Chapter 5 Getting In, Getting Out

• Jurisdiction: United States

Chapter 5 Getting In, Getting Out

§ 5.1 ~ The Ins and Outs of Bankruptcy

If you think the debtor is concealing or wasting significant assets, you may want him in bankruptcy, where his conduct is regulated and a trustee may be appointed. If you perceive that he is stalling a foreclosure, you probably want him out, so you can have your way with the property. In short, the question of whether to push him in or out is a strategic choice that will depend on the facts of the individual case.

At one extreme is the case where the debtor is concealing or wasting assets, you want him to stop, and there is no other route to relief. In this case, bankruptcy is the prescription and the involuntary filing may be the solution.

At the other extreme, suppose you are trying to foreclose on your collateral when the debtor files for relief under chapter 11. Your main concern is to get relief from the stay so you can finish your foreclosure. You don't want to push him into a chapter 7. If you did that, you would only buy yourself a new enemy in the form of a trustee who might challenge your lien (or whatever) — and you might pick up a host of competing creditors as well. Dismissal of the case wouldn't hurt, but you don't need it, certainly not at the cost of provoking opposition from other creditors. What you want is just relief from the stay.

There are any number of positions in between these extremes. The merits will vary depending on the facts of the case.

§ 5.2 ~ The case: a restatement

Earlier, we provided a sketch of a simple bankruptcy case.¹ To frame up the current discussion, here we offer a slightly different sketch. Recall that the typical bankruptcy case begins when the debtor files a petition.²

Along with it (or soon thereafter), he files schedules and statements of affairs.³ In the old days, we used to say that most debtors are individuals; most file under chapter 7 with the intent of getting a discharge; and most get what they want. While that is for the most part still true, since the 2005 amendments the Bankruptcy Code now imposes a "means test," which requires an analysis of whether the debtors' income is above the median amount in their state and, after deducting allowable expenses, would leave a sufficient surplus to service past debt. At the beginning of the individual debtor's chapter 7 case, the debtor must file certain forms to show that he passes the "means test" under § 707(b).⁴ If the debtor flunks the means test, his case will either be dismissed or converted, typically to chapter 13.

The "means test" language in § 707(b)(2)(A)(i) is complicated at first glance, but it boils down to this: Estimate the debtor's net disposable income over the next five years. If the debtor will have less than $7,475 aggregate net, then he passes and can stay in chapter 7. If he will have more than $12,475 net, then he (presumptively) flunks and cannot stay in chapter 7. Between $7,475 and $12,475, there is a percentage rule: If he can pay more than 25 percent of his unsecured nonpriority debts, he flunks; otherwise, he passes.

If you flunk the means test, the result is that your chapter 7 filing is "presumed" to be an abuse. Your choices then are to forget bankruptcy altogether, convert to chapter 13 (if you fall within the debt limits for chapter 13 and are willing and able to use your discretionary income to pay some or all of your debts), convert to chapter 11, or try to rebut the presumption of abuse. The grounds for rebutting the presumption are stringent, requiring, inter alia, "special circumstances, such as a serious medical condition or a call or order to active duty in the Armed Forces."⁵

At first blush, this may sound fairly stringent. But the means test only applies if the debtor's income is above the "median" for his state. At this writing, medians for a family of four run from $28,763 (in Puerto Rico) to $105,299 (in Maryland). Since most bankruptcy filers fall below the median, the number of cases in which the means test actually applies is fairly small.

The alert reader will ask, Who ever came up with such a mishmash? The answer is that it is a legislative compromise: Some wanted a hard number; some wanted a sliding scale. So we get a little bit of each. Note that it leads to some weird results, though: If the debtor has $12,474 in projected net income and debts of $50,000, he passes and can stay in chapter 7. If he has $12,475 net income and debts of $10 million, he (presumptively) flunks.⁶ At the other end, if he has net income of $7,474 and debts of only $1,000, he passes and can stay in chapter 7, but if he has a net of $7,475 and debts of $29,000, he (presumptively) flunks.

The avowed purpose of the means test was to cut down on the number of chapter 7s: to reduce the number of "frivolous" or "unnecessary" filings, and (perhaps more important) to leverage some debtors into chapter 13 (or chapter 11), where they will be required to pay some or all of their debt.⁷ However, as it has turned out, debtors who have filed for chapter 7 have, for the most part, had below-median incomes and have in fact needed relief. One thing that the means test (and other BAPCPA amendments) did manage to accomplish is to increase complexity and drive up costs.⁸

In previous editions of this book, we also said:

A smaller number of debtors file for relief under chapter 13.⁹ Unlike debtors in chapter 7, these chapter 13 debtors surrender a portion of their post-petition earnings to the court for distribution among creditors. In exchange, they get a "premium" discharge, broader in scope than they would get in chapter 7.

This is probably still broadly correct, but it needs nuance. One purpose of the means test was to redirect debtors away from chapter 7 and into chapter 13,¹⁰ which is not overly hospitable to debtors. For example, the typical chapter 13 plan period is five years,¹¹ and the scope of the former "superdischarge" is not as broad as it used to be.¹²

Fewer in number, but perhaps more important to lawyers, are the cases filed under chapter 11.¹³ While a few of these cases involve individual debtors, most involve businesses. Typically, no trustee is appointed, and the debtor remains in possession (as DIP) with the powers and responsibilities of a trustee. The premise of chapter 11 is that someone (usually the debtor's management) will propose a plan of reorganization. If it is confirmed, and the debtor will remain in business rather than liquidate, then the debtor receives a discharge. What the discharge means in chapter 11 is that creditors can only be paid to the extent provided in the confirmed plan.

The drafters set forth threshold requirements for relief in bankruptcy in § 109 and in §§ 301 through 303, and related rules. The statutes and rules make for intricate reading on first encounter, but they present few practical problems in application.

§ 5.3 ~ Who May be a debtor: in general

Section 109 defines who may be a debtor. Section 109(a) specifies that a "person" may be a debtor. "Person" is a term defined under the Code. Section 101(41) provides that "'person' includes individual, partnership, and corporation."¹⁴ Section 101(9) defines "corporation" and specifies that the term includes business trusts. Nonetheless, the courts have encountered occasional difficulty in figuring out where to put specialized entities such as the "Illinois land trust."¹⁵

"Individual" and "partnership" are undefined. An "individual" in ordinary parlance means a human being.¹⁶ A "partnership" is generally defined by reference to state partnership law.¹⁷ "Person" does not include a government unit, except in limited cases.¹⁸ Two classes of persons are excluded from chapter 7. The first excluded class is financial intermediaries: banks and insurance companies, both domestic and foreign. The second excluded class is railroads. The exclusion of financial intermediaries is justified on the grounds that there are fully developed regulatory schemes for financial institutions already in place elsewhere.¹⁹ In the case of insurance companies, there is also the deep-rooted congressional policy of deferring insurance regulation to the states.²⁰

Both justifications carry a superficial plausibility. But while regulatory schemes may function for both banks and insurance companies, it is not obvious that regulators have any special competence at liquidation or reorganization. Anyone who watched the regulators administer the crisis in the savings and loan industry during the late 1980s and early 1990s or the government's attempts to rescue financial institutions from the 2008 recession may well wonder whether the chapter 11 process might have been a better option. The Bankruptcy Code does cover stock and commodity brokers, who are covered by their own subchapters of chapter 7.²¹

There are some curious interpretation problems in deciding just who is an insurance company, particularly in the case of health care providers. A provider who offers to furnish all necessary health care for a fixed fee is, after all, accepting a fee in exchange for bearing a risk — which is exactly what an insurance company does. Some courts, when confronted with the question of whether a particular health care entity is eligible for bankruptcy relief, seem to have resorted to inquiring as to whether there is any other regulatory scheme in place. If there is no other regulator (so the reasoning seems to go), then the entity must not be an insurance company and correspondingly must be eligible for bankruptcy.²² This is probably good rough-and-ready justice.

§ 5.4 ~ Who May be a debtor: chapter 11

Anyone who may be a debtor in chapter 7 may be a debtor in chapter 11, except for stock and commodity brokers.²³ The exclusion of brokers can be read as embodying a policy that the failing broker must be disposed of swiftly so as to maintain confidence in the financial system. This is consistent with the general notion of the separateness of financial assets and entities.²⁴

At any...