It is not unusual for consumer debtors to have borrowed from a qualified retirement or savings plan pre-petition to meet cash needs. Typically the debtor schedules the plan as a creditor with a claim in the amount of the outstanding balance due on the plan loan.¹

But does the plan have a claim against the bankruptcy estate? Probably not. The overwhelming majority of courts that have considered the issue hold that a debtor's plan loan does not give rise to a claim in bankruptcy, and the courts' treatment of the plan loan and repayment under the provisions of the Bankruptcy Code takes a few interesting twists and turns.

Plan Loan Not a Claim

The first reported decision to address the status of a debtor's plan loan is New York City Employees' Retirement System v. Villarie.² The chapter 7 debtor scheduled the plan as a secured creditor, but the plan filed a complaint seeking a declaration that the advance was not a debt under the Bankruptcy Code and therefore was not dischargeable. The Second Circuit ruled in favor of the plan.

The court considered analogous transactions. An annuitant's withdrawal from his savings account of his annuity fund and an insured's advance from the reserve fund of his insurance policy did not create debtor-creditor relationships.³ In essence, the borrower was merely borrowing his own money. He was not liable to the lender for repayment. Similarly, the debtor that has borrowed from his plan has only borrowed from himself. There is no debtor-creditor relationship and therefore, no basis for a claim under 11 U.S.C. §101(5).

The Villarie court also noted that the plan did not have the right to sue the employee for the amount of the loan. If the employee were to retire or resign, the plan's sole remedy was to offset the amount borrowed against the amount remaining in the employee's account. Hence, under 11 U.S.C. §502(b), the claim was unenforceable against the debtor and could not give rise to a debt that could be discharged in bankruptcy. Accordingly, the Second Circuit held that the plan loan was not a debt or claim of the bankruptcy estate and therefore it was not dischargeable. With only one exception, courts have consistently followed Villarie, despite additional legal arguments made by a plan or a debtor.⁴ For example, in In re Scott,⁵ the debtor argued that the plan was a secured creditor of the bankruptcy estate. The loan was documented with a promissory note, providing for interest and principal to be repaid through a wage assignment on the debtor's compensation. In the event the debtor defaulted, the plan would treat the loan balance as a hardship withdrawal with attendant tax consequences to the employee, and the employee's vested account balance would be reduced by the amount the employee failed to pay.

But the district court held that the plan could not prevail in asserting a secured claim. The debtor's plan account was not property of the bankruptcy estate. Therefore, the plan could not have a lien against property of the estate.⁶ In addition, the setoff provisions of 11 U.S.C. §553(a) were not applicable because they require the existence of mutual debts. In this instance, the plan loan did not create a debt or claim in bankruptcy. Finally, it is well-settled that a wage assignment does not give rise to a continuing lien.⁷ For all of these reasons, the plan was not a secured creditor of the debtor.

The one exception to Villarie is a 1997 opinion of the Eastern District of New York. In In re Buchferer,⁸ the district court refused to extend the Villarie decision, which involved a chapter 7 debtor, to the case before it, in which the chapter 13 trustee objected to confirmation of a debtor's plan as unfairly discriminating against the unsecured creditors under 11 U.S.C. §1322(b). The court reviewed the legislative history of the definitions of "claim" and "debt" under the Bankruptcy Code and then moved to the provisions of 11 U.S.C. §§553(a) and 506(a) to conclude that although the plan did not have an in personam claim against the debtor, the plan did hold a valid secured claim. Relying on the words of 11 U.S.C. §102(2), the court held that the plan had a non-recourse secured claim against the debtor's estate, and therefore was entitled to be paid under the debtor's plan.⁹

However, 11 U.S.C. §102(2) provides that a claim against the debtor includes a claim against property of the debtor (emphasis added). Notably, nowhere in the Buchferer 12-page opinion does the court address how 11 U.S.C. §102(2) is applicable if the debtor's interest in the pension plan is not property of the debtor under the Bankruptcy Code.¹⁰ No court has yet followed Buchferer, although the Eastern District of Pennsylvania noted in dicta that it found "considerable merit in the reasoning of Buchferer."¹¹

Post-petition Payroll Deductions

If the plan loan does not give rise to a debt or claim in bankruptcy, the debtor's obligation to repay the loan will not be dischargeable. In that case, can the plan continue to receive payroll deductions post-petition in repayment of the loan?

Post-petition payroll deductions are generally held to violate the automatic stay provisions of 11 U.S.C. §362(6) because they are a means of collecting payment of a pre-petition claim.¹² However, as noted above, the plan does not have a pre-petition claim. Hence, as the Villarie court held, the plan may continue to accept payroll deductions post-petition in repayment of the loan, at least for a chapter 7 debtor.¹³

The chapter 13 debtor is in a different situation. Under 11 U.S.C. §1306(a)(2), post-petition earnings of the chapter 13 debtor are property of the bankruptcy estate until the case is closed, dismissed or converted.¹⁴ Consequently, not only do post-petition automatic payroll deductions from a chapter 13 debtor violate the automatic stay provisions of 11 U.S.C. §362, but they also may be avoidable under 11 U.S.C. §§549 and 522(h).¹⁵

Chapter 13 Plans

Yet despite the provisions of 11 U.S.C. §362, many consumer debtors propose to continue their automatic payroll deductions in full repayment of the plan loan—either within or outside their chapter 13 plan—while at the same time providing for less than 100 percent payment to their creditors. It is in this context that most of the law concerning plan loans has been made.

The analysis usually focuses on whether the chapter 13 plan meets the disposable income provisions of 11 U.S.C. §1325(b).

(1) If the trustee or the holder of an allowed unsecured claim objects to the confirmation of the plan, then the court may not approve the plan unless, as of the effective date of the plan —

(A)...; or
(B) the plan provides that all of the debtor's projected disposable income to be received in the three-year period beginning on the date that the first payment is due under the plan will be applied to make payments under the plan.

(2) For purposes of this subsection, "disposable income" means income which is received by the debtor and which is not reasonably necessary to be expended —

(A) for the maintenance or support of the debtor or a dependent of the debtor;...

Courts generally hold that post-petition wages of a chapter 13 debtor that would be automatically deducted from the debtor's wages for repayment of a plan loan must be included in the debtor's disposable income.¹⁶ Debtors have unsuccessfully argued the loan payments are necessary for the maintenance and support of the debtor;¹⁷ the payments are compulsory or a condition of their employment;¹⁸ the tax and penalty consequences of not repaying the loan make the repayments necessary;¹⁹ and even that in equity under 11 U.S.C. §105(a) the court should allow the payments.²⁰

In addition to contravening Bankruptcy Code provisions, the courts are guided by public policy.²¹ A debtor will not be allowed, in essence, to pay himself in full, while paying his other creditors less than 100 percent of their claims. To do so would unfairly discriminate against the debtor's creditors in violation of 11 U.S.C. §1322. Second, allowing debtors to pay themselves in full at the expense of their creditors would send an inappropriate message to future debtors, who would be encouraged to take out a loan in order to protect their future earnings from creditors. Last, a debtor's fresh start should be accomplished under the guiding principles of "good faith" and "fairness" in the treatment of creditors. Consequently, a post-petition chapter 13 debtor may continue to make payments on a plan loan outside the chapter 13 plan only if the debtor's chapter 13 plan provides for payment of 100 percent of the creditors' claims.²²

The disposable income issue may arise even without an objection by a trustee or creditor. In In re Fulton,²³ four separate debtors each sought confirmation of a chapter 13 plan. Each of the plans provided for the debtor to continue repayments for a pre-petition qualified plan loan while paying less than 100 percent of the unsecured creditors' claims. Absent objections from creditors, the trustee recommended each of the plans for confirmation. Nevertheless, the bankruptcy court, sua sponte, informed the debtors their plans would not be confirmed until and unless their plan complied with the Sixth Circuit's holding in Harshbarger. The court overruled the trustee's challenge that the court could not deny confirmation for failure to comply with 11 U.S.C. §1325(b) absent an objection. Relying on 11 U.S.C. §§1325(a)(1) and (3), which require the plan to comply with all provisions of chapter 13 and to have been proposed in good faith and not forbidden by law, the bankruptcy court held that it was bound by the Harshbarger precedent and, in fact, had an affirmative duty to follow Harshbarger.²⁴ Hence, confirmation of the chapter 13 debtors' plans was denied for failure to comply with Harshbarger and 11 U.S.C. §1325(b).

---

Footnotes

¹ In this article, "plan" refers to any retirement or savings plan that is a qualified trust under §401 of the Internal Revenue Code. 26 U.S.C. §401. Return to article

² New York City Employees' Retirement Sys. v. Villarie (In re Villarie), 648 F.2d 810 (2nd Cir. 1981). Return to article

³ Villarie, 648 F.2d at 812 (citations omitted). See, also, Mullen v. United States, 696 F.2d 470 (6th Cir. 1983) (readjustment allowance was type of prepaid retirement benefit that did not give rise to a claim); In re Vianese, 192 B.R. 61 (Bankr. N.D.N.Y. 1996) (a loan against an annuity is not a debt); In re Killian, 22 B.R. 551 (Bankr. E.D.N.Y. 1982) (claim for wages attributable to leave time advanced to the debtor was not a debt and not dischargeable). Return to article

⁴ In re Anes, 216 B.R. 514 (Bankr. M.D. Pa. 1998) (pension plan loans are not debts); In re Delnero, 191 B.R. 539 (Bankr. N.D.N.Y. 1996) (reaffirmation did not apply to debtors' retirement plan loan because it was not a debt); In re Goewey, 185 B.R. 444 (Bankr. N.D.N.Y. 1995) (debtor's obligation to repay retirement plan loan was not a debt); In re Schleifer, 170 B.R. 283 (Bankr. D. V.I. 1994) (not only was plan loan not a debt, but the debtor's employment would be considered an executory contract and when the debtor continued his employment he assumed as a condition of his employment to repay the loan). In contrast, but consistent with Villarie, in In re Miranda Soto, 667 F.2d 235 (1st Cir. 1981), the First Circuit Court of Appeals held the debtor's loan from the Asociacion de Empleados del Estado Libre Asociado de Puerto Rico to be a claim in bankruptcy. The First Circuit distinguished the loan from the Asociacion, a compulsory savings and loan association, from the retirement fund in Villarie, noting that in the case of the Asociacion, the debtor had borrowed not from just himself but from the entire fund. Hence a debtor-creditor relationship was created. Return to article

⁵ 142 B.R. 126 (Bankr. E.D. Va. 1992). Return to article

⁶ 11 U.S.C. §506(a) provides that "An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under §553 of the title, is a secured claim..." Return to article

⁷ Scott, 142 B.R. at 132, citing Miranda Soto, 667 F.2d at 237 and cases cited therein. Return to article

⁸ 216 B.R. 332 (Bankr. E.D.N.Y. 1997). Return to article

⁹ The Buchferer court likened the retirement plan loan to a debtor's refinancing a first mortgage and using the net loan proceeds to meet accrued unsecured debts. 216 B.R. at 343. The tax and penalty consequences to the debtor of defaulting on its plan loan also seemed to weigh heavily in the court's decision. Id. at 342. Other courts have been unswayed. See below. Return to article

¹⁰ Patterson v. Shumate, 504 U.S. 753 (1992). See, also, Scott, 142 B.R. at 130 ("Because the debtor's ERISA pension plan account is not part of the bankruptcy estate, the ERISA pension plan cannot have a lien on property of the estate securing debtor's loan."). Return to article

¹¹ In re MacDonald, 222 B.R. 69, 76 (Bankr. E.D. Pa. 1998). But see In re Devine, 1198 WL 386380 (Bankr. E.D. Pa. 1998) disagreeing with Buchferer on other grounds. Return to article

¹² In re Hellums, 772 F.2d 379 (7th Cir. 1985). In addition, at least one court has held that the fact that the post-petition payroll deductions are automatic does not relieve the creditor of its responsibility to ensure the stay is not violated. O'Neal v. Beneficial of Tennessee Inc. (In re O'Neal), 165 B.R. 859, 863 (Bankr. M.D. Tenn. 1994) ("Creditors should have the burden and responsibility of ensuring that no post-petition automatic loan payments are withdrawn from a debtor's checking account, absent the debtor's clear, post-petition consent to do so. The creditor should take whatever action is necessary and appropriate to achieve this goal. Failure to do so will lead to the imposition of sanctions in the form of the debtor's actual damages, including attorneys' fees and costs.") Return to article

¹³ Post-petition earnings of a chapter 7 debtor are not property of the bankruptcy estate. 11 U.S.C. 541(a)(6). Return to article

¹⁴ In addition, the chapter 13 trustee is vested with the right to control and supervise the use of the debtor's post-petition wages for execution of the plan. 11 U.S.C. §1322(a)(1). Return to article

¹⁵ In re Shepherd, 12 B.R. 151 (Bankr. E.D. Pa. 1981). Return to article

¹⁶ In re Harshbarger, 66 F.3d 775 (6th Cir. 1995), and see cases cited in Devine at 1998 WL 386380. This holding is consistent with cases holding that voluntary contributions to a 401K plan or other savings plan must be included in disposable income. See, e.g., In re Cavanaugh, 175 B.R. 369 (Bankr. D. Idaho 1994); In re Fountain, 142 B.R. 135 (Bankr. E.D. Va. 1992); In re Ward, 129 B.R. 664 (Bankr. W.D. Okla. 1991). Return to article

¹⁷ In re Festner, 54 B.R. 532, 533 (Bankr. E.D.N.C. 1985) ("These expenditures [including repayment of credit union loan] are desirable from the debtor's standpoint, but they certainly are not necessary. Additional pension plans and stock purchases may be a wise investment that enhance an individual's financial security, but the debtor is not entitled to acquire them at the expense of unpaid creditors."); See, also, Harshbarger, 66 F.3d at 777; MacDonald, 222 B.R. at 76; Scott, 142 B.R. at 134. Return to article

¹⁸ In re Delnero, 191 B.R. 539, 543 (Bankr. N.D.N.Y. 1996) (the court was not precluded from issuing an order ceasing payroll deductions despite the plan's statement that the employee could not terminate deductions). See, also, Anes, 216 B.R. at 515; Goewey, 185 B.R. at 446. But see In re Colon Vazquez, 111 B.R. 19 (Bankr. D. P.R. 1990) for the exception, where the court found that the evidence showed the deduction to be compulsory and a condition of the debtor's continued employment as a public school teacher. Return to article

¹⁹ In re Fulton, 211 B.R. 247, 258 (Bankr. S.D. Ohio 1997); In re Delnero, 191 B.R. at 543-4; Scott, 142 B.R. at 134. Return to article

²⁰ Fulton, 211 B.R. at 261. Return to article

²¹ Harshbarger, 66 F.3d at 778; Fulton, 211 B.R. at 260; Delnero, 191 B.R. at 544; Scott, 142 B.R. at 134; In re Jones, 138 B.R. 536, 539 (Bankr. S.D. Ohio 1991). Return to article

²² In re Carpenter, 23 B.R. 318, 320 (Bankr. D. N.J. 1982) (The balance of the debtor's post-petition wages after turning over wages sufficient to make payments under its plan for paying creditors 100 percent of their claims may be used to repay the plan loan). Return to article

²³ 211 B.R. 247 (Bankr. S.D. Ohio 1997). Return to article

²⁴ Fulton, 211 B.R. at 256. Return to article