Chapter 7 Bankruptcy and Section 707(b): Should the "substantial Abuse" Standard Be Replaced? - J. Kaz Espy

• Publication year: 2005

Comment

Chapter 7 Bankruptcy and Section 707(b): Should the Subjective "Substantial Abuse" Standard Be Replaced by an Objective "Means-testing" Formula?

I. Introduction

Because our society has become more and more reliant on the concept of "credit," the level of individual indebtedness has risen and, as a direct corollary, individual filings for bankruptcy relief have also increased.¹ Credit can be beneficial to John D. Consumer ("Consumer")² by allowing him to take possession of goods and pay for them at a later date. This in turn stimulates the economy by giving consumers more buying power. However, when Consumer fails to use discretion in his use of credit, he quickly finds out how the seemingly wonderful concept of credit can become a nightmare. If Consumer becomes insolvent he may begin to consider various options to resolve his situation, one of which is to file bankruptcy.³ However, even if he is not insolvent, he still has the option of filing bankruptcy.⁴

In the United States, the consumer bankruptcy system began in 1898 with the "advent of a permanent federal bankruptcy law, and a discharge law similar to that still in effect today."⁵ The Bankruptcy Act of 1898⁶ "remained on the books for eighty years."⁷ Nevertheless, since its inception, the consumer bankruptcy system has not remained static. When this country was in the grasp of the Great Depression, "Congress passed a variety of 'reorganization' laws designed to help debtors retain their property or businesses."⁸ These reorganization laws substituted equity receiverships, previously the primary means of effecting reorganizations.⁹ In 1978 Congress restructured bankruptcy procedure and bankruptcy courts by enacting the 1978 Bankruptcy Reform Act¹⁰ (the "Act").¹¹ Substantively, the Act created Title 11 of the United States Code or the Bankruptcy Code (the "Code").¹² Congress remains free to amend the Code as it sees fit or, probably, to amend as pressure from different segments from our economic society is exerted. This is evidenced by two major revisions in 1984 and 1994.¹³

The Code is presently divided into the following chapters: One, Three, Five, Seven, Nine, Eleven, Twelve, and Thirteen.¹⁴ Chapters One, Three, and Five are chapters of general applicability; whereas, Chapters Seven, Nine, Eleven, Twelve, and Thirteen address specific bankruptcy procedures for liquidation or reorganization of debt.¹⁵ The Code is structured in a way that enables a debtor's affairs to be worked out in a single forum.¹⁶ Pursuant to 28 U.S.C. Sec. 1334,¹⁷ "[f]ederal district courts have original and exclusive jurisdiction over all 'cases' under Title 11."¹⁸ However, "[b]ankruptcy courts are adjuncts of the district courts" and 28 U.S.C. Sec. 1334,¹⁹ read in conjunction with 28 U.S.C. Sec. 157(a), "allows the district court to 'refer' any or all bankruptcy cases to bankruptcy judges."²⁰ This language authorizing district court judges to refer bankruptcy matters to bankruptcy judges has become a firmly institutionalized practice with practically all bankruptcy petitions being filed in bankruptcy courts.²¹

When an individual files for bankruptcy he normally has two primary choices: (1) Chapter 7 liquidation or (2) Chapter 13 "wage earner's plan."²² Chapter 7 and Chapter 13 facilitate relief for individual consumers, whereas other chapters address types of reorganization—Chapter 9 for a municipality; Chapter 11 for business; and Chapter 12 for family farmers. Despite both of these forms of debtor relief (Chapter 7 and Chapter 13) having their respective qualities, to an individual debtor, Chapter 7 is often considered the more attractive of the two because of its "fresh start" concept. A Chapter 7 debtor, who offers his non-exempt assets, if any, for liquidation so a distribution can be made of the proceeds to his creditors, is relieved of all liabilities and is entitled to a financial clean slate completely unencumbered by pre-petition liabilities subject to discharge.²³ Because there generally is not a bright-line test or any other objective criteria requisite to filing a Chapter 7 petition, many debtors file under this section despite having the ability to pay a portion of their debts out of future income (i.e., under a Chapter 13 wage earner's plan).²⁴ Further, 11 U.S.C. Sec. 303(a) only authorizes the involuntary commencement of a Chapter 7 or a Chapter 11 case.²⁵ Thus, concerned creditors cannot force an individual consumer debtor into a Chapter 13. A debtor can only voluntarily file a petition under Chapter 13.²⁶ This dilemma is often referred to as the problem of the "Can-Pay" debtor.²⁷

In response to the influential concerns of the consumer credit industry, in 1984 Congress attempted to alleviate the "Can-Pay" debtor problem by adding Sec. 707(b) to the Code.²⁸ This section authorizes bankruptcy courts to dismiss a Chapter 7 case if the following criteria are satisfied: (1) the debtor is an "individual" within the meaning of the Code; (2) the debts are primarily consumer debts; and (3) the court finds the filing was a "substantial abuse" of Chapter 7 proceedings.²⁹ Normally, whether a debtor is an individual and whether his debts are consumer in nature are questions that are easily determined by the courts. On the other hand, the "substantial abuse" provision has been subject to inconsistent interpretation. As Part II of this Comment will demonstrate, the elements of "substantial abuse" have been left to judges' discretion; and Congress has provided little guidance as to the exact conduct this phrase was intended to prevent. Consequently, there has been a wide variation in the methods courts use to determine "substantial abuse" under Sec. 707(b).

The primary method proposed to address the Can-Pay debtor problem is "means-testing."³⁰ Although "means-testing," as a concept, has various formulations, in essence, the idea is to remove some of the discretion judges currently have and institute some form of objective criteria by which an individual debtor would be evaluated and possibly precluded from proceeding under Chapter 7. Those debtors who have the financial means to repay some specified portion of their debts in the future will be forced into Chapter 13. Part III of this Comment will focus on means-testing as a resolution to the "Can-Pay" debtor problem.

Prior to 1984 the consumer credit industry lobbied for Congress to address the Can-Pay debtor problem.³¹ Congress's response was the enactment of Sec. 707(b).³² Now, however, because the credit industry perceives Sec. 707(b) as ineffective, it is again pressuring Congress to institute some additional safe guards that will bar certain individuals from filing under Chapter 7 (i.e., means-testing).³³ But even if the industry's concerns are justified, is the consumer credit industry really blameless in the creation of this problem? Further, if they are to blame, is there a way industry policy, and not legislation, could alleviate the "Can-Pay" debtor problem? Parts IV and V of this Comment will address these questions.

II. Section 707(b) and "Substantial Abuse": Judges Call It How They See It

A. The Attraction of Chapter 7

The modern era of bankruptcy law began in 1898 when Congress enacted the 1898 Bankruptcy Act.³⁴ The inception of the modern era of bankruptcy law ushered in "a strong and unmistakenly debtor-friendly posture"³⁵ as demonstrated by the 1898 Bankruptcy Act providing "few grounds for denying discharge."³⁶ The American consumer bankruptcy system was based on the idea that all honest individual debtors should have an immediate and unconditional discharge freely-available "in exchange for the surrender of current non-exempt [sic] assets, if any."³⁷

Today, the idea of a freely-available, immediate, and unconditional discharge, contingent upon the surrender of non-exempt assets, remains alive (Chapter 7 liquidation), although its future health is questionable. Present bankruptcy laws provide consumer debtors with options of how they would like to proceed in bankruptcy.³⁸ The debtor chooses the bankruptcy relief option that best effectuates his purposes and goals, not the needs of the creditors.³⁹ The primary options available to an individual consumer debtor are the filing of a Chapter 7 liquidation petition or a Chapter 13 wage-earner's plan.⁴⁰ Although Chapter 13 consolidates debts and structures a payout over time before entry of a discharge, a Chapter 7 case results in an immediate discharge of pre-petition liabilities, and thus enables the debtor to have a "fresh start." This apparent windfall appears to have minimal procedural safeguards in that there are no limitations prohibiting an individual debtor from filing Chapter 7 other than Sec. 707(a) and (b).⁴¹ Further, those safeguards that are present are inconsistently interpreted, as we will see later.

In essence, when a debtor files a Chapter 13 petition, the debtor is agreeing to surrender future earnings for a specified period of time, hence the label, wage-earner's plan. In order for the court to confirm a Chapter 13 plan, the debtor must demonstrate that unsecured creditors will be paid at least the amount that the unsecured creditors would receive if the debtor liquidated under Chapter 7.⁴² Generally, this is referred to as the "best interest" test.⁴³ Consequently, the analysis of any Chapter 13 case concerns a measure of the debtor's nonexempt assets available for liquidation. As a general rule, if after this analysis it is determined that unsecured creditors will be paid more under a Chapter 13 plan, it is presumed these unsecured creditors would prefer the debtor proceed under Chapter 13 as opposed to Chapter 7.⁴⁴ Nevertheless, proceeding under Chapter 13 is entirely at the debtor's discretion.⁴⁵ Thus, "[a] debtor ... is free to play [his] strengths in choosing the appropriate chapter under which to file."⁴⁶

Considering these strengths, proceeding under Chapter 13 only makes sense if the debtor not only desires to retain his...