SC Lawyer, January 2007, #6. A Bankruptcy Primer for Personal Injury Lawyers.

• Author: By William T. Clarke

South Carolina Lawyer

2007.

SC Lawyer, January 2007, #6.

A Bankruptcy Primer for Personal Injury Lawyers

South Carolina LawyerJanuary 2007A Bankruptcy Primer for Personal Injury LawyersBy William T. ClarkeThe intent of this article is to highlight some of the facets of bankruptcy significant to personal injury practice and to suggest that personal injury lawyers might do well to take the financial pulse of their clients at some point in their representation. Anyone who has handled personal injury cases knows that a serious personal injury situation can be financially catastrophic for clients. Since some of them may be on the edge financially anyway, a serious personal injury that puts them out of work for a number of weeks or months may be all it takes to ruin them, especially in those situations where insurance coverage is inadequate. However, there are quite a few lawyers whose areas of practice permit them not to have to wander into the bankruptcy field. Consequently, many lawyers remain oblivious to the occasional salutary effects of a well-timed bankruptcy or, for that matter, to the potential negative fallout from an untimely one.

For the non-bankruptcy lawyer, it's likely that a basic overview of a Chapter 7 bankruptcy is appropriate. To begin with, the filing of a Chapter 7 bankruptcy by a debtor creates the "bankruptcy estate." This consists of all property belonging to the debtor-real and personal, tangible and intangible-including intangible causes of action, such as causes of action for personal injury. 11 U.S.C § 541(a)(1). A trustee is appointed in every case to review the debtor's schedules and conduct an investigation to determine whether there are any assets that might be seized and liquidated in order to pay a distribution to creditors. The trustee cannot, however, sell property subject to an unavoidable lien without paying off the lien holder, or property for which there is an exemption without paying the debtor the value of the exemption. As a practical matter, therefore, a substantial percentage of cases become "no asset" cases. This is simply because the debtors' assets are protected sufficiently by the various exemptions, encumbered by valid liens or perhaps some combination of the two. Occasionally, however, there is an asset issue involving some item for which value, net of any liens, exceeds the applicable exemption, such as, for example, a pick-up truck worth $6,000 that is paid for (the South Carolina exemption for a motor vehicle is $1,200-S.C Code § 15-41-30(2)). What would otherwise be a "no asset" case becomes an "asset case" with the trustee taking the truck and selling it and, after paying the debtor his exemption, using the proceeds to pay a distribution to creditors. All of the debtor's debts are discharged, but the debtor loses the truck in the process.

On the other hand, many bankrupts elect to go into Chapter 13, often referred to as the wage earner plan, whereby their future earnings are used to pay a Chapter 13 trustee each month, and generally for five years, thereby paying at least a percentage of their debt over time. Aside from the noble purpose and satisfaction of paying at least part of one's debts, two of the major advantages to filing under Chapter 13 are that in Chapter 13 a debtor can "cure" a mortgage arrearage over time through the plan, and thus stop a foreclosure, and the fact that the Chapter 13 trustee does not liquidate assets. Thus, your client need not worry about losing his bass boat and pick-up, both of which are paid for. The downside of Chapter 13 is that your client is strapped to a payment plan for the next five years, with payments that eventually may prove to be too much. Statistics indicate that the failure rate for Chapter 13 plans is more than 50 percent. No wonder then that some bankruptcy attorneys consider Chapter 13 to be "slow death" and adhere to the precept that "any Chapter 7 is better than a Chapter 13." Moreover, while your clients may take solace in the fact that in Chapter 13 they will not lose a particular asset that is either not exempt at all or valued substantially in excess of the applicable exemption, the significance of nonexempt assets in Chapter 13 is that their value must be taken into account by the Chapter 13 trustee in determining the extent of payout under the plan, i.e., the trustee is required to perform a "liquidation analysis," as under 11 USC Section 1325(a)(4), the debtor must pay over the course of the plan at least as much as his creditors would realize if he were filing under Chapter 7. Thus, your client's pick-up and bass boat might be "safe" but they may be the albatross around his neck that eventually drowns him.

It is important to understand that the exemptions can vary from state to state, and the variances can be quite substantial, owing to the fact that when Congress passed the Bankruptcy Code in 1979, it created a set of federal exemptions, but also provided that the states could "opt out" of the federal exemptions in favor of their own state exemptions. South Carolina, like some 33 other states, has elected to opt out of the federal exemptions in favor of our own exemptions listed in S.C. Code § 15-41-30, which exempts:

(11) The debtor's right to receive or property that is traceable to;

... (B) a payment on account of the bodily injury of the debtor or of the wrongful death or bodily injury of another individual of whom the debtor was or is a dependent.

Unfortunately, there have been very few cases discussing our exemption statute and none from our jurisdiction specifically construing the statute with regard to the sort of elements of damages that are protected. Some trustees, for example, have taken the position that punitive damages, lost earnings, property damage and loss of consortium are not exempt. The fact that the exemption has no monetary cap, however, is clear. See, e.g., Scholtec v. Reeves, 327 S.C. 551, 490 S.E. 2d 603 (Ct. of Appeals 1998), and Cerny v. Salter, 311 S.C. 430, 429 S.E.2d 809 (1993). From a close reading of the statute, a pretty compelling argument can be made that consortium actions were intended to be exempted. After all, the statute protects any "payment on account of . the wrongful death or bodily injury of another individual of whom the debtor was or is a dependent" (emphasis added). With the exemptions varying significantly from state to state, inevitably there have been debtors forum-shopping for exemptions. The new bankruptcy legislation (the "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005," hereinafter "BAPCPA"), effective October 2005, tries to remedy that with the new rule that restricts a debtor to claiming the exemption from the state in which he has resided for the 730-day period preceding the filing of the bankruptcy, assuming that the debtor's domicile for that period of time has been continuous, and, if it has not, then the exemption law applied is the law from "the place in which the debtor's domicile was located for 180 days immediately preceding the 730-day period or for a longer portion of such 180-day period than in any other place." 11 U.S.C. § 522 (b)(3)(A).

A prime consideration for developing an awareness of the possibility of a subsequent bankruptcy is the fact that not being aware or involved could prove embarrassing to you and your client. Suppose for example that you verbally settle your client's case in February. Settlement papers and insurance checks do not arrive until some 10 days to two weeks later. Your client shows up in March to sign a release and several days later picks up his settlement check. As a part of the settlement process, your client agrees that it would probably be a good idea to pay Dr. Bones, his orthopedic surgeon, with whom you have cultivated an excellent relationship over the years. Dr. Bones' office incidentally does not have an assignment of proceeds. Dr. Bones' office is paid their outstanding balance of some $6,000, but the checks are not issued immediately and do not clear the bank until April. Meanwhile, your client has spent the better part of his money catching up his house payments and credit cards, only to realize by the first of June that he is in over his head financially, at which point he retains a bankruptcy attorney to file a Chapter 7 bankruptcy. Unfortunately, since he did not actually write a check himself to Dr. Bones, in response to the question whether he has made any payments in excess of $600 within the last 90 days, he answers, in good faith, in the negative. Perhaps he does indeed remember the fact that Dr. Bones was paid, but recalls that the settlement was some time in February, and since it is now June, figures that is simply not an issue. The trustee, however, keenly aware that the operative date for preference purposes is the date the check clears the bank, after some minimal degree of investigation, identifies the payment as a preference and demands that Dr. Bones return the $6,000, much to the chagrin of you and your client.

The initial knee-jerk response in this situation is to question how or why a payment with otherwise exempt funds could constitute a preference. While under the old Bankruptcy Act (pre-1979) this would not be a preference, it clearly seems to be settled now under the Bankruptcy Code that it is. See, e.g., In Re Everhart, 11 BR 770 (Bankr.N.D.Ohio), In re Smith, 45 BR 100 (Bankr.E.D. Va.).

For that matter, in the case of "insiders" (a bankruptcy term of art that includes relatives) the "look back" period for preferential payments on antecedent debts is up to one year, and your client who may be intending to pay back a family member for previous financial assistance during the period of his incapacity would do well to wait until after he files bankruptcy to do so.

But let's go back to Dr. Bones for a minute. In the earlier hypothetical it was mentioned that Dr. Bones did not have an assignment. If in fact he did have an assignment, then the assignment operates to transfer the debtor's interest in his personal injury case (at least to the extent of the assignment) pre-petition, such that it does not become part of the bankruptcy estate. In re Duty, 78 BR 111, (E.D. Va. 1987). Problems arise if the assignment is executed "after-the-fact," as hindsight action, in which case it is an effort to secure an antecedent debt and, if executed within the 90-day period prior to bankruptcy, becomes a transfer voidable by the trustee. For that matter, if you are interested in protecting the medical provider, you probably should make sure that the document used is an assignment and not simply a "letter of protection," as one court has held that a "letter of protection" did not create a valid assignment. See, e.g. In re Colombraro, 230 BR 673, (D.N.J.1999).

Assuming that you have developed an awareness of bankruptcy as a possibility for your client, you need to make a point of telling your client to keep his or her personal injury proceeds separate from other funds, i.e., don't "commingle" it with other monies. Some trustees take the position that commingled personal injury funds lose their "identity" as exempt property. While arguably this makes no sense since money, like soybeans, is a fungible commodity, courts in some other jurisdictions have taken the position that commingling destroys the exemption, and there are some arguments to support this position. Since the bankruptcy court in this district hasn't issued any precedent on this particular issue, it makes good sense to play it safe. See, e.g. In re Weaver, 93 BR 172, (U.S. Dist. Ct M.D. Ind. 1988) (exemption disallowed where workers compensation monies commingled); but see, In re Rozier, 116 BR 675 (W.D. Wis. 1990), and In re Mix, 244 BR 877 (S.D. Fla. 2000).

If you have a personal injury client you suspect may be a bankruptcy candidate, another reason for being tuned in to the decision-making process is to make sure where you stand timing-wise with regard to the settlement process. Once the debtor files bankruptcy, his personal injury cause of action becomes "property of the estate." 11 U.S.C § 541 (a)(1). From that point forward, the automatic stay not only stays creditor collection activity, but, per 11 U.S.C. § 362 (a) (3), prohibits the debtor from exercising control over property of the estate. The trustee thereafter has authority under 11 U.S.C. § 323 to sue on behalf of the estate, and Bankruptcy Rule 9019(a) provides that the trustee may file motions to approve any settlement on behalf of the estate. Moreover, 11 U.S.C. § 327 provides for court approval of professionals and, as a general default rule of thumb, you should probably assume that, not only may the proposed settlement have to be "noticed," but that your employment as well may have to be approved by the court, depending on the nature of the case and whether your client is in Chapter 7 or Chapter 13.

When it comes to post-petition settlements, if there is any hard and fast rule, it is that there are no hard and fast rules other than the rule that you should always at least consult with the trustee and make sure that your client has disclosed his personal injury cause of action on his bankruptcy schedules. There is case law to the effect that the failure to disclose an asset prohibits the debtor from thereafter claiming it as exempt. See, e.g., In re St. Angelo, 189 B.R. 24 (D.R.I. 1995) (failure to disclose personal injury litigation in schedules a bar to exemption of proceeds) and In re Barber, 223 B.R. 830 (N. D. Ga.1998). Treatment of post-petition settlements is generally handled on a case-by-case basis. If, for example, you are handling a relatively small personal injury case for a debtor in Chapter 7 with nothing "in it" for the trustee and you are able to communicate with the trustee prior to the "341 meeting" (first meeting of creditors), you may be able to get the trustee simply to "abandon" the personal injury cause of action from the estate, on the record, at the hearing, thereby eliminating having to "notice" the settlement.

Chapter 13 cases can be a little more problematic, as there is case law to the effect that, although personal injury proceeds may be exempt, they may nonetheless still be considered as "disposable income," thereby impacting the total amount of your client's payment to the trustee. See, e.g. Stuart v. Koch, 109 F3d 1285 (8th Cir.); In re Minor, 177 B.R. 576, (E.D.Tenn.1995). Thus, depending upon the nature of the case and the amount of the settlement, the Chapter 13 trustee may require that your client pay some portion (possibly even all) of his settlement into the plan.

Not only do most bankruptcy trustees prefer that you get your case settled prior to filing, if you settle your case after the filing date without involving or at least consulting with the trustee, you may do so at your peril. For example, in In re Stinson, 221 B.R. 726 (E.D. Mich.1998), the court denied the debtor his exemption because he had settled his case post-petition without involving the trustee and without filing motions to approve the settlement, and the court ordered the debtor to turn over his settlement money and ordered his attorney to turn over his fee.

Another timing consideration that may prove significant from a practical standpoint is the fact that under BAPCPA your client's earning history during the six months preceding any bankruptcy filing is critical in determining his eligibility to file under Chapter 7. Simplistically put, the new legislation creates certain income thresholds and requires an income and budget analysis which, depending upon your client's family size, may require filing under Chapter 13. However, for purposes of this "means testing," as it is so referred, the income focus is on the average income for the six months period preceding the bankruptcy filing. Thus, depending upon the circumstances, your client who remains out of work from an injury and does not know whether he will have a job when he returns, and has not yet settled his case, may want to file bankruptcy while Chapter 7 is still at least a possible option rather than waiting six months to a year when his income situation may force him into Chapter 13. Then again, the U.S. Trustee's Office and the bankruptcy trustees are (presently at least) taking the position that personal injury settlement monies are to be considered part of the "income from all sources" used to calculate the debtor's average income for the six-month period preceding the bankruptcy filing for purposes of the "means testing"; thus, your client whose case has just been settled may want to wait six months, if possible, before filing bankruptcy.

The fact that your client has received or may be anticipating some sort of settlement in the near future may provide added flexibility and, through a sort of leveraging, permit the filing of a Chapter 7 bankruptcy that might otherwise be unacceptable, as in the situation where a client might be reluctant to file under Chapter 7 because of the likelihood of losing a particular asset that is not sufficiently protected by an exemption. Bankruptcy practitioners are aware that a debtor has the option of purchasing back from the estate assets which otherwise would be seized by the trustee and sold. The difficult part about this is that the client often may not have the funds with which to effect the purchase. Ordinarily, telling your client that he will be permitted to purchase back the excess equity in his truck for the nominal sum of $6,000 is likely to be met by some choice words. He will tell you that, if he had that sort of money available, he wouldn't be filing bankruptcy. While some debtors have IRA funds (which are exempt) to tap into, many do not, some often having spent them by the time they see the bankruptcy attorney. Moreover, withdrawing IRA funds is a taxable event anyway, and, while some have family members they can turn to, some simply have no one to turn to for the funds to save an asset that the trustee will surely take. This is where the personal injury settlement comes in. Being able to tap into funds that are protected by an exemption and therefore protected from the trustee permits your client in Chapter 7 to retain assets that otherwise might be lost and eliminate the need to file a Chapter 13 bankruptcy which might not be feasible. Even the money that your client gets from what you might consider to be a small settlement can provide your client with tremendous "leverage." Also, there is the fact that bankruptcy clients frequently can repurchase their assets for prices that are quite reasonable. Most bankruptcy trustees subscribe to the "bird in the hand" philosophy and will accept a reasonable offer, often on a wholesale value basis, as this is a lot simpler than having to locate another buyer, pay a sales commission and deal with a potentially disgruntled purchaser.

The personal injury "slush fund" can also be critical as a means of "redeeming" collateral, such as a car, from a non-purchase money lien. While in most purchase-money car loan situations the car value generally declines faster than the loan payoff and generates a potential deficiency balance, it is not uncommon to see potential bankruptcy clients with substantial non-purchase money loans, for example, $12,000, secured by an automobile that is worth far less than the loan balance, e.g., $3,000. Under 11 U.S.C. § 722, the debtor in a Chapter 7 may redeem the vehicle from the lien with a lump-sum payment for its fair market value ("replacement value" under the new legislation), and thereby eliminate a monthly payment and a long term drag on his cash flow. It really makes no sense to continue to pay over time on a loan balance of $12,000 for a car that presently is worth $3,000 and which will eventually be worthless by the time the loan is paid off, which brings me to another point.

In my experience, many prospective bankruptcy clients are often "in denial." For some, the personal injury settlement is just a short term "fix" to a long-term problem that won't change until they hit rock bottom. Unfortunately, it is after they hit rock bottom that they consult a bankruptcy attorney, and by then it is "too late"-perhaps not too late to file bankruptcy, but late in the sense that they would have been better off had they seen a bankruptcy attorney six months to a year earlier. Truly, in bankruptcy, timing can be everything, and a stitch in time can often be critical. Unfortunately, sometimes by the time the bankruptcy attorney sees them they have paid back a family member for monies advanced during their disability and caught up the payments on their home, perhaps made some frivolous purchases and paid down some of the balances on their eight credit cards. All of their personal injury settlement money is gone, and you want to cry when you realize they could have used it in a Chapter 7 to redeem their $3,000 automobile from the $12,000 lien and/or perhaps used it to purchase from the trustee (the bankruptcy estate) the excess "at risk" equity in some other item they can't bear to lose. However, because bankruptcy is such a loathsome idea to so many debtors (as it probably should be), many put off addressing the issue until well after the point when they should, which is why bankruptcy attorneys sometimes see them "too late." For that matter, I suspect some eventual bankruptcies in hindsight may have been "borderline" bankruptcy candidates, and a really judicious use of their personal injury proceeds together with some sound financial advice from a bankruptcy attorney or credit counselor at the right time may have indeed been all they actually needed to have avoided altogether having to file bankruptcy down the road.

Another problem area counsel need to avoid is the matter of your clients deliberately incurring debt once they have been identified as bankruptcy candidates. Deliberately incurring debt with no intention of repaying it is fraudulent, and, aside from the fact that it renders the debt itself nondischargeable, see, e.g., In re Karelin, 109 B.R. 943 (Bankr. 9th Cir.1990), can lead to other problems.

One of the significant features of the new bankruptcy legislation is the requirement that debtors receive credit counseling within the six-month period prior to filing bankruptcy. For the personal injury attorney, perhaps your cue that it's time to take a pulse is when your clients start pressuring you to settle the case or want you to arrange for them to get a loan from one of the companies that specialize in loaning money to personal injury clients at high interest rates. This may be the time to review their finances with them yourself, or perhaps, if they are receptive to the idea, refer them to a credit counselor, which couldn't hurt and might help take care of the credit counseling prerequisite if they wind up having to file bankruptcy later. Depending on their circumstances, a bankruptcy lawyer or credit counselor may be able to help them make wise use of their personal injury settlement and help them avoid making foolish mistakes with their money down the road.

Many bankruptcy clients will tell you that they "never dreamed that they would be in this position." Under BAPCPA a debtor can now file a Chapter 7 bankruptcy only once every eight years, as opposed to six years under the old law, a change that is really insignificant for most debtors, as, for most of them, having to file bankruptcy is a once-in-a-lifetime event and a one-shot deal. Timing, so important before the new law, is even more so now. For your occasional personal injury clients who wind up having to file bankruptcy, getting them back on their feet economically means optimizing the "fresh start" contemplated by the Bankruptcy Code and dealing correctly with some of the issues raised herein by getting involved with some of your clients perhaps to a greater degree than you might have been in the past and, where appropriate, having their financial situation evaluated by a credit counselor and/or competent bankruptcy counsel.