off the plan early without a full dividend, but that the process to follow would be a §1329 motion to modify and not a motion to approve a new mortgage loan. However, the Keller court then found in dicta that §1325(b)(1) was incorporated into §1325(a), and since §1325(a) was in fact referenced in §1329, all of the pre-confirmation rules applied to a §1329 modification.
It is not clear how the Keller court would deal with the issue of “projected disposable income” under BAPCPA and §1329. However, the Keller reasoning is suspect because it is based on the general requirement of §1325(a)(1) that the court shall confirm a plan if “the plan complies with the provisions of this chapter and with the other applicable provisions of this title.” Given the very strict constructionalist approach to BAPCPA, it seems safe to assume that the vast majority of courts will follow Sunahara and reject Keller. And, unless it were reverse the precedent of Lamie, the Supreme Court is bound to follow Sunahara.
A good predictor of what the courts will finally do on this issue can be found in a 1989 decision by the Fourth Circuit. The case is In re Arnold, 869 F.2d 240 (4th Cir. 1989). In Arnold, the court was called on to interpret §1329 in a case where the debtor’s post-confirmation income increased from $80,000 a year to more than $200,000 per year. The court held that in this case, where there had been an unanticipated and substantial change for the better in the debtor’s financial circumstances, then either the trustee or an unsecured creditor could file a §1329 motion to modify the plan to increase the dividend to the general body of unsecured creditors. In a very detailed analysis of §1329, the Arnold court never once mentioned §1325(b) and certainly found no “direct” or “indirect” incorporation of that section into §1329.
The Arnold holding was strongly reaffirmed on Jan. 18, 2006, when the Fourth Circuit filed its opinion in In re Murphy, 2007 WL 117746 (4th Cir. 2007). Murphy involved two cases where the trustees sought to modify confirmed chapter 13 plans to increase the amount to be paid to the unsecured creditors. The court combined both cases for decision in order to “set forth a thorough analysis on how a bankruptcy court should analyze a motion for modification pursuant to §1329(a)(1) or (a)(2).” Slip at 8.
The Murphy court noted that under “§1329 of the Bankruptcy Code, a confirmed plan may be modified at ‘any time after confirmation of the plan but before the completion of payments’ at the request of the debtor, the chapter 13 trustee, or an allowed unsecured creditor in order to, among other things, ‘increase or reduce the amount of payments on claims of a particular class provided for by the plan, [or to] extend or reduce the time for such payments.’” Id. at 7. The court the made it crystal clear that any modification under §§1329(a), (a)(1) and (a)(2) had to comply with §1329(b)(1). Specifically, the court stated that “[u]nder §1329(b)(1), any post-confirmation modification must comply with §§1322(a) and (b), and §1323(c), and §1325(a) of the Bankruptcy Code.” Id. at 7-8. The court made absolutely no reference to § 1325(b).
The Murphy court then went on to explain that the doctrine of res judicata prevented the modification of a confirmed plan pursuant to §1329(a)(1) or (a)(2) “unless the party seeking modification demonstrates that the debtor experienced ‘substantial’ and ‘unanticipated’ post-confirmation changes in his financial condition.” Id. at 8, citing Arnold. The court then took pains to note that “this doctrine” of finality is designed to ensure that “confirmation orders will be accorded the necessary degree of finality, preventing parties from seeking to modify plans when minor and anticipated changes in the debtor’s financial condition take place.” Id. To further emphasize this point, the court, quoting from In re Butler, 174 B.R. 44, 47 (Bankr. M.D.N.C. 1994), stated that “[a]s a matter of sound policy as well as appropriate judicial economy, there is no reason why either a creditor or a debtor should be permitted to re-litigate issues which were decided in the confirmation order or which were available at the time of the confirmation but not raised by the parties. Absent this salutary policy, there is no readily available brake on the filing of motions under §1329 by creditors and debtors simply hoping to produce a more favorable plan based on the same facts presented at the original confirmation hearing.”
The most important thing about the Murphy decision is that the court never makes any reference whatsoever to §1325(b). Simply stated, it seemed so clear to the court that, since §1325(b) was not incorporated directly into any of the relevant §1329 provisions, any reference to the section was not even worth a footnote. The court went to some lengths on this point by including the full text of all “relevant” statutes in the footnotes.
As noted, Murphy involved two cases. In the first case, the chapter 13 trustee sought to modify a confirmed plan after the bankruptcy court granted the debtors permission to refinance the mortgage on their residence. In fact, the refinance produced an excess of “cash out” equity for the debtors, and it was this extra money that the trustee sought to recapture for the unsecured creditors. In the second case, the chapter 13 trustee sought to modify the plan after the debtor had secured authority to sell his condominium. Because the condo had appreciated more than 50 percent in about a year, the debtor was in position to pocket about $80,000 of the appreciation after paying off the original confirmed plan amount.
As to case number one, the court held that the “cash-out refinancing” did not rise to the level of a §1329 modification and denied the trustee’s motion to modify. The court held that all these debtors did “was eliminate a portion of their equity in the property for cash in exchange for a corresponding amount of debt. Thus, even when one considers that the [debtors’] residence appreciated in value post-confirmation, at most, they simply received a large loan in place of a small one. By any stretch, a loan, regardless of the size, is not income. [emphasis added].” The court even characterized the refinancing as evidence that the debtors “unquestionably took the more noble course of seeking to fulfill their obligations under the confirmed plan. . .” Slip at 12. Specifically, the court held: “A debtor’s proposal of any early payoff through the refinancing of a mortgage simply does not alter the financial condition of the debtor and, therefore, cannot provide a basis for the modification of a confirmed plan pursuant to §1329(a)(1) or (a)(2).” Slip at 11.
As to the second case, the court found that the debtor did experience a substantial and unanticipated change of circumstances when his condominium was scheduled for $121,000 in value as of Dec. 15, 2003, the date of the confirmation, and was sold for $235,000 in November 2004. The court noted that a 51.6 percent appreciation in value in less than a year constituted both a “substantial change in circumstances” and “an unanticipated change given the current market trends.” The holding in this case is of further interest because the debtor argued that since his plan had been confirmed under §1327(b), the condominium had revested in him at the time of confirmation, and therefore, the appreciation was beyond the reach of the trustee and the bankruptcy estate. The court noted this vesting rule and stated that under §1327(c), such vesting “is free and clear of any claim or interest of any creditor provided for by the plan.” The court addressed the differences between §1306 and 1327 by noting the “varying interpretations,” while holding that neither statute could be used by a debtor “to shield himself from the reach of his creditors when he experiences a substantial and unanticipated change in his income.” Slip at 16. Since the primary purpose for filing a plan that vests property of the estate in the debtor upon confirmation is to avoid this result, it would make no sense for any attorney in the Fourth Circuit to file anything other than a plan that vests property in the estate upon completion of the plan.
Section 1329(c), as amended, also raises additional issues that seem consistent with the pre-BAPCPA law on plan modifications. This section was amended to include a reference to the “applicable commitment period under §1325(b)(1)(B).” The wording of the new section is tortuous. However, the meaning is clear: If a plan is modified under §1329, the extended time period to pay cannot exceed five years, even if the court finds good cause to so extend the plan. This limited reference to §1325(b) in §1329(c) certainly provides clear and convincing (perhaps irrefutable) evidence that Congress was fully aware of this section when it enacted BAPCPA. The fact that Congress incorporated §1325(b) in one provision of §1329, but not in the truly substantive sections, is certainly a highly relevant fact and can only lead to the conclusion that the omission was intentional.
This startling congressional omission from §1329 (not incorporating §1325(b)) effectively writes the projected disposable income rules and the B22C analysis right out of the plan-modification process. This also means that there is no “best efforts” test under a §1329 motion. In addition, if a majority of courts follow the Fourth Circuit’s res judicata reasoning in Murphy, then plan a modification should not be granted absent a substantial and unanticipated change of the debtor’s financial circumstances.
Thus, this is the reason for describing the past 15 months as a monumental smoke-and-mirrors game. At this point, at least with respect to plan-modifications, it seems fairly clear that we are really back to the way things were in the old chapter 13 pre-BAPCPA days. If you have a high-income, above-median-income debtor with nominal monthly net income in Schedule J, then perhaps what you need to do is get the plan confirmed under §1325(b) using the B22C numbers, and then quickly turn around and file a §1329 motion with the real Schedule I & J numbers. On the other hand, would the “real income” on the I & J Schedules allow a chapter 13 trustee to do the same thing post confirmation? It sounds so simple and almost too good to be true. At the same time, it seems fully supported by the well-developed case law on §1329, which should not be modified by BAPCPA.
At this point, it would appear that in the modification mode the only really new things to deal with are 910-day vehicles and 365-day purchase-money claims. They still would apply to a modification, since §1325(a) is incorporated into §1329. Although one could possibly argue that since applicable subsections of §1329 were not changed at all by BAPCPA, the old section of §1329 that incorporated the old provisions of §1325(a) WITHOUT the hanging paragraph also eliminated the 910 and 365 claims from the modification process! But this may well be a bridge too far for many courts.
Could it really be this easy? After all of the pain and suffering imposed on the bankruptcy system since Oct. 17, 2005, is it possible that we are really back to the way the world used to be? Time will tell.
The IRS’ Policy of Refusing to Process Offers-in-Compromise Submitted by Taxpayers in Bankruptcy: A Roadblock to a Business Owner’s “Fresh Start” in Chapter 13
The frequency with which small businesses fail gives rise to a common scenario: Former small-business owners finding themselves burdened with not only personally guaranteed trade payables, but also with significant amounts of business-related tax obligations, commonly in the form of tax penalties assessed personally against the business’ principals under 26 U.S.C. §6672.
Not surprisingly, facing significant tax obligations that are nondischargeable under the Bankruptcy Code,1 many entrepreneurs will turn to chapter 13 of the Code in an effort to formulate a manageable plan through which they can not only eliminate much of their lingering business-related debt, but also repay nondischargeable tax obligations owed to the Internal Revenue Service, thereby forestalling most tax-collection efforts. Unfortunately, under the Code, the priority treatment2 afforded to tax penalties assessed under §6672 can, in many instances, make full payment of such penalties an impossible task. This is because many entrepreneurs who find themselves attempting to regroup in chapter 13 before embarking upon their next business venture simply do not have the financial resources to pay a large priority obligation in full within the limited time period allowed under the Code. 3 In those instances, an offer-in-compromise submitted by the taxpayer to the IRS should be an effective tool to allow chapter 13 debtors to potentially settle their tax obligations for less than the full amount owed as part of a chapter 13 plan. The IRS, however, has adopted a policy of refusing to even process an offer-in-compromise submitted by a taxpayer if such taxpayer is a debtor in a pending bankruptcy proceeding.4
The General Mechanics of an Offer-in-Compromise
The IRS has the authority to compromise all tax liabilities under 26 U.S.C. §7122(a). That provision provides, in part, that:
The secretary may compromise any civil or criminal case arising under the internal revenue laws prior to reference to the Department of Justice for prosecution or defense, and the Attorney General or his delegate may compromise any such case after reference to the Department of Justice for prosecution or defense.
In order to facilitate the negotiation of a compromise of the kind described in §7122(a), the IRS has invited taxpayers to present it with an offer of settlement by way of the IRS’ development and dissemination of IRS “Form 656,” entitled “Offer in Compromise.” Form 656 invites taxpayers to list in a concise format all of the relevant information that would ever be needed by the IRS in evaluating a taxpayer’s settlement offer under the applicable criteria set forth in 26 C.F.R. 301.7122-1(b). Treas. Reg. §301.7122-1(b) delineates the criteria to be applied by the IRS in evaluating any taxpayer’s offer to compromise a civil or criminal tax liability. However, even when a taxpayer has properly completed form 656 and otherwise complied with the procedural rules attendant to an offer-in-compromise, the IRS will nonetheless summarily reject the same when the taxpayer is also a debtor under the Bankruptcy Code.
The IRS’ Policy of Summarily Rejecting Offers-in-Compromise Submitted by Taxpayers in Bankruptcy Violates the Bankruptcy Code’s Anti-Discrimination Provision
It was not until February 1997 that the IRS began refusing to process offers-in-compromise submitted by bankrupt taxpayers.5 Importantly, the IRS’ decision at that time to begin rejecting such offers was not based on any amendment to the Internal Revenue Code (IRC), the Treasury Regulations or the Bankruptcy Code; rather, it was based on nothing more than an amendment by the IRS to its own internal procedures manual, entitled “Internal Revenue Manual.”6 That manual now provides that the IRS will return to the taxpayer any offer-in-compromise submitted by a debtor in bankruptcy on the basis that such an offer is “nonprocessable.”7 The IRS normally argues that its authority to reject offers in that manner derives from Treas. Reg. §301.7122-1(b), which admittedly allows the IRS to return offers deemed to be nonprocessable, although neither the IRC or the Treasury Regulations define that term. In fact, it is precisely because the term nonprocessable is not defined that the IRS argues that it has the discretion to promulgate its own definition to include those offers submitted by taxpayers in bankruptcy. Importantly, however, such an argument misses the critical point. The IRS’ refusal to process an offer-in-compromise submitted by a bankrupt taxpayer does not involve a question of discretion, it involves a question of whether the IRS has the authority to exercise whatever discretion it may hold in a way that discriminates against a taxpayer based solely on the taxpayer’s status as a debtor in bankruptcy. Put another way, even assuming the IRS has the authority to promulgate the mechanics that control the actual processing of an offer-in-compromise, the question that must still be answered is whether the IRS’ policy of rejecting certain offers based solely on a bankruptcy filing violates the Bankruptcy Code’s anti-discrimination provision.
Section 525(a), provides, in pertinent part, the following:
A governmental unit may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise or other similar grant to, or…discriminate with respect to such a grant against…a person that is…a debtor under this title…solely because such…debtor is…a debtor under this title.
Given the protections afforded within that statute, certain debtors have sought to utilize §525(a) as a basis to seek the intervention of a bankruptcy court to redress the IRS’ rejection of a debtor’s offer-in-compromise based solely on such person or entity’s status as a debtor under the Bankruptcy Code. In those instances, the IRS normally argues that the act of returning, as nonprocessable, offers-in-compromise submitted by debtors in bankruptcy does not fall within the so-called “limited” scope of §525(a), i.e., that such an act does not constitute the denial of a “license, permit, charter, franchise or other similar grant.” On its face, such an argument initially has some appeal – at least until the statute’s legislative history and purpose is analyzed.
Indeed, in creating §525(a), Congress did not mince words. It went so far as to state its specific intent that courts would have not only the authority, but also the affirmative duty, to expand the acts enumerated within the statute to ensure that many other types of bankruptcy-based governmental discrimination were not allowed. Congress specifically said:
The section is not exhaustive. The enumeration of various forms of discrimination against former bankrupts is not intended to permit other forms of discrimination. The courts have been developing the Perez rule. This section permits further development to prohibit actions by governmental or quasi-governmental organizations that perform licensing functions, such as a state bar association or a medical society, or by other organizations that can seriously affect the debtors' livelihood or fresh start, such as exclusion from a union on the basis of discharge of a debt to the union's credit union… The courts will continue to mark the contours of the anti-discrimination provision in pursuit of sound bankruptcy policy.
H.Rept. No. 95-595 to accompany H.R. 8200, 95th Cong., 1st Sess. at p. 367, 1978 U.S. Code Cong. & Ad. News at pp. 5963, 6323 (1977).
Given Congress’ clear pronouncement that §525(a) was to be “further developed” to prohibit “other forms of discrimination” in addition to those enumerated, it is not surprising that the first bankruptcy court to address the issue of whether the IRS’ policy of rejecting offers-in-compromise submitted by taxpayers in bankruptcy violated §525(a) held that it did indeed. See In re Mills, 240 B.R. 689 (Bankr. S.D. W.Va. 1999). Accordingly, the Mills court ordered the IRS to process the debtors’ offer-in-compromise in the same manner the IRS would process an offer submitted by any non debtor.
Applicable Case Law Continues to Develop
In addition to Mills, there exists a handful of subsequent cases that have also addressed this very issue, but with varying results. Both In re Macher, 2003 WL 23169807 (Bankr. W.D. Va. June 5, 2003), and In re Holmes, 298 B.R. 477 (Bankr. M.D. Ga. 2003), aff'd, 309 B.R. 824 (M.D. Ga. 2004), also found the IRS’ conduct to be offensive; however, the Macher and Holmes courts did not find such conduct to fall within the scope of §525(a). Instead, those courts found that the IRS’ policy of returning offers-in-compromise submitted by taxpayers in bankruptcy frustrated the Bankruptcy Code’s general purpose of providing “fresh starts” and thus relied not on §525(a), but on their equitable authority codified under §105 as a basis to order the IRS to process the offers submitted in those cases. See, also, In re Peterson, 321 B.R. 259 (Bankr. D. Neb. 2004).
While employing some of the same reasoning set forth in Macher and Holmes, several other courts have declined to force the IRS to process an offer submitted by a debtor, regardless of the effect it may have on a debtor’s ability to confirm a plan. In In re 1900 M Restaurant, 352 B.R. 1 (D. D.C. 2006); In re Shope, 347 B.R. 270 (Bankr. S.D. Ohio 2006); and In re Uzialko, 339 B.R. 579 (Bankr. E.D. Pa. 2006), the respective courts not only agreed that the IRS’ conduct did not fall within the scope of §525(a), but went one step further and rejected the contention set forth in Macher and Holmes that a debtor’s right to a fresh start combined with the authority vested under §105 formed a basis to grant relief.
While the handful of cases addressing this issue have produced a mixed bag of results, it would seem that the first court to address this matter, the Mills court, made the most analytically correct finding. As noted, Congress specifically instructed courts to “further develop” §525(a) in order to prohibit “other forms of discrimination,” not just those specifically enumerated. That mandate, when applied to well-settled canons of statutory construction,8 would suggest that it is proper to apply §525(a) to prohibit the IRS’ discriminatory policy discussed here, because that policy not only directly inhibits a debtor’s ability to obtain a fresh start, it also denies a privilege afforded to every taxpayer – at least every taxpayer that is not also a debtor in bankruptcy.
2 See 11 U.S.C. §507(a)(8).
3 See 11 U.S.C. §§1322(a)(2) and 1325(b)(4), which collectively require chapter 13 debtors to pay through their chapter 13 plans certain priority tax obligations in full in a period of no more than five (5) years.
4 See Rev. Proc. 2003-71, §5, 2003-36 I.R.B. 517, 2003 WL 21982210.
5 In re Chapman, 1999 WL 550793, *2 (Bankr. S.D. W.Va.):
6 Id., at *2.
7 See Rev. Proc. 2003-71, §5, 2003-36 I.R.B. 517, 2003 WL 21982210.
8 See United States v. Ron Pair Enter., 489 U.S. 236, 242 (1989) (the plain meaning of a statute is not conclusive when “the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters.”) (citing Griffin v. Oceanic Contractors Inc., 458 U.S. 564, 571 (1982)).