Unsecured Creditors – Challenges after Bankruptcy Reform

Bankruptcy reform is sure to have an impact on the debt purchasing industry for years to come. But what are the key points that debt buyers need to look at?

by Alane Becket

With the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), fundamental changes in how distribution of a debtor’s income will be made during a bankruptcy case went into effect. Unfortunately, touted as a “creditor’s bill,” an analysis of BAPCPA has uncovered several examples of the law of unintended consequences. Indeed, credit card companies and other unsecured creditors, and those who purchase this type of account, should proceed with caution when making projections based on media hype and rumor.

When analyzing and anticipating the net result of BAPCPA for a creditor or debt buyer’s bottom line, it is one thing to make general predictions about recoveries, but another to understand why the changes will occur and what can be done by unsecured creditors to make a positive difference for recoveries. This article will focus on some of the major changes made by BAPCPA and their effects on unsecured recoveries.

First, the Means Test, which is designed to require debtors who have the ability to make at least partial repayment to their creditors to enter into a Chapter 13 Plan or face dismissal from bankruptcy, is probably the single most publicized aspect of the consumer amendments to the Bankruptcy Code. However, under scrutiny, it does not appear that this provision will result in a significant shift of debtors into Chapter 13 as intended. One of the primary reasons for this is that the Means Test is only applied to debtors with income above the median income for their state. As a majority of consumer debtors have incomes below their state median, the Means Test will be inapplicable to a large percentage of debtors. Thus, a majority of Chapter 7 filers will be permitted to remain in Chapter 7, unaffected by the Means Test.

On the other hand, the ability to pass the Means Test and file under Chapter 7 does not mean that a debtor eligible for Chapter 7 will necessarily file under that chapter. Debtors will continue to use Chapter 13, regardless of whether or not they have passed the Means Test, for traditional reasons, such as to prevent foreclosure on real property, to modify secured claims, to discharge certain taxes, to pay attorney fees and the like. Thus, it appears that, while the Means Test will require a percentage of debtors to proceed under Chapter 13, this provision alone will not translate into significantly larger recoveries for unsecured creditors. This is especially true when considered along with some of the sleeper provisions in BAPCPA.

Second, BAPCPA’s definition of income raises several issues when put into practice. Under BAPCPA, all of the debtors’ income is calculated under its new definition of Current Monthly Income (CMI). CMI is calculated as the average of the last six months’ income received by the debtor from all sources, with some exclusions, most notably, Social Security Income. Thus, unlike under the old law where a debtor’s future income determined plan payments, under BAPCPA, a debtor’s CMI is used as a starting point, and thus, by definition, is backward looking – a formula that may not accurately reflect a debtor’s current or future available income. For example, a debtor who was unemployed for part of the last six months but who is now employed will have CMI – the average of the previous 6 months’ income – that is less than his actual monthly income. When calculating the plan payment, then, the debtor begins the process by using an income amount that is less than the debtor’s actual monthly available income. As a result, creditors share in a smaller payment amount.

As with the Means Test in Chapter 7, in Chapter 13, a debtor’s CMI is again determinative and dictates important aspects of the repayment plan. Once a debtor’s CMI is determined, the debtor is permitted to deduct monthly expenses to reach the debtor’s “disposable income”, which is then used to pay unsecured creditors. For debtors whose income is below the median, monthly expenses must be “reasonable and necessary” and will be viewed under traditional standards established by previous judicial decisions on what constitutes reasonable and necessary expenses for a Chapter 13 debtor. For debtors with income above the state median, monthly expenses will be those set forth in section 707 that are used for the Means Test. Close scrutiny of these standard expenses uncovers numerous ways in which these expenses, and the official forms developed for use by debtors in determining disposable income, produce artificial results, potentially shielding significant income from creditors.

Another issue is whether a debtor is required to include all or any part of a non-filing spouse’s income as part of the debtor’s CMI. According to the precise terms of BAPCPA, CMI includes income that the debtor receives from all sources and includes “any amount paid by any entity other than the debtor … on a regular basis for the household expenses of the debtor…” There are sure to be heated debates over whether and how much of a debtor’s spouse’s income should or must be included in a debtor’s CMI, especially if a debtor claims deductions for dependents, one of whom is the spouse.

Third, all debtors are now permitted to both contribute to and repay loans from retirement plans as part of their monthly expenses. In the past, these practices were judged under the reasonable and necessary standard, with the result that in many cases, debtors were prohibited from continuing contributions or making repayments to retirement plans before paying unsecured creditors. Now that these payments are sanctioned under BAPCPA, debtors have incentive to both contribute to retirement plans and to take loans from those assets, knowing that they will be repaid while the debtor is in bankruptcy.

BAPCPA also calls for repayment, in full, of certain secured loans, which in the past had been subject to strip down, a process which required a debtor to repay only the value of the collateral, while remainder of the debt was an unsecured claim. Under BAPCPA, automobiles purchased within two and a half years of the bankruptcy and other secured personal property purchased within a year of bankruptcy must be paid for in full or surrendered. Payment in full now means that money which, under the old law, had gone to unsecured creditors will now go to secured creditors.

As these provisions demonstrate, BAPCPA is not necessarily living up to its reputation as a “creditor’s bill.” And, while secured creditors reap the most benefit from the new law, there are still ways unsecured creditors can participate in bankruptcies and take full advantage of the opportunities available to them. The details of the bankruptcy bill and a discussion of how unsecured creditors can realize the most from their accounts was discussed at the Debt Buyers Association Conference, “Racing for Debt”, held February 7-9, 2006 in Las Vegas, Nevada. For more information log onto www.debtbuyers.com.

Alane Becket is a managing partner at Malvern, Pennsylvania based Becket & Lee, LLP, a law firm specializing in the representation of consumer creditors and debt purchasers in bankruptcy matters. Information on the firm can be found at www.becket-lee.com.