The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) has been the subject of most of the articles in the Consumer Corner column of this Journal for the past year. Much of the discussion has focused on the additional burdens imposed on consumer debtors, their attorneys and the courts resulting from additional disclosure obligations, additional calculations of income and expenses, additional steps to preserve, extend or impose the automatic stay and additional hearings imposed on what otherwise would have been a simple chapter 7 case. The impact, however, may reach far deeper and into the pockets of the unsecured creditor.

One of the expressed goals of the drafters of BAPCPA was to compel more debtors into chapter 13 repayment plans. The history of this legislation makes a key assumption: that the changes effected by BAPCPA will result in greater payback of debts. As President Bush indicated when signing the bill into law:

Under the new law, Americans who have the ability to pay will be required to pay back at least a portion of their debts... This practical reform will help ensure that debtors make a good faith effort to repay as much as they can afford.¹

The President's view is understandable. The legislative history also supports the notion that the law was intended to increase distributions to creditors:

The heart of the bill's consumer bankruptcy reforms consists of the implementation of an income/ expense screening mechanism ("needs-based bankruptcy relief" or "means testing"), which is intended to ensure that debtors repay creditors the maximum they can afford.²

Chapter 13 was the vehicle that would carry these increased payments to the unsecured creditors:

[I]f needs-based reforms and other measures were implemented, the rate of repayment to creditors would increase as more debtors would be shifted into chapter 13 (a form of bankruptcy relief where the debtor commits to repay a portion or all of his debts in exchange for receiving a broad discharge of debt)."³

The assumption that underlies these statements, and the assumption at the very heart of BAPCPA, is that by imposing an abuse test, debtors will elect to or be forced to convert to chapter 13, which will increase distributions to creditors. That was the way it was supposed to work. Reality is much different.

Across the country, practitioners and trustees are recognizing the new truth about chapter 13: The disposable-income test, as modified by BAPCPA, no longer compels a debtor to pay what a debtor can afford to pay; what must be repaid is much less. No longer must a debtor actually commit to a plan the funds available after deducting reasonable and necessary expenses. No longer must the debtor actually be subject to judicial and trustee supervision for at least three years, and no longer will general unsecured creditors be entitled to partake of the crumbs that might fall from a chapter 13 plan after the secured and priority creditors complete their feast.

Life Before the Disposable-Income Test

When the Bankruptcy Code was first crafted in 1978, it did not include a provision specifically requiring a chapter 13 debtor to dedicate available income to fund a chapter 13 plan. The judicial response was varied, but many courts applied the "good faith" requirement of §1325(a)(3) as requiring a debtor to use the debtor's "best efforts" to repay creditors.⁴ As one court early in the history of the Bankruptcy Code noted, "whether the debtor makes his best effort to pay his creditors as much as possible under the circumstances, or any other degree of effort which the debtor employs, may be considered by the bankruptcy judge in confirmation hearings."⁵

Most courts, however, applied a "totality of the circumstances" approach to the good-faith analysis, refusing to apply an "ability to pay" test as the sole factor on determining whether a chapter 13 plan met the good-faith standard.⁶ This was an unsatisfactory way to deal with a chapter 13 debtor that had the capacity to pay.

The Disposable-Income Test

In 1984, Congress remedied the confusion over the good faith of a low-paying plan by adopting the disposable-income test of §1325(b). As a result, courts abandoned the cumbersome tool of applying the good-faith test as the method to compel chapter 13 debtors to apply available income to repay creditors.⁷ In the intervening 22 years, courts have examined a chapter 13 debtor's income and expenses, struggling to determine what expenses are reasonable and necessary for the maintenance and support of the debtor or a dependent of the debtor. Trustees have used §1325(b) as a means to maximize distributions to unsecured creditors, challenging private school tuition,⁸ luxury automobiles,⁹ vacation homes,¹⁰ excessive recreation expenses¹¹ and other questionable lifestyle choices.

Practitioners grew accustomed to the jurisprudence of §1325(b). A debtor's actual projected income—irrespective of its source—would be reduced by these expenses, which would be considered reasonable and necessary. The resulting balance would be applied to fund the debtor's plan. This gave the trustees and courts the opportunity to actually employ a "best efforts" test in chapter 13 cases.

Disposable Income after BAPCPA

BAPCPA discarded the two decades of case law that had grown out of the disposable-income test, favoring a strict mathematical model to determine the amount of funds that would be paid to unsecured claimholders. Two tests have been created: one test for the below-median-income debtor and one test for the above-median-income debtor.

Both tests start with a palpable fiction: that the debtor's actual income is the same as the debtor's "current monthly income."¹² Many chapter 13 debtors have a somewhat transient employment history, and the average income experienced six full months prior to the filing of a chapter 13 petition is less than that debtor's actual income at the time of filing.¹³ This fiction is furthered by the exclusion of child support, foster care payments, social security income and unemployment income. The income of a nonfiling spouse of a debtor not devoted to expenses of the household is also excluded. Through timing, a debtor can cause the current monthly income to also be reduced.¹⁴ The expenses that are subtracted from the below-median-income debtor's current monthly income are the "amounts reasonably necessary to be expended for the maintenance or support of the debtor or dependent of the debtor."¹⁵ For a debtor whose actual income has increased from the current monthly income calculated, the reasonable family expenses will be proportionately higher. This, coupled with the statutory permitted expenses that are deducted from the debtor's current monthly income irrespective of the wisdom, need or fairness of such deduction (e.g., charitable contributions,¹⁶ payments for pension loan payments¹⁷ and pension contributions¹⁸) results in many—if not most—chapter 13 debtors having no available disposable income, as statutorily defined.

The statute then fixes the amount that must be paid in a chapter 13 case to unsecured creditors at zero. That the "applicable commitment period" is 36 months¹⁹ is fairly meaningless, since zero times 36 months is still nothing. This leads to the uncomfortable result: Where a debtor has the capacity to make such payments,²⁰ a chapter 13 plan can be confirmed, paying "all of the debtor's projected disposable income" to unsecured creditors—nothing—over a plan that can be completed in a period shorter (in some cases, remarkably shorter) than the 36 months that some proponents anticipated.

For the debtor with income above the median, the results are even more confounding, for a chapter 13 debtor may deduct from the potentially diminished current monthly income the amounts permitted under the abuse test of §707(b)(2)(A). As many other writers to this publication have indicated, the deductions permitted can be generous in an unintended way, since debtors may subtract payments that would have been paid to secured creditors outside of bankruptcy in an amount that is "scheduled as contractually due" over the five-year period. The debtor that elects to surrender collateral in the chapter 13 case would be permitted to subtract those payments contractually due. A debtor who has seen an acceleration of a long-term secured debt—as, for example, where a mortgage is in default and progressing toward foreclosure—the entire secured balance may be "scheduled as contractually due," grossly and artificially reducing what is available as disposable income. Again, large numbers of chapter 13 debtors are discovering that even though they have real income (or even "current monthly income") above the applicable state median, their disposable income is nothing. Just as with the below-median-income debtor, if disposable monthly income calculates to be nothing, the amount required to be paid to unsecured creditors remains nothing, even though the applicable commitment period is five years. In addition, as with the below-median-income debtor, a plan might easily satisfy the requirements of chapter 13, pay the statutorily established dividend to unsecured creditors (nothing), and complete payments in a time period far shorter than the applicable commitment period.

The Trustee Response

It should come as no surprise that this dramatic and unrecognized impact of the evisceration of the disposable-income test has confounded the community of chapter 13 trustees. Born and bred to work toward maximizing the distributions to unsecured creditors, trustees are seeking new and innovative ways to increase the pool to unsecured creditors.

Several trustees have indicated that they intend to reach back to pre-1984 jurisprudence to argue that a debtor with a demonstrated capacity to pay cannot satisfy the good-faith requirement of §1325(a)(3) if the debtor proposes a distribution to unsecured creditors limited to the debtor's disposable income. Several trustees have contested the ability of a debtor to confirm a chapter 13 plan that does not devote available funds to unsecured creditors over the time specified as the "applicable commitment period."²¹ In so doing, they argue that the distributions to unsecured creditors under the disposable-income test is a minimum, not fixed, amount.

Finally, some trustees are simply "jaw-boning" a minimal distribution to unsecured creditors that exceeds the disposable-income amount. Some are using their new statutory ability to demand post-petition tax returns and verified schedules of income and expenses as a way to get a greater dividend on the front end of a case.²² Some are threatening a laborious process of proof to reach confirmation of a "no-dividend case." How far this will extend probably depends on the fortitude of the debtors' bar.

The trustee still has one weapon to increase distributions to unsecured creditors—seeking a modification of the plan. Although disposable income is key in limiting payments to unsecured creditors at the confirmation of the plan, the disposable-income test does not appear to be applicable in a motion to modify brought under §1329.²³ Thus, a trustee might successfully seek a modification to increase the payments to unsecured creditors based on reality free from the fiction of the disposable-income test. To what extent a trustee's efforts will be limited by §1327 is unknown, but many trustees have indicated a willingness to explore that route.

The end result of BAPCPA may already be visible. Debtors may file more chapter 13 cases than prior to the new law, but they do so paying far less to unsecured creditors than was intended. Those who struggled for seven years to pass bankruptcy reform—i.e., the consumer creditor community—may wind up becoming the ones most hurt by its effect.

---

Footnotes

¹ Statement of the President in signing P.L. 109-8, April 20, 2005. 2005 WL 6393173 (Leg. Hist.).

² H.Rep. 109-31(I), p.1, 109th Conf. 1st Session 2005 WL 832198 (Leg. Hist.).

³ Id. at p. 12.

⁴ Interestingly, the reference to best efforts does not appear in chapter 13; it appears in §727(a)(9):

The court shall grant the debtor a discharge unless...the debtor has been granted a discharge under...§1328 of this title...in a case commenced within six years before the date of filing the petition, unless payments under the plan in such case totaled at least...

(B) (i) 70 percent of such claims; and
(ii) the plan was proposed by the debtor in good faith, and was the debtor's best effort... (emphasis added).

⁵ Matter of Kull, 12 B.R. 654, 659-660 (D. Ga. 1981). See, also, In re Long, 10 B.R. 880 (D. S.D. 1981): "If...the debtor's plan provides...a substantial bi-monthly surplus, then the bankruptcy court should not confirm the plan until a significant portion has been dedicated as a dividend for unsecured creditors." Id. at 883.

⁶ See, e.g., In re Estus, 695 F.2d 311 (8th Cir. 1982).

⁷ "Congress adopted the 'ability-to-pay' provisions of §1325(b)...which provided that the amount that a debtor could reasonably afford to pay would be both a floor and a ceiling for chapter 13 plan payments." In re Stein, 91 B.R. 796, 800 (Bankr. S.D. Ohio 1998).

⁸ In re Watson, 309 B.R. 652 (1st Cir. BAP 2004).

⁹ In re Reyes, 106 B.R. 155 (Bankr. N.D. Ill. 1989).

¹⁰ In re Cardillo, 170 B.R. 490 (Bankr. D. N.H. 1994).

¹¹ In re McNichols, 249 B.R. 160 (Bankr. N.D. Ill. 2000).

¹² 11 U.S.C. §101(10A).

¹³ Many practitioners advise that bankruptcy, and chapter 13 in particular, is a tool to be used when a debtor is on the way up, when there is income available to retain a house or car following default. Thus, a chapter 13 may often be filed when a debtor's financial condition has just improved.

¹⁴ For example, a debtor that has been unemployed for several months prior to filing will have a much lower current monthly income than a debtor enjoying the same income at the time of filing.

¹⁵ 11 U.S.C. §1325(b).

¹⁶ 11 U.S.C. §1325(b)(2)(A)(ii). It is interesting to note that the ability to subtract charitable contributions from current monthly income may be restricted to chapter 13 debtors whose income is below the median income, since the mandate that charitable contributions constitute amounts reasonably necessary to be expended is in §1325(b)(2)(A) and not in §1325(b)(2)(B), which outlines the method of calculating amounts reasonably necessary to be expended for a debtor above the median income.

¹⁷ 11 U.S.C. §1322(f).

¹⁸ 11 U.S.C. §541(b)(7).

¹⁹ 11 U.S.C. §1325(b)(4).

²⁰ Such would be the case if the current monthly income is less than the debtor's actual income, permitting a chapter 13 debtor to propose payments that the debtor can afford, pay secured claims, cure defaults and satisfy the obligation to unsecured claims (mostly nothing) in whatever time period the debtor may elect.

²¹ The recent case law has been trending away from this "temporal" component to the applicable commitment period. For example, the recent case of In re Sunahara, 326 B.R. 768 (9th Cir. BAP 2005), held that a chapter 13 plan could be completed in fewer than 36 months (under the "old" disposable income test). See, also, In re Sounakhene, 249 B.R. 801 (Bankr. S.D. Cal. 2000) (debtor could refinance home and pay off a plan in a time period shorter than 36 months).

²² 11 U.S.C. §521(f)(4) gives to any party in interest the ability to compel a chapter 13 debtor to submit tax returns and statements of income and expenses on an annual basis. Most parties anticipate that it will be the trustee that will require this.

²³ See Sunahara, infra.