The Hidden Costs of Bankruptcy Reform
Congress is once again embarking on the quest that is approached about every two decades—the search for a "fair" consumer bankruptcy system. As Congressman George W. Gekas (R-PA) noted upon the introduction of his reform bill H.R. 3150, the public perception is that for too long the relief afforded by bankruptcy has been too easily obtained by too many people who simply do not need the relief that bankruptcy provides. The Bankruptcy Reform Act of 1998 is designed to close the loopholes through which many debtors have slipped since the Code was enacted.
The heated debate that has followed the introduction of the bill has concentrated on the basic notions of bankruptcy, failure and forgiveness of debt,1 and whether there is a reason to be concerned that the number of bank-ruptcy filings has grown so substantially over the past two decades. Putting aside the basic philosophical debate that is raised by consideration of the legislation, practitioners in the consumer bankruptcy field have become concerned about the costs that the legislation will impose upon a system that already is overworked. Both creditor and debtor advocates are legiti-mately concerned that the costs imposed will be overwhelming. Examining the legislation for its transactional costs leads me to the conclusion that litigation and the need for judicial intervention will increase.
H.R. 3150 attempts to create a "means test" based on a combination of a debtor’s household income, and the amount of debt that could be repaid to creditors if the debtor lived by a very strict budget.2 The drafters of the bill hope to provide a quick litmus test for eligibility. A debtor could still qualify for chapter 7 relief if it could establish that extraordinary circumstances exist. Every trustee, both chapter 7 panel trustees and standing chapter 13 trustees, would be required to review debtors’ filings, "investigate and verify" the debtor’s projected monthly net income, and file a report with the court as to whether a debtor qualifies for chapter 7 relief.
It is clear that a chapter 7 trustee, even in a no asset case, would be required to conduct an investigation and submit a report. If the investigation by a trustee required about an hour and the preparation of the report required one-half hour, then the time required would total about 1.5 million hours of time (assuming a bankruptcy filing rate of one million petitions filed in a year, which would be a reduction of about 25 percent). If the value of that time were calculated at $150 per hour, the costs would be $225 million of time.
Assuming that one out of nine cases filing for chapter 7 relief would be contested3 and further assuming that the contest would require about two hours of pre-trial preparation and one hour of court time, the litigation would require 276,000 additional hours, about 90,000 of which would occupy the court.
The legislation limits the extent of the "superdischarge" found in §1328(a) of the Code by adding claims that are defined in §§523(a)(2) and (4) to the claims that are excepted from discharge in chapter 13.4 Simply grafting the provisions applicable to chapter 7 to the discharge provisions of chapter 13 will result in a significant increase in litigation in chapter 13 cases. Because debts that are listed under §§523(a)(2), (4) and (6) are discharged, unless within 60 days of the meeting of creditors an adversary action is brought by the creditor under §523(c), creditors holding such claims in chapter 13 cases also would be compelled to commence the required adversary action before expiration of the deadline. Even in cases in which a chapter 13 plan was proposed to pay a 100 percent dividend to the affected creditor, to prevent the loss of any rights in the event of a plan modification or a request for hardship discharge (§1328(b)), a creditor must initiate an adversary action within 60 days of the meeting of creditors. Debtors and creditors would be subjected to the necessity of litigation in cases where such litigation might not be needed.
While it might be possible for a court to simply place a number of adversaries on a dormant docket to see if there would be a need to actually litigate the issues presented, the number of unresolved adversaries would explode. Further, if litigation were to be needed at the end of a chapter 13 plan, perhaps five (or even seven) years after the filing of a case, the ability of a creditor to prosecute and the ability of a debtor to defend would be severely impaired. By delaying litigation, the costs of the trial would be increased. The legislation fails to provide a mech-anism to avoid unnecessary trials.
The Expansion of the Deemed Filed Rule
The legislation would expand the "deemed filed" rule to cases in chapters 7 and 13.5 Trustees would be deprived of the opportunity to actually review the proofs of claim that are filed by creditors to ascertain the amount of debt, whether the debt is based on a writing and whether an asserted security interest is properly perfected under state law. In any case in which there might be a doubt (and many trustees have indicated that all secured claims would need to be reviewed) the trustee would need to contest the allowance of the claim. Once a matter reaches the level of litigation, including the question of the allowance of claims, a creditor no longer can rely on the use of non-attorney paralegals to shepherd claims through the process. There would be additional court time required to resolve claims issues. The amount of time required by creditors to contest trustee motions is difficult to ascertain.
The bill would allow debtors additional time to file a chapter 13 plan.6 The bill would extend the time in which a meeting of creditors could be held,7 and it would preclude confirmation of a chapter 13 plan, even if the plan is uncontested, until at least 20 days after the meeting of creditors.8 A creditor actively involved in a chapter 13 case would be required to attend more meetings and hearings, would be required to obtain counsel if it wished to be heard at the court hearing and would reduce the benefits of compromise and settlement.
The impact on chapter 13 distri-butions would be significant. If the time delay becomes greater, initial disburse-ments would likewise be delayed. In those cases where a financial institution holds a claim that is secured by property of the debtor, and where the plan provides specific treatment of the claim, a mandatory write-off of the obligation would not be necessary if the distribution is prompt. By institutionalizing additional delays in chapter 13 distributions, the bill would result in the mandatory write off of many secured debts by financial institutions. Delay should be built into the system only where it is needed to resolve disputes between parties and protect individual rights.
Eliminating Trustee Expense Funds
The bill establishes a dual distribution of payments on claims in chapter 13 cases. Section 162 of the bill would require debtors to make payments directly to purchase money creditors at the contract rate until the confirmed plan would provide and actually pay full payments to the creditors. The effect of diverting from the trustee funds needed to implement a chapter 13 plan would deprive the trustee of the funds needed to accomplish all of the additional responsibilities imposed on the trustee by the legislation.9
Additional litigation would result when disputes are raised over the pre-confirmation payments made by the debtor. Since there would be no independent verification of the disbursements, the court may need to actually hold fact-finding hearings to determine whether a debtor had made all of the pre-confirmation payments required.
Since pre-confirmation payments would only be the regular contract payments and could not include "any arrearages, penalties or default or delinquency charges," disputes over the creditor’s application of the funds would arise. Assuming that an additional issue of confirmation of a chapter 13 plan would include how pre-confirmation payments would be applied, additional litigation could be assumed. If the recipient of the pre-confirmation payment by the debtor is an undersecured creditor, the application of any of the payments to interest would be in violation of §502 of the Code, and such funds might need to be returned to the debtor or applied to principal—placing the creditor with a claim balance actually less than the claim would have been had the debtor made all of the contract payments.
The costs of H.R. 3150 have not been tested. While a number of studies have examined the impact that "needs-based bankruptcy" would have on chapter 7 cases, no study has examined the way in which the bill would actually work in the field. Until that is done, we risk the chance that there will be a substantial cost component to all parties by its enactment.
1An excellent discussion of the larger societal implications in bankruptcy is found in Prof. Karen Gross’ work, Failure and Forgiveness, Rebalancing the Bankruptcy System, ©1997 Yale University Press. Return to text.
2Section 101 of the bill would allow a debtor to file for chapter 7 relief only if the debtor has income equal to or less than 75 percent of the median family income, if the debtor does not have at least $50 per month left over after consideration of the debtor’s reasonable living expenses as determined by the Internal Revenue Service allowances, and if the debtor could not repay at least 20 percent of unsecured claims allowing for the IRS living allowances, the secured claim payments and priority claims. Return to text.
3A study authored by The Policy Economics and Quantitative Analysis Group of Ernst & Young concluded that 11.8 percent of the chapter 7 petitions studied could be questioned. An informal survey of debtor’s practitioners indicates that most of these debtors, when represented by counsel, would avail themselves of the opportunity to litigate eligibility. Return to text.
4Section 143 of the bill would amend §1328(a)(2) of the Code by adding "(2) and (4)" to the list of subsections of 523 that are to be included in the exceptions to discharge. Return to text.
5The "deemed filed" rule can be found in §403 of the bill. Return to text.
6Section 406 of the bill would extend the time to file a chapter 13 plan from the current 15 days found in Rule 3015 FRBP to 30 days. Return to text.
7Section 401 of the bill would prohibit a meeting of creditors from being held earlier than 60 days from the filing of the petition. Currently, a meeting of creditors in a chapter 13 case cannot be held later than 50 days (in districts in which the court sits). Return to text.
8It should be noted that the bill contains inconsistencies in that it requires the court to hold a confirmation hearing within 45 days of the filing of a chapter 13 plan (§406) but precludes the holding of a confirmation hearing until 80 days after the filing of the plan if the plan is filed with the petition (60 days is the earliest time that a meeting of creditors could be held per §406, 20 days after a meeting of creditors is the earliest time for a confirmation hearing per §409). Return to text.
928 U.S.C. 586 permits a trustee to collect a percentage commission only on funds that are actually disbursed by the trustee and only in accordance with a confirmed chapter 13 plan. Pre-confirmation disbursements made by a debtor could not be subject to the trustee commission under existing law. One trustee already has estimated that the cost of administering a chapter 13 program would double. Most trustees could not double the commission imposed without a statutory amendment allowing an increased percentage fee. Return to text.