Consumer abuse of bankruptcy: an evolving philosophy of debtor qualification for bankruptcy discharge.

• Author: Coulson, Richard E.

INTRODUCTION

In 1984, Congress amended section 707 of title 11, United States Code ("Bankruptcy Code" or "Code") to provide for dismissal of a consumer debtor's Chapter 7 (liquidation) petition in bankruptcy if the court found that granting "relief would be a substantial abuse of the provisions" of Chapter 7.(1) This amendment was contained in section 312 of subtitle A, entitled "Consumer Credit Amendments," of the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA).(2) Congress enacted the amendment after a prolonged period of contention during which representatives of the consumer finance industry sought to reduce the availability of the protection of bankruptcy for some debtors who were viewed as abusing the bankruptcy process.(3) The nature of the abuse was empirically presented in a study commissioned and paid for by the consumer finance industry.(4) The thrust of the study, as used in Congress, was that some consumer debtors were discharging debt in Chapter 7 bankruptcy liquidation proceedings who could in fact pay a substantial part of the discharged debt over a three to five year period out of future income.(5) The amount of such debt being discharged but payable, or "affordable debt," was estimated to be almost $1.1 billion.(6) On the ground that unpaid debt is a burden on other borrowers, it was urged that this was an unnecessary addition to the cost of credit and that debtors discharging such "affordable debt" were abusing the bankruptcy process which ought to limit relief to the debtor who could not pay.(7)

The credit industry explicitly proposed that debtors with an ability to pay a reasonable proportion of their non-first mortgage debt from future income should be ineligible for Chapter 7 relief.(8) This, of course, left certain qualifying(9) debtors eligible for the "voluntary" Chapter 13 relief.(10) Despite the clarity of the proposals,(11) none were enacted. Instead, the "substantial abuse" amendment was added to Senate Bill 445.(12) The meaning of this phrase, especially as it relates to future income, was the subject of substantial academic comment.(13) The 1984 amendment to 707(b) has been effective for more than thirteen years. One additional amendment was made to section 707(b) in 1986,(14) but while it involved an important matter of procedure, it did not clarify any substantive standard.

This Article seeks to examine the "future income" aspect of the debate in Part I by sketching in Part I.A, the history of the "bankruptcy bargain," and in Part I.B, the evolution of the bankruptcy discharge. In Part I.C, the relation of future income to debtors' repayment and the working of Chapter 7 liquidation is compared with Chapter 13 debt adjustment plans. In Part II.A, a brief restatement of the text of section 707(b) is presented, and in Part II.B, the history of the development of "substantial abuse" is discussed. In Part II.C, the circuit court cases considering the substantive content of "substantial abuse" under 707(b) are considered and analyzed. In Part III, comments on a philosophy of consumer bankruptcy are considered, and in Part IV, certain pending legislation is related to these developments and the contention that a radical change in the official philosophy is underway. Case law construing Bankruptcy Code section 707(b) has erected a barrier to the bankruptcy discharge unprecedented in United States bankruptcy history since voluntary liquidations were first allowed in the Bankruptcy Act of 1841.(15) This innovation radically changed the concept of bankruptcy as it affects individual debtors principally burdened with consumer debt, without a clear expression of such intent by Congress and without meaningful congressional guidance as to the applicable standards. Moreover, the judicial interpretations of substantial abuse innovated in an obscure fashion without adding any clarity to the national philosophy of bankruptcy relief. More recent developments indicate a further evolution of bankruptcy philosophy with some added clarity for the judicial task.

1. THE EVOLUTION OF AMERICAN BANKRUPTCY

   1. The "Bankruptcy Bargain"

      Simplified, the traditional Chapter 7 scenario has involved the debtor(16) giving up, voluntarily or involuntarily, all of her property (broadly defined), keeping for herself and her dependents the exempt(17) property, and receiving under various conditions a discharge of all or some of her debts. Since the first federal bankruptcy act in 1800, the content of the variables in this formula has changed significantly, but the traces of each component are found throughout. Since this Article argues in part that dismissal for substantial abuse based on ability to pay from future income is a radical departure from the past, this Part provides a brief sketch of the debtor's situation under prior bankruptcy acts.

      1. The 1800 Act

         The Bankruptcy Act of 1800(18) ("1800 Act") was modeled in large part on the then-existing English statute.(19) It was limited to involuntary proceedings against merchants or bankers.(20) The merchant or banker was allowed to retain the family's necessary wearing apparel and bedding,(21) and, if she surrendered her property and cooperated,(22) she received five to ten percent of the net estate (not to exceed $500 and $800 respectively) depending on whether her creditors received either fifty or seventy-five percent payments on proven debts.(23) Even where creditors did not receive fifty percent on their proven debts, a debtor could receive up to $300 or three percent, at the discretion of the bankruptcy commissioner(s).(24) Additionally, the notion of discharge for pre-bankruptcy debts was recognized under certain conditions.(25) These conditions required both: (a) written certification by the commissioners to the judge that the debtor cooperated (or the judge finding that the commissioners unreasonably withheld the written certification); and (b) the signed consent to the discharge from creditors holding two-thirds in number and value of the proven debts.(26) The debtor's cooperation and consent of two-thirds of the creditors were essential to the discharge. The discharge was from "all debts by him or her due or owing,"(27) including discharge from prison where debtor had been imprisoned for debt(28) and could be pleaded in any action on such debts. This necessarily meant that the discharge protected from future execution, on pre-bankruptcy debts, income earned by the debtor after bankruptcy or derived from the sale of her exempt property or earned as interest on any allowed distribution.(29) Thus, the basic contours of bankruptcy liquidation,(30) i.e., the non-exempt property to the creditors, exempt property to the debtor, and a discharge subject to conditions, were early established as to involuntary merchant or banker debtors.(31)

         The 1800 Act was repealed in 1803.(32) Author Charles Warren details the interesting contest from roughly 1818 to 1827 over a new bankruptcy act.(33) The economic panic of 1837 once again created interest in "uniform Laws on the subject of Bankruptcies."(34) Again, the battle was strongly fought.(35) The Bankruptcy Act of 1841 ("1841 Act") was passed August 19, 1841, but did not become effective until February 1, 1842. It lasted a little more than one year before being repealed on March 3, 1843.(36)

      2. The 1841 Act

         The 1800 Act was a creditor relief bill. It only provided for bankruptcy for merchants and bankers on request of creditors, and can best be viewed as a creditor collection device.(37) The 1841 Act first made bankruptcy available for voluntary debtors.(38) Involuntary proceedings against merchants or bankers were included in language similar to the 1800 Act, with the addition of a minimum indebtedness of $2000.(39) Both voluntary and involuntary debtors retained household and kitchen furniture and other articles judged necessary by the assignee of the debtor's estate with "reference in the amount to the family, condition, and circumstances" of the debtor but not to exceed $300.(40) Additionally, as with the 1800 Act, the debtor could keep the family's wearing apparel.(41) But in contrast to the 1800 Act, the debtor was not entitled to any distribution unless, of course, everyone was paid in full.(42)

         The 1841 discharge included all the debts, if, as before, the debtor surrendered her property, complied with all court orders, and conformed to the Act.(43) If a majority in number and value of the creditors holding proven debts objected in writing to a discharge, the discharge was to be denied; but, the debtor could demand a jury trial and receive a discharge if "it shall appear ... that the ... [debtor] has made a full disclosure and surrender of all his estate, as by this act required, and has in all things conformed to the directions thereof."(44) Thus, unlike the 1800 Act, creditor dissent could not bar a discharge where the debtor could show that she surrendered her property, complied with the terms of the Act, and cooperated. Majority creditor dissent put the debtor to the burden of proving this compliance with the Act and cooperation but did not cut off the right to a discharge.(45) Thus, a debtor could control the granting of a discharge by complying with the Act.(46) The main change between the 1800 Act and the 1841 Act was in the provision permitting any person to file a voluntary petition for relief.

      3. The 1867 Act

         As noted, the 1841 Act existed for a briefer time than even the short-lived 1800 Act. From the panic of 1857 and for a period after, agitation for a bankruptcy act again occurred.(47) But it was not until March 2, 1867, that Congress passed the Bankruptcy Act of 1867 ("1867 Act").(48) It was effective for petitions filed on and after June 1, 1867.(49) Although this Act was much more sophisticated than earlier acts, and in ways anticipated the Bankruptcy Act of 1898, it also followed the contours outlined thus far. Both voluntary and involuntary cases were allowed.(50) The...