Is There A Movement To Force Chapter 7 Debtors Into Chapter 11 Bankruptcies?

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In the Ninth Circuit where I practice, this question is relatively new terrain. To understand what’s happening it’s helpful to review a few basic Chapter 7 concepts before diving in. In Chapter 7 debts are erased all at once. The whole process typically takes between five and six months, from the day we file the petition until the debtor gets the discharge. Once the Court grants the debtor a discharge, the dischargeable debts are wiped out without the debtor paying anything on them. Of course, from the creditors’ perspective, this is a bit of a hit. Therefore, there are limitations. One of the limitation is getting in the Chapter 7 door in the first place.

Congress has given us a three-part test to determine eligibility for Chapter 7 protection. I realize most people think in terms of the two-part means test, but there is a third part. The idea behind this three-part test is to weed people out of Chapter 7 bankruptcy who have the resources to pay their creditors something in a plan of reorganization.

1. The Two-Part Means Test

   In the two-part means test, we begin with current monthly income (CMI), which is defined in the Bankruptcy Code as the six-month arithmetic average of gross income for the six full calendar months immediately before the month the debtor files the bankruptcy petition.

   In the first part of the test we annualize current monthly income by multiplying by twelve, and compare the annualized current monthly income (ACMI) to the median annual income in California for a family of the debtor’s size. If ACMI is less than the median income, the debtor probably belongs in Chapter 7.

   If ACMI is greater than the median income, we apply the second part of the means test. In the second part of the test we use CMI without annualizing it. From CMI we subtract taxes and social security, and living expenses, to calculate disposable monthly income (DMI). Most of the living expenses we subtract are IRS standard living expenses for the debtor’s family size. Finally, we subtract any additional living expenses the debtor might have that aren’t envisioned in the IRS standard expenses, that the debtor can convince the judge and the U.S. Trustee’s Office are legitimate. The result is the DMI.

   The reason we calculate DMI is to answer the question: If the debtor didn’t have any unsecured debt, how much money would be left over after paying taxes and social security and reasonable living expenses to pay creditors? Therefore, we do not include payments on credit card debt in reasonable living expenses.

   Ideally, we want DMI to be negative, meaning that the debtor has nothing left over to pay creditors. Technically, you can file with a positive DMI, but I don’t like to because I think it is like poking the beast with a sharp stick.

   The two-part means test I have just limned, is the embodiment of Section 707(b)(2) of the Bankruptcy Code. If you fail the means test, and still file a Chapter 7 petition, then either the U.S. Trustee, or a creditor, may seek to dismiss the case under pursuant to section 707(b)(2) of the Bankruptcy Code; or in the alternative — and only with your consent — convert the case to one under either Chapter 11 or Chapter 13.

2. The Problems With The Means Test

   There are two obvious artificialities in the means test.

   The first artificiality is the use of CMI, which is a six-month arithmetic average of gross income. Unfortunately, CMI might not accurately predict the debtor’s future income. On the one hand, suppose the debtor had a drop in income. Then the six-month arithmetic average might overstate what the future income will be. On the other hand, suppose the debtor’s income went up. Then the six-month average might understate the debtor’s future income.

   The second artificiality is the use of IRS standard living expenses, which may bear little, if any, resemblance to the debtor’s real-life living expenses.

   In light of these artificialities there is another place in the bankruptcy papers where we list income and expenses: Schedule I for income, and Schedule J for expenses. In Schedule I we list income as of the date we file the petition rather than a six-month average, and in Schedule J we list real-life living expenses rather than IRS standard expenses. We then subtract the Schedule J total of expenses from the Schedule I total of income to get the so-called, IJ Difference. Sometimes the IJ Difference is considerably larger than DMI because some people live more frugally than the IRS standard family. This means that there may be money left over to pay creditors in a Chapter 11 or Chapter 13 plan of reorganization. If that is the case, then either the U.S. Trustee or a creditor may seek to dismiss the case under the totality of circumstances standard of section 707(b)(3)(B) of the Bankruptcy Code.

3. An Important Limitation Of Section 707(b)

   Section 707 is the only section of the Bankruptcy Code under which a Court can dismiss a Chapter 7 case. Based on Ninth Circuit case law, section 707(a) is generally not used to dismiss a case based on ability to pay, so the action is limited to section 707(b).

   According to section 707(b)(1), section 707(b) only applies to a case in which the debtor’s debts are primarily consumer debts. If the debtor’s debts are not primarily consumer debts, then section 707(b) does not apply, so the case cannot be dismissed under any subsection of section 707(b). As a consequence, the debtor does not have to complete the means test. For linguistic simplicity, we’ll refer to such a case as a nonconsumer case.

4. Can The Court Force The Debtor Into Another Chapter?

   What happens in a nonconsumer case with a relatively large IJ Difference?

   There are two other chapters that we typically put people in: Chapters 13 and 11. Both of them involve repayment plans. If dismissal is unavailable, can the Court force the debtor into one of those chapters by converting the case?

• The Court Cannot Force An Individual Debtor Into Chapter 13

  The Congressional legislative history and the Bankruptcy Code make it very clear that the Court cannot force somebody into Chapter 13. Why? Because a conversion to Chapter 13 would violate the thirteenth amendment to the U.S. Constitution. That amendment, which was enacted just a few months after the civil war ended, bars involuntary servitude and slavery. Congress explicitly stated in the legislative record that forcing somebody into a Chapter 13 case would constitute involuntary servitude, thus violating the thirteenth amendment. And in 1991, the U.S. Supreme Court stated as much in Toibb v. Radloff.

• The Chapter 11 Context

  However, in the Toibb case the Supreme Court also stated that there was no constitutional impediment to forcing an individual debtor into a Chapter 11. Why the difference?

  In 1991, the Bankruptcy Code had two Chapter 13 provisions without Chapter 11 analogues. First, the debtor’s postpetition income — income earned after filing the petition — was part of the bankruptcy estate created upon filing the petition. Second, the debtor had to devote postpetition income to paying creditors through a Chapter 13 plan. Therefore, forcing a debtor into a Chapter 13 would compel the debtor to work for the creditors: involuntary servitude. At the time, those provisions did not exist in Chapter 11, so there was no thirteenth amendment problem with forcing the debtor into Chapter 11.

  In 2005, Congress enacted the Bankruptcy Abuse Prevention And Consumer Protection Act (BAPCPA). BAPCPA changed many things in the Bankruptcy Code, including Chapter 11. In the process it added analogues to the two Chapter 13 provision regarding postpetition income to Chapter 11. As a consequence, an individual Chapter 11 debtor’s postpetition earnings now go into the bankruptcy estate, and must be devoted to plan payments.

   

  Therefore, based on the Toibb holding, one would naturally conclude that the constitutional prohibition against forcing an individual debtor into a Chapter 13 bankruptcy would now apply, mutatis mutandis, to Chapter 11.

5. Motions To Convert Under Section 706(b)

   The Court can dismiss a Chapter 7 case only under section 707. And in a consumer case, the Court can convert the case to one under Chapter 11 or Chapter 13 only with the debtor’s consent.

   The other way the Court can convert a Chapter 7 case to one under another chapter is using section 706.

   The debtor can request conversion to Chapter 11, 12, or 13 under section 706(a) if the case has not been previously converted. A party in interest (including the debtor) can request conversion to Chapter 11 under section 706(b).

   There is no constitution impediment to a party in interest requesting such a conversion in the case of a nonindividual debtor because the thirteenth amendment protects individuals rather than businesses.

   What about the nonconsumer case with a relatively large IJ Difference? Based on the Toibb holding it seems apodictic that in the post-BAPCPA world a section 706(b) motion to convert to Chapter 11 filed by someone other than the debtor would violate the thirteenth amendment.

   However, there has been a movement to apply section 706(b) to nonconsumer cases.

   In fact, I recently faced a section 706(b) motion filed by the IRS to convert to Chapter 11 in a nonconsumer case. Unfortunately, the judge granted the motion, which we are currently appealing. I will say that the judge felt a little uncomfortable with granting the motion because of the lack of an enforcement mechanism if the nonconsumer debtor is uncooperative. If he were to dismiss the Chapter 11, the result would ultimately be dismissal of the original Chapter 7 without using section 707: An end run around the nonconsumer prohibition of section 707(b)(1). Seems like bad faith to me.

6. Options

   If you are listening to this video right now, you might be asking how this discussion applies to you. What are your options?

   Before this move to apply section 706(b) to individual cases, if I had a client who came in with primarily nonconsumer debts, I would suggest Chapter 7 because, according to section 707(b)(1), the means test didn’t apply. But now, if I have a high-income client who comes in with primarily nonconsumer debts, I’m going to warn that person that there is a high likelihood that the U.S. Trustee or a creditor will file a motion under section 706(b) to convert the case to Chapter 11. Unless the debtor wants to fund the ensuing litigation, I will counsel filing under a different chapter.

   Chapter 11 is the most complicated in the Bankruptcy Code, and is therefore the most expensive. Therefore, on a first pass I might suggest filing under Chapter 13 because it’s much less complicated than Chapter 11. It does have a multi-year debt repayment plan, but it doesn’t have the complexities that make Chapter 11 so expensive.

   Unfortunately, Chapter 13 has two debt ceilings, one for secured debts, the other for unsecured debts. Therefore, if the debtor’s debts exceed either of these ceilings, Chapter 11 may be the only available chapter. I am of course happy to file a Chapter 11 for you, if that is necessary.

7. Closing Thoughts

   Whether we win on the appeal remains to be seen. I think the thirteenth amendment argument is very strong — indeed, dispositive — and the case may bubble up to the U.S. Supreme Court, where Toibb can be applied. But that will take some time.

   While there have been a few cases around the country, there haven’t been very many in the Ninth Circuit where I practice — and all the Ninth Circuit ones have been at the Bankruptcy Court level.

   We have to see how appellate courts will rule because of a doctrine called stare decisis. Under stare decisis an opinion by an appellate court is binding on all courts below it. If, for example, the Ninth Circuit rules on this question, then its decision will be binding on all courts in the Ninth Circuit. Of course, it will not be binding on courts in other circuits.

   This may ultimately end up before the U.S. Supreme Court because the U.S. Constitution says that one of Congress’s enumerated powers is to develop uniform laws on the subject of bankruptcies throughout the United States. If the Supreme Court rules on the question, its holding will be binding on all courts, thus producing uniform law on it.

   In sum, this is an unsettled area of law, so if you have relatively high income and primarily nonconsumer debts, you might not want to roll the Chapter 7 dice. Instead, you may wish to consider either a Chapter 13, or if your debts are too large to qualify for a Chapter 13, a Chapter 11.

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