The Top 10 Things To Know About Bankruptcy Reform

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act.  This legislation was designed to eliminate perceived abuses in the bankruptcy system.  Among other things, it seeks to require debtors who can pay some, but not all, of their debts, to file Chapter 13 bankruptcy as opposed to discharging their debt in full in a Chapter 7.  This was the first substantial change in the Bankruptcy Code since it was enacted 30 years ago.

This is an overview of the more substantial and interesting changes.

10.  The New Law Did Not Eliminate the Right to File Bankruptcy

Some have reported that the New Law would make debt, or certain types of debt, impossible to discharge. Some even indicated that the New Law would eliminate the availability of bankruptcy relief for a vast number of people. For the most part, this is just not the case. 

The New Law certainly made filing for bankruptcy tougher and more time-consuming.  The Debtor, the Debtor's attorney, and even the Trustee have been given additional duties within the system (see # 4 below), but the basic system itself remains intact.  These additional duties, and risks, will make it almost impossible for a person to file bankruptcy without the assistance of an attorney. Further, it will most certainly result in increased attorneys' fees. (The filing fee has already increased from $209 to $299.)  People will still file bankruptcy, but it will just cost more.

9.  The New Law Took Effect October 17, 2005

With a few minor exceptions, the New Law only applies to cases filed after October 17, 2005.  This means that the Bankruptcy Courts will, for a period of time, be administering cases under two separate sets of laws.  Eventually, the pre-October 17, 2005 cases will run their course through the system.  This could still take several years.

8.  Community Property Equalization Payments Are Now Non-Dischargeable

Under the Old Law, spousal and child support were non-dischargable. Other payments, typically community property equalization payments, were dischargeable unless the non-filing spouse filed a complaint asking that the debt not go away.  This is not the case under the New Law.  Support of any kind still will not be discharged in all chapters. However, all other obligations to a spouse (again, mostly community property equalization payments) will automatically be non-dischargeable in  Chapter 7.  The only exception to the new rule will be Chapter 13 where these payments will still be able to be discharged.

7.  A Bankruptcy May Not Stop an Eviction

The New Law provides that the automatic stay which arises when a bankruptcy of any type is filed will not stop an eviction if the State Court has already entered a judgment for possession of the premises.  The Old Law provided differently and the various State Courts interpreted this differently from Court to Court.

6. IRA Accounts Are Now Exempt Up to $1,000,000.

The Old Law exempted (protected) 401(k) and traditional retirement plans (those that were "ERISA qualified") in their entirety.  IRAs, which are not ERISA qualified, were exempt to the extent that a Court deemed them to be reasonable and necessary for a person in their retirement.  This applied to rollover IRA accounts as well.  This ambiguous standard created much litigation and resulted in people losing their IRA account.

The New Law continues to provide that 401(k) and traditional retirement plans are protected from creditors.  However, IRA accounts, including rollover IRA accounts, are now exempt up to $1,000,000. This creates a clear standard. Additional amounts can be protected if the Court can be persuaded that it is necessary for a debtor in their retirement or in the general interests of justice.

What this additional language will mean is unclear. For example, it would seem hard to imagine someone arguing for more retirement if they had a funded 401(k) and a million dollars in their IRA.  

5.  New Limitations on Exemptions and Homestead Rights

The Old Law provided that a person was entitled the exemption rights of the state in which they resided if they lived there for a minimum of 91 days.  The New Law has a 2-year residency requirement. The New Law also provides that a person is only entitled to a maximum homestead of $125,000 until such time as they have lived in that state for approximately 3.4 years.  (Remember that in California, the homestead amount is $50,000 for a single person, $75,000 for married or head of household, and $150,000 for persons over 65 or disabled.  So the effect of this last provision would only effect the aged or disabled.) The New Law was designed to prevent individuals from moving to states, like Texas and Florida, and immediately taking advantage of their unlimited homestead exemption.

4.  Increased Burdens on the Debtor and Counsel

The New Law significantly increases the burden on persons using the bankruptcy system. It provides that debtors must provide the Trustee with their most recent tax return seven days prior to the first meeting of creditors.  Any pay stubs, or evidences of income, from the 60-day period prior to the bankruptcy must be filed with the bankruptcy petition and schedules.  Every person filing bankruptcy must first go through a pre-bankruptcy briefing provided by a non-profit budget and credit counseling service. This counseling must include an analysis of the debtor's income and expenses and discuss the availability of credit counseling through a third party.  Further, before a debtor can receive a discharge they must go through a Trustee-approved debtor education course. 

The role of the debtor's attorney changes under the New Law. First, they are now referred to not as attorneys but "debt adjustment agencies." Second, it appears that they are now verifying the accuracy of the information their clients give them. The New Law provides that a debtor's attorney can be sanctioned if any information presented to the Court or the Trustee is inaccurate after a reasonably inquiry is made to verify that it is correct. What exactly this means will need to be sorted out by the Courts. Finally, if a motion is filed due to the presumption of abuse arising (see #1 below), and it is successful, the debtor's attorney can be compelled by the Court to reimburse the U.S. Trustee's Office for all of their fees and costs incurred in pursuing the motion.  This sum of money could be significant.  Accordingly, debtors' counsel will need to be extremely educated and informed when filing bankruptcy petitions in the future due to this very significant risk.

3.  The Length of Chapter 13 Plans

Under the Old Law, the duration of Chapter 13 plans was for 3 years.  They could be extended for up to 5 years by a judge in appropriate circumstances.  The New Law provides that any individual whose income is less than the median can still confirm a 3-year Chapter 13 plan.  However, if an individual's income is greater than the median, the Chapter 13 plan will now be for a mandatory 5 years.

2.  Audits 

The U.S. Trustee's Office is required to use independent certified public accountants to audit at least 1 in every 1,000 cases.  Further, the law has been modified so that in the event someone does not cooperate with the audit, or discrepancies are found as a result of the audit, their discharge can be revoked significantly later.

And the #1 thing to know about bankruptcy reform is:

1.  Means testing

Means testing is perhaps the most controversial portion of the New Law. It was designed to force debtors to file Chapter 13 repayment plans if they had some means to do so. The Old Law addressed this issue on a case-by-case basis. If a judge found that there was sufficient income over expenses to show a  "substantial abuse," a case would be dismissed.

This case-by-case analysis, in which the Court had broad discretion, has now been replaced by "means testing." This is a very mechanical analysis of a debtor's monthly income and expenses. If there is a prescribed amount of excess income each month, a "presumption of abuse" arises and the case must be dismissed. Essentially, every debtor will need to provide a statement of monthly income and expenses.  Debtors who make more than the median income each year (in California, approximately $50,000) will need to also file a means test analysis.  This analysis will measure  their income as an average for the six-month period prior to the bankruptcy filing.  They will then deduct their actual mortgage and car payments. They will then deduct payments for priority debt (usually past due taxes and support). Finally, they will be allowed to deduct other normal living expenses as defined by the tables the IRS when collecting taxes. (There are several other allowed deductions such as charitable contributions and a small amount for private schooling.)

If the amount left is more than about $100, a "presumption of abuse" will arise if this monthly payment over a five-year period would pay at least 25 percent of the debtor's unsecured debt.  If the amount is greater than about $166, the presumption of abuse arises regardless.

If the presumption arises, the debtor will need to show some type of exceptional circumstance.  Otherwise, the case will be dismissed or the debtor will be given the opportunity to convert the case to a Chapter 13 and propose a 5-year repayment plan.

Bankruptcy isn't dead, far from it. Consumer debt in the United States is currently in excess of 2 trillion dollars! This is up from 1 trillion dollars just a few years ago. Some of this debt will go always go bad. It is just not reasonable to assume otherwise.  This debt will need to be discharged in bankruptcy or people will be forced to go underground or move from the jurisdiction. Bankruptcy will still be the remedy for most. However, this remedy will now be more burdensome, costly, and almost certainly require the assistance of an experienced professional.