Wednesday, November 22, 2006

Judge Kelly Finds 401k Loans Deductible Under Means Test

Judge Larry Kelly has recently held that 401k loans may be deducted in performing the chapter 7 means test. In re Otero, 06-30691 (Bankr. W.D. Tex. 11/2/06). BAPCPA expressly designates 401k loans as allowable expenses in chapter 13 cases. 11 U.S.C. Sec. 1322(f). However, there is not a similar provision with respect to the chapter 7 means test. Judge Kelly's ruling differs from a recent decision on this issue out of the Northern District. In re Barraza, 346 B.R. 724 (Bankr. N.D. Tex. 2006).

BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.

When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"

However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.

Judge Kelly stated:

"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."

Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out.


The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.

The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.

First Amendment vs. BAPCPA: Connecticut Court Strikes Down Section 526(a)(4)

Another U.S. District Court has found that Sec. 526(a)(4), which prohibits advising an assisted person to incur debt in contemplation of bankruptcy, violates the First Amendment. In Zelotes v. Martini, No. 3:05vc1591, 2006 U.S. Dist. LEXIS 81385 (D. Ct. 11/7/06), Judge Peter Dorsey of the U.S. District Court for the District of Connecticut found that attorney Zenas Zelotes had standing to challenge the law and that the particular section was facially unconstitutional. Judge Dorsey noted that the law would prohibit attorneys from giving advice to refinance a debt with one at a lower interest rate, to purchase and automobile which would allow the debtor to work as well as other legitimate actions. "By prohibiting lawyers from advising clients to take lawful, prudent actions as well as abusive ones, Sec. 526(a)(4) is abusive and restricts attorney speech behond what is 'narrow and necessary' to further the governmental interest."

Zelotes is the third opinion to find Sec. 526(a)(4) to be unconstitutional. Previously, Olsen v. Gonzales, No. 05-6365-HO, 2006 U.S. Dist. LEXIS 56197 (D. Or. 8/11/06) and Hersh v. United States, 347 B.R. 19 (N.D. Tex. 2006) had reached the same result. Another case pending in Connecticut District Court, Connecticut Bar Association v. United States, has challenged multiple sections of BAPCPA. That case is still pending.

Tuesday, October 31, 2006

Don't Mess With Judge Bohm

This column has devoted several articles to lawyers behaving badly in Houston. The Houston judges have been very proactive in writing about unprofessional conduct lately. Before beginning, two important caveats are important. First, these cases generally deal with the bottom 1% of the bar and are not representative of the bar in general. Second, these cases are presently coming out of Houston, but they could happen anywhere. The latest installment of Lawyers Behaving Badly involves an attorney-debtor who filed cases in bad faith, ignored court orders, failed to appear, evaded the U.S. Marshals and could not count.

A Brief Trip to Bankruptcy Court

In In re David Ortiz, No. 05-39982 (Bankr. S.D. Tex. 10/13/06), the attorney debtor filed an initial chapter 7 petition in January 2005 to avoid being evicted from his law office. The case was assigned to Judge Isgur. The Debtor received only a short delay since the stay was lifted early on. Once the eviction was allowed to go forward, he lost interest in his case. The case was dismissed for failure to attend the 341 meeting on May 31, 2005. Judge Isgur dismissed the case with prejudice to refiling for 180 days. Unfortunately, because the Debtor failed to update his address (most likely the one that he had been evicted from), he claimed that he never received the notice.

Return to Bankruptcy Court

Less than one month later, on June 29, 2005, the Debtor filed his second case, which was assigned to Judge Bohm. This case was filed for the same reason as the first case. In the space of six months, the Debtor had managed to find another landlord, fall behind on the rent and receive eviction papers.

Things Start to Get Bad—The First Sanctions Order

The U.S. Trustee promptly moved for sanctions. The Debtor appeared and pleaded ignorance of the prior order. The patient Judge Bohm agreed to abate the U.S. Trustee’s motion long enough to allow the Debtor to return to Judge Isgur and seek a modification of the prior order. When the parties returned to Court, Judge Bohm found that the Debtor had not sought to modify Judge Isgur’s order. He also determined that the Debtor had failed to file accurate schedules and did not have a good reason for failing to appear at the 341 meeting in the first case. At that point, Judge Bohm ordered the Debtor to pay attorney’s fees of $1,875 to each of his landlords and continued the matter to consider whether other sanctions might be appropriate. The Debtor finally retained an attorney at this point. At the continued hearing, Judge Bohm ordered that the Debtor pay $1,000 in sanctions to the Clerk within 60 days and barred him from filing again for a year without prior permission.

Things Get Worse--The Bench Warrant(s)

By the time of the first sanctions order on November 17, 2005, the Debtor had angered a federal bankruptcy judge. However, his problems could have been solved by paying $4,750. It would have been a really good idea to comply with this order through whatever means possible. The Debtor didn’t get the message. Some four months later, the U.S. Trustee filed a Certificate of Non-Compliance indicating that the Clerk had not been paid. Judge Bohm scheduled yet another hearing, which was continued to May 10, 2006. Neither the Debtor nor his attorney appeared at this hearing. The Debtor also failed to accept service from the U.S. Trustee’s process server after agreeing to do so. Judge Bohm issued a bench warrant that day.

In response to the bench warrant, an attorney who said she was acting merely as an intermediary contacted the U.S. Marshal and promised to inform the Debtor about the bench warrant. She gave the Marshal a non-working number for the Debtor. When the Debtor could not be located at his home or office, Judge Bohm issued a bench warrant for the intermediary attorney. This bench warrant met with more success and the “intermediary” appeared and testified that the Debtor was aware that there was a bench warrant out for him, but wanted to meet with his attorney first. Judge Bohm ordered the intermediary to check in with the U.S. Marshal twice a day until the Debtor was apprehended.

Judge Bohm Tries to Get the Debtor’s Attention—The Second Sanctions Order

On May 16, 2006, Judge Bohm, who had no doubt progressed from furious to livid, issued a second sanctions order which required the Debtor to pay $500 per day for each day that he failed to surrender and to pay $250 per day for each day that he failed to pay the $1,000 sanction to the clerk. The Court ordered the Debtor’s attorney to appear two days later to report whether he had informed the Debtor of the second sanctions order.

Melt-Down—The Third Sanctions Order

On May 18, 2006, the Debtor appeared with a new attorney (a respected bankruptcy attorney) and paid the $1,000 owing to the Clerk. The Debtor claimed that while he was aware of the May 10 hearing, that his attorney was scheduled to be out of the country and assured him that he would get the hearing re-set. The attorney did not do this. However, when the Debtor contacted the attorney’s office to see if any arrangements had been made, he was told that they were not aware of any, but that that the attorney would not have left town without having done something. The Debtor also testified that when he learned of the bench warrant, he checked into a hotel to avoid being found.

Judge Bohm was not amused. However, the order he entered was remarkably restrained. He ordered the Debtor to:

1. Write a letter apologizing to the U.S. Marshals for not turning himself in immediately;
2. Contact the Texas Lawyers Assistance Program to see if he would benefit from counseling;
3. Take 10 hours of bankruptcy continuing legal education (including three hours of ethics) if he ever planned to appear in the Southern District again;
4. Find other counsel for a client he was currently representing in a chapter 7 case; and
5. Either pay $750.00 or write “I will respect the judicial system, and such respect includes obeying all court orders” 750 times.

Judge Bohm gave the Debtor five days to comply.

When the Debtor returned five days later, he only tendered 700 sentences instead of 750, he had failed to pay the prior sanction to his landlords and he had failed to find alternate counsel for his client (whose case was subsequently dismissed by Judge Brown). However, he did complete his CLE.

The Judge gave the Debtor one more opportunity to comply and at the next hearing, he presented cashier’s checks to pay his landlords’ attorney’s fees and tendered the remaining 50 sentences. As a final sanction, the Court wrote a lengthy opinion chronicling the pattern of abuse which had led to his orders.

What Were They Thinking?

Attorneys make mistakes. Sometimes the difference between a good attorney and a disgraced attorney is the ability to engage in damage control. The attorney(s) here did not learn that lesson.

Mr. Ortiz’s motivations in filing bankruptcy to avoid eviction were not pure. Filing a second bankruptcy in violation of a court order that he arguably did not know about was bad but not fatal. At this stage, the Debtor/Attorney had a problem, but the court offered a way out (returning to Judge Isgur to modify the prior order of dismissal). This was a serious mistake.

When the Debtor missed his first opportunity to extricate himself, he could have begged or borrowed the money to pay the initial sanctions and limped away, humbled but not crushed. However, at the point that he failed to appear in court and then evaded the U.S. Marshal, he risked serious jail time. The fact that the ultimate consequences were so light may have been because the Debtor finally retained a competent bankruptcy attorney or perhaps because the court was happy just to have gotten his attention. However, it is clear that things could have been worse—much worse.

The Debtor’s first attorney and the “intermediary” attorney do not come off very well either. The opinion does not explain why the first attorney went off to Jordan without obtaining a continuance of the May 10 hearing. However, the attorney had to know that he was dealing with an extremely volatile situation. His absence caused a bench warrant to be issued for his client. The attorney who appeared only as an intermediary does not fare very well either. She was in contact with the Debtor on a regular basis, but somehow managed to provide the U.S. Marshal with a non-working number to contact him. The court found her testimony to be less than forthcoming.

When all was said and done, three attorneys found themselves named in an opinion which did not reflect well upon them. This opinion should be made required reading in legal ethics courses.

Friday, October 27, 2006

Don't Mess With Judge Jernigan

Stacey Jernigan is both the newest and the youngest bankruptcy judge in the State of Texas. However, in a recent opinion she made it clear that she is not one to be fooled by clever lawyers.

In Baker v. Sharpe, Adv. No. 06-3208 (Bankr. N.D. Tex. 9/28/06), a male debtor dressed to impress as he persuaded a recent divorcee to loan him large amounts of money. Having run through her money, he then filed chapter 7. She then sued to establish a non-dischargeable debt under Sec. 523(a)(2)(A) and 523(a)(6). The only problem was that most of her case revolved around verbal and implied statements concerning his solvency (including his statement that he could pay her out of the money he was hiding from his current wife).

Section 523(a)(2) draws a careful dichotomy between fraudulent statements of financial condition and other fraudulent representations. Section 523(a)(2)(A) expressly excludes statements of financial condition from its scope, while Section 523(a)(2)(B) only applies to written statements of financial condition. Thus, verbal statements of financial condition can never form the basis for a dischargeability action (at least not under Sec. 523(a)(2)).

The clever plaintiff's attorney tried to conceal this distinction from Judge Jernigan by omitting a few words when quoting the statute.

Judge Jernigan was not fooled. In a footnote, she stated:

"Indeed, Ms. Baker--or at least her attorney--knew there was this very large flaw in her argument, for in the Plaintiff's Brief in Support of Non-Dischargeability of Indebtedness Under Sec. 523(a)(2)(A) and (a)(6) filed with this court in advance of trial, the plaintiff quoted Section 523(a)(2)(A), but left out, with the convenient use of an ellipsis, the critical phrase 'other than a statement regarding the debtor's or an insider's financial condition.' Thankfully, the court has several copies of the Bankruptcy Code handy so it could consult the entire statutory provision in addressing this this question."

Memorandum Opinion, p. 26, n. 13 (emphasis added).

It is good to know that in these days of budgetary shortfalls that bankruptcy judges have not just one but several copies of the Bankruptcy Code available for use.

With the vigilant eye of the judge to protect him, the pro se defendant prevailed.

Thursday, October 26, 2006

Individual Involuntary Petitions Remain Viable Under BAPCPA

The Bankruptcy Abuse Prevention and Consumer Protection Act requires that an individual filing for relief under Title 11 obtain credit counseling within 180 days prior to filing bankruptcy. 11 U.S.C. Sec. 109(h). Some commentators have questioned whether this requirement would spell the end of involuntary bankruptcy cases against individuals (since they would not have completed credit counseling). Judge Monroe has recently held that involuntary cases are not subject to the credit counseling mandate. In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06).

In Sadler, the Cadle Company filed an involuntary petition against the debtor without the joinder of any other creditors. The alleged debtor moved to dismiss the case claiming that he was not eligible for chapter 7 relief because he had not completed credit counseling, that he was generally paying his debts as they came due and that he had more than 11 creditors requiring three petitioning creditors.

Judge Monroe parsed the statutory language of Sec. 109(h) and found that it referred to completing credit counseling within 180 days "preceding the filing of the petition by such individual." Since an involuntary case is not filed by the debtor, then the eligibility provision does not apply. This result seems to be consistent with both the statutory language and congressional intent. BAPCPA is all about shifting control from debtors to creditors. While some have questioned the benefits of credit counseling (See Opinions Regarding Failure to Seek Credit Counseling Underscore Dissatisfaction With Law, 7/18/06), its only efficacy would be in the case of a voluntary filing. If a creditor takes the unusual step of initiating a petition, it is unlikely that credit counseling by the debtor would change the creditor's mind about the need to seek relief.

The rest of the opinion is devoted to creditor counting for purposes of Sec. 303(b). Cadle took the gutsy step of filing the involuntary petition without the joinder of any other creditors. If the debtor could show that he had at least 12 creditors, then the petition would be required to be dismissed unless additional joining creditors could be found. The debtor, who clearly did not want to be in bankruptcy, came up with a list of 24 creditors. However, this was not sufficient to keep him out of bankruptcy.

After an initial pass, Judge Monroe eliminated 11 potential creditors from the calculus, allowed 10 and saved three for further scrutiny. The debts excluded on the first pass included several that were owed by other parties, one which was time barred and eight which were for current, recurring expenses. Judge Monroe excluded the recurring expenses, which included such items as the electric bill and insurance based on an old Fifth Circuit case, Denham v. Shellman Grain Elevator, Inc., 444 F.2d 1375 (5th Cir. 1971).

The court's initial ruling created high drama. If the debtor could include two out of the three remaining debts, then the case could be dismissed and the creditor would face potential sanctions. If the creditor could exclude at least two of the three debts, then the case would proceed. The Court excluded all three remaining debts for three different reasons.

First. the debtor claimed that he owed a judgment to First Financial Resolution for $156,000. Unfotunately, the debtor could not provide a copy of the judgment or even an address for the creditor. Bankruptcy Rule 1003(b) requires that a debtor claiming to owe more than 12 debts file a list of the names and addresses of his creditors. Because the debtor could not provide an address for the creditor or otherwise prove that the debt existed, it did not count.

Second, the debtor relied on a debt owed to company controlled by his wife and brother-in-law. This company loaned him $65,000 to settle a $3 million debt. Judge Monroe classified this creditor as an insider so that they did not count toward the number of creditors.

Finally, the debtor claimed that he owed money to the IRS. Since the debtor had not filed tax returns for several years, it was very likely that he did owe taxes. However, because he could not prove any specific liability, Judge Monroe did not count the debt.

Thus, the creditor count stalled out at 10 and the involuntary was allowed to stand with a single petitioning creditor.

Tuesday, October 17, 2006

One Year Since BAPCPA Took Effect

One year ago today the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) took effect. This followed what can only be described as a period of insanity as potential debtors raced to file under the old law. One year later, consumer bankruptcy filings are a mere shadow of their former self. Congress has certainly succeeded in limiting the number of debtors seeking a quick discharge under chapter 7, but has dramatically decreased chapter 13 filings as well.

A Tale of Three Times

To make sense of the numbers, it is important to look at three periods of time. The year from April 17, 2004 to April 16, 2005 is the last record we have of what "normal" bankruptcy filings used to look like. (Technically this period should run through April 19, 2005, the day before BAPCPA was signed. However, for ease of comparison, I have used used months running from the 17th through the 16th to reflect the fact that BAPCPA took effect on October 17, 2005). The period from April 17, 2005 through October 16, 2005 reflects the "rush" period as debtors flocked to the bankruptcy courts in record numbers. Finally, the period since October 17, 2005 is the BAPCPA period.

During the "normal" period, there were 92,872 consumer bankruptcy cases filed in the State of Texas. Of these, 52,985 were chapter 7 liquidations, while 39,887 were chapter 13 liquidations. This reflects the trend prior to the new law for more people to choose liquidation over reorganization.

During the "rush" period, an astonishing 65,797 chapter 7 cases were filed. Thus, the cases filed in just six months represented 124% of the total for the entire previous year. Chapter 13 filings during the "rush" period numbered 22,118 representing only a slightly elevated level of filings.

Filings Anemic Under BAPCPA

Since BAPCPA, filings have been relatively anemic. For the past 12 months, there have been just 29,163 consumer bankruptcy cases filed statewide. This compares to 42,420 cases filed in just one month from September 17, 2005 to October 16, 2005. Under the new world of BAPCPA, chapter 13 cases predominate with 17,419 filings under chapter 13 and just 11,744 under chapter 7. Thus, chapter 13 is now the dominant form of consumer bankruptcy relief as opposed to practice under the old law. However, the newly dominant chapter 13 filings are themselves a mere shadow of filings under the old law.

The new chapter 13 filings of 17,419 represent a mere 44% of the filings during the "normal" period, while the 11,744 chapter 7 cases are just 22% of the "normal" period filings.

The trend shows a gradually increasing number of Texas consumer cases. In the first month after the effective date, there were a puny 743 cases filed statewide. After that, there were a series of ever increasing plateaus.

Month 1: 743
Months 2-3: 1,575 (avg.)
Months 4-5: 2,289 (avg.)
Months 6-9: 2,680 (avg.)
Months 10-12: 3,323 (avg.)

By comparison, the average filings during the "normal" year were 7,739 per month. The past seven months show an average increase of 92 cases per month. Rounding up, if filings increase by an average of 100 cases per month on a steady basis, it would take about 44 months for filings to return to their old levels.

Thus, the recap after one year is that chapter 13s are down, chapter 7s are way down, but the overall volume is slowly increasing.

Friday, October 13, 2006

Fourth Catholic Diocese Files Chapter 11

This week the Diocese of Davenport filed for chapter 11 protection in the Southern District of Iowa (Case No. 06-02229). At least three other Catholic Dioceses have filed for chapter 11 protection in response to sexual abuse lawsuits. Each of the three other cases was filed during 2004. Of the prior cases, the Roman Catholic Church of the Diocese of Tucson has successfully confirmed a plan (although that order is under appeal), while the cases for the Roman Catholic Archbishop of Portland and the Catholic Bishop of Spokane are pending with competing plans. Together, the four dioceses serve nearly 900,000 parishioners.

The Difficult Dynamic

The Catholic Diocese cases present an unusual dynamic for a chapter 11 case.

(1) The cases were prompted by waves of sexual abuse tort claims dating back decades. In each instance, the case was precipitated by sexual abuse tort claims. The underlying acts of abuse occurred anywhere from the 1930s to the 1980s. However, the lawsuit claims did not emerge until the late 1990s and early 2000s. Although several of the dioceses were able to settle an initial wave of cases, they found more cases coming out of the woodwork as publicity spread and claims averaged in the millions. As a result, the dioceses could not determine how many claims would ultimately be filed and could not rely upon insurance and current assets to resolve claims as they came in.

(2) The cases created a conflict between the betrayed and the faithful. The bad acts were performed by a limited number of bad actors (approximately 15 in the Spokane case) and were allegedly covered up by a finite number of persons in positions of authority. However, it was not possible to get justice from the bad actors and their facilitators, some of whom were already dead themselves. Instead, the major liability would be borne by the dioceses and their insurance companies. The insurance companies, many of whom were defending under a reservation of rights, were able to limit their exposure through their contracts. That left the dioceses themselves holding the final liability. However, a diocese is nothing more than the current and accumulated contributions of the faithful. As a result, the current faithful were in a position of having to pay for the sins of their church. This conflict between the faithful and the betrayed was especially apparent in Spokane and Portland where the courts ruled that property used by the parishes was owned by the dioceses rather than the individual congregations.

The challenge for the Catholic Dioceses and the lawyers for the tort claimants was to find a solution which would provide compensation and vindication to those who had been sexually abused without so alienating the parishioners that they lost faith and allowed the diocese to collapse.

A Learning Process

The Catholic Dioceses appear to be learning from experience. The Portland case, which was the first filed, was marked by acrimony from day one. While first day motions are normally routine, one pro se creditor objected to a motion to maintain cash management systems on the ground that the church should not be allowed to use a bank with Catholic officers due to the potential for conflict of interest. In the subsequent cases, the first day motions were used as a vehicle to tell the Diocese's story with descriptions of the historic background of the diocese, the ministries provided, the persons served and the church's response to the sexual abuse crisis. The first day motions in the recent Davenport case show a remarkable similarity to those in the Tucson and Spokane cases.

In the Portland case, the Debtor did not file a plan for sixteen months (by which time it was docket entry #2389) and drew a competing plan shortly thereafter. However, in the Tucson case, the Debtor filed a plan on the first day of the case, which was ultimately confirmed.

In the Portland and Spokane cases, the Debtor was faced with adversary proceedings determining that parish properties were property of the estate. In the Tucson and Davenport cases, the Debtor entered the case with a position as to why the parish properties were not included in the estate.

Based on a review of the lengthy docket in the Portland case, it appears that every issue that could be committed to paper and litigated was. In at least the Tucson case, the process appeared to be more focused and battles were chosen more selectively.

A Note About Fees

One feature common to all of the Catholic Diocese cases has been the relatively low billing rates charged by Debtor's counsel. The rates charged by principal counsel include $200 per hour in Spokane, $230 per hour in Davenport, $300 per hour in Tucson and $325 per hour in Portland. This contrasts with the eye-popping rates of $500-$600 per hour starting to appear in some large cases. Perhaps the church lawyers realized that there was already plenty that would appear obscene in their cases without obscene billings.

Tuesday, October 10, 2006

Judge Clark Attracts Attention With War on Terror Comments

Judge Leif Clark is a frequent source of colorful commentary. Whether he is skewering BAPCPA or illustrating the difficulty with multi-prong tests, his opinions make for interesting reading. He has even garnered the attention of NPR by quoting Adam Sandler in a footnote. He has been featured on NPR again, but this time, the subject is the war on terror. Judge Clark recently sent an email critical of comments by a Bush administration spokesman discussing enemy combatant rules. Now, according to an article carried in the Austin American Statesman, some are questioning whether Clark's comments went too far. See "Judge likens U.S. policy to that of Soviet Union," Austin American Statesman, October 10, 2006, p. B3.

The following email appears on NPR's web site:

'Can This Be America?'

Listening to John Yoo talk about this new legislation was chilling. I'm a federal judge, and have taught constitutional law for 16 years. The very idea of holding anyone without trial, without the right to see the evidence that was used to justify naming them an "enemy combatant," and depriving them of the ability to challenge why they are even there is so repugnant to a constitutional democracy that I am shocked that this man actually claims to be defending American values. These are the tactics of the old Soviet Union, not of a country that stands for freedom and the rule of law.

I also quibble with his contention that U.S. citizens still have the right to habeas review. I've read the law. The president can form his own tribunal, which can determine who is an "enemy combatant" (not just an alien enemy combatant), and the decision of that tribunal would not be subject to habeas review. Moreover, persons targeted by this tribunal would not even have access to the military tribunal trial created under this law.

How easy it would be for a president to use such a law to make his political enemies simply disappear. Can this be America? -- Leif Clark, San Antonio, Texas

According to the article carried in the American Statesman, some unnamed lawyers think that Judge Clark's "outburst" could subject him to discipline. Chief Judge Edith Jones of the Fifth Circuit acknowleged that "This is a very novel situation." Judge Jones said that she didn't know how the situation would be handled or if it would be handled at all.

A quick review of the Code of Conduct for United States Judges appears to support the judge's ability to speak out on legal issues. Canon 4(A) states that "A judge may speak, write, lecture, teach, and participate in other activities concerning the law, the legal system, and the administration of justice." To continue the theme, Canon 5(A) states that, "A judge may write, lecture, teach, and speak on non-legal subjects, and engage in the arts, sports, and other social and recreational activities, if such avocational activities do not detract from the dignity of the judge's office or interfere with the performance of the judge's judicial duties." Thus, the canons seems to protect the ability of a judge to write, lecture, teach or speak on legal or non-legal topics.

The canons which might limit judicial speech are more oblique when applied to this situation. Canon 1 requires a judge to uphold the "integrity and independence" of the judiciary, while Canon 2 requires a judge to obey the law and to "act at all times in a manner that promotes public confidence in the integrity and impartiality of the judiciary." Canon 7 states that a judge should refrain from political activity. However, the specifically prohibited conduct does not address speaking out on politically charged topics.

Thus, with all due respect to the anonymous lawyers quoted in the newspaper, and regardless of whether you agree with the substance of Judge Clark's statements, the judicial canons allow him to speak on both legal and non-legal topics so long as his comments do not detract from the dignity of his office. Unless it is considered just plain unseemly for a member of the judicial branch to criticize the executive branch, then it is hard to see how Judge Clark's comments detract from the dignity of his office.

The interesting thing here is because he is a bankruptcy judge, Judge Clark is unlikely to have these issues arise in his court. His email identified himself as a federal judge and constitutional law professor. However, because he is a very specialized federal judge, he has no jurisdiction over and thus no special expertise with respect to writs of habeas corpus. As a result, his status as a federal bankruptcy judge may be more of a red herring. Instead, his real standing to speak on the issue arises from his status as a private citizen and constitutional law professor. These are both capacities in which he should be free to speak his mind.

Thursday, October 05, 2006

Gadzooks! Northern District Judge Limits Impact of Pro-Snax

Judge Harlin Hale was just written an important opinion on attorney's fees in chapter 11. In re Gadzooks, Inc., No. 04-31486 (Bankr. N.D. Tex. 10/5/06). Judge Hale questions the applicability of the Fifth Circuit's Pro-Snax dicta in light of subsequent Supreme court precedent. Alternatively, he would limit the opinion to debtor's counsel in doomed cases.

A Little Background

Since the Bankruptcy Reform Act of 1978, bankruptcy has become big business. Large firms which once shunned bankruptcy as being beneath them now have large departments. As a result, issues relating to employing and compensating professionals are of keen interest to those who make their living in the bankruptcy world.

In 1998, the Fifth Circuit decided the narrow issue of whether the statutory language of 11 U.S.C. Section 330(a) allowed debtor's counsel to be compensated subsequent to appointment of a trustee. The Fifth Circuit followed the statutory language and said no. Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). That result was subsequently upheld by the Supreme Court in another case. Lamie v. U.S. Trustee, 540 U.S. 526, 124 S.Ct. 1023 (2004). Not surprisingly, the Supreme Court said that courts should follow statute as written.

However, Pro-Snax had a second component to it. Because the firm was going to be able to receive some compensation, the Fifth Circuit gave instructions on how that compensation should be determined. The Court stated that in order to be compensable, services must result in an "identifiable, tangible and material benefit to the estate." The Court rejected the argument that services "need only be reasonable to be compensable." This holding arguably re-wrote the statute. Section 330(a)(4)(A) states that services may not be compensable if they "were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.” Since services "not ...reasonably likely" to benefit the estate could not be compensated, by negative implication, services which were reasonably likely to benefit the estate should be compensated even if they did not ultimately turn out to yield a benefit. It could be argued that while Pro-Snax was uniformly harsh toward debtors' counsel, it was schizophrenic when it came to statutory language; the primary holding was based on a strict reading of the statute, while the dicta edited out part of the text.

At least one court has held that, regardless of whether Pro-Snax properly read the statute, that it was still the law in the Fifth Circuit and should be followed. In re Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).

The Gadzooks Case

The recent opinion by Judge Hale addresses the situation where an Equity Security Holders Committee performed services which were objectively reasonable at the time they were performed, but did not yield a benefit to the equity holders for reasons beyond the committee's control. Gadzooks was a publicly traded company which catered to women between the ages of 14-22. At the time that it filed, equity was still in the money and the U.S. Trustee appointed an equity committee. The equity committee proposed a plan which could have paid unsecured creditors as much as 75% on their claims and would have allowed equity to buy back in. Unfortunately, the Debtor's sales tanked over the 2004 holiday season. As a result, the Debtor defaulted on its DIP financing, the proposed investment transaction was canceled and the equity committee was dissolved.

Hughes & Luce, the counsel to the equity committee, filed a fee application for approximately one million dollars. Both the creditors' committee and the liquidating trustee under the subsequently confirmed plan objected based on Pro-Snax. The case set up a perfect opportunity to examine the apparent conflict between Pro-Snax and Section 330(a). First, all parties stipulated that the services were reasonably calculated to provide a benefit up through the point that the Debtor's performance crashed. Second, the failure to achieve results was a result of factors the committee could not control. Third, the party making the request was not the debtor.

The Ruling

After a lengthy analysis, Judge Hale allowed compensation up until the point of futility for two independent reasons. First, Judge Hale applied the traditional lodestar analysis used by the Fifth Circuit prior to Pro-Snax to determine how much compensation was allowable. This conclusion was based on the preceeding analysis which rejected hindsight as a basis for denying fees. Judge Hale quoted the following language from the Supreme Court's Lamie opinion: "It is well established that 'when the statute's language is plain, the sole function of the courts--at least where the disposition required by the text is not absurd--is to enforce it according to its terms." Judge Hale added his own conclusion that, "This Court finds that, based on the wording in Section 330(a)(3) and (4), professional fees are not to be judged in hindsight."

Judge Hale relied on the intervening Supreme Court decision overturn the inconsistency in Pro-Snax.The Supreme Court said to follow the text of Section 330(a). The Pro-Snax dicta strayed from the text. Thus, while the Supreme Court upheld the holding in Pro-Snax, it implicitly rejected the dicta.

Judge Hale acknowledged that his ruling might be a little bold. He stated, "This Court realizes that its understanding of Pro-Snax may be misplaced. Certainly, other courts in Texas have constured the decision as requiring a hindsight analysis for professionals." Consequently, he offered a second rationale, finding that "Nevertheless, the Pro-Snax opinion is directed at a debtor's professionals, for obvious reasons--usually they have far more control over the reorganization efforts and strategy in a bankruptcy case. At least in Pro-Snax, they controlled the conversion to chapter 11 and the failed plan process." In his concluding paragraph, Judge Hale characterized Pro-Snax as "directed to professionals for the debtor who knew that their efforts were futile."

Judge Hale's order (which preceded the opinion) has already been appealed. Therefore it is likely that the Fifth Circuit will have the opportunity to revisit Pro-Snax in light of a decision squarely on point. If Gadzooks holds up, it will mean that professionals in bankruptcy will be less likely to have their fees denied based on factors beyond their control, such as poor holiday shopping sales. Of course, Gadzooks can't fix the largest problem in professional compensation--estates with no cash to pay professionals. However, it does remove an artificial roadblock.


On appeal, U.S. District Judge Jane Boyle reversed the Bankruptcy Court's opinion in Gadzooks. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07). Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.

The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct and that many courts had disagreed with its logic. On the other hand, the District Court found that Sec. 330 could possibly be construed consistently with Pro-Snax.

Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.

The District Court ruling has been appealed to the Fifth Circuit.

Wednesday, September 27, 2006

On Abstention, Multi-Prong Tests and Being Mistaken for David Bowie

Who would have thought that abstention could be so interesting? Judge Leif Clark has written a new opinion on abstention which jabs at some of the boilerplate language found in motions to abstain and contains a footnote destined to become a Clark-classic. The Official Committee of Unsecured Creditors of Schlotzsky's, Inc. v. Grant Thornton, LLP, Adv. No. 05-5109, 2006 Bankr. LEXIS 2435 (Bankr. W.D. Tex. 8/30/06).

In the Grant Thornton case, the creditors' committee received permission to sue the debtor's auditors. They brought seven causes of action, five of which arose under state law. Grant Thornton responded with a motion to abstain from hearing the state law claims and a motion to dismiss. In denying the motion to abstain, Judge Clark resisted the temptation to check off factors on a multi-prong test. In fact, he questioned the usefulness of such tests in general. He stated:

"Many courts, in an effort to give expression to the parameters of that (equitable) discretion, have developed multi-factor tests. While helpful, they are by their very nature, not dispositive. Mechanical applications of such tests to rule on equitable issues that are heavily fact-specific are often doomed to produce incorrect outcomes. The various tests offered by these opinions must be viewed in the larger context of the task presented--to arrive at the equitable application of the permissive abstention doctrine, as appropriately applied in the bankruptcy context. Or, more simply, we must avoid losing the forest for the trees."

Slip Op. at 5.

Judge Clark illustrated his point in a footnote which only he could have written.

"A person is sent into a crowded room with directions to find Judge Clark by applying the following multi-factor test: (1) tall, (2) blond hair, (3) angular features, (4) dressed stylishly and (5) having a resonant voice. The person returns with David Bowie in tow. If the person had simply been given a recent picture of Judge Clark (which would have been worth far more than all the factors one could write down on a piece of paper), chances are he would have quickly returned with the judge, not the singer."

Instead, Judge Clark tried to identify the larger policies served the abstention doctrine, stating:

"The larger context of permissive abstention is informed by the base principles that led to its inclusion in the bankruptcy jurisdiction statute in 1978. Those principles included the importance of centralized administration in one forum, the breadth of bankruptcy jurisdiction intended to have been conferred, the need to deal with unexpected exigencies or to step back when the matter to be litigated is especially important to be resolved in a state forum, and the need to do justice (as well as to avoid doing an injustice)."

Slip Op. at 5.

In the discussion which followed, Judge Clark addressed some of the boilerplate allegations which turn up in most motions to abstain:

* Forum Shopping
* State Law Issues
* Non-Core Status

With regard to forum shopping, Judge Clark pointed out that all parties with a choice of venue engage in forum shopping. The pertinent question is whether the particular exercize of forum shopping is abusive or consistent with the jurisdictional provisions of the Bankruptcy Code. In this case, the presumption in favor of centralizing proceedings related to the bankruptcy case in the Bankruptcy Court won out.

With regard to the prevalence of state law issues, Judge Clark pointed out many of the issues which the bankruptcy court deals with a daily basis, such as property of the estate, allowance of claims, determination of exemptions, validity and priority of liens, avoidance actions brought under section 544(b) and questions concerning the enforceability of executory contracts, all arise under state law. Judge Clark had previously ruled upon a case involving professional liability. Therefore, the mere presence of questions of state law was not dispositive.

With regard to non-core status, Judge Clark pointed out that this should really be a non-factor, since bankruptcy courts are expressly given the authority to hear non-core proceedings in the jurisdictional scheme of title 28. "Unless we are to read Congress' own enactment of section 157(c)(1) of title 28 as a perverse sort of statutory self-fulfilling prophesy, that section's operation should not factor into the abstention calculus." Slip Op. at 9. Properly understood, non-core status is a prerequisite to asking the abstention question. However, beyond that, it is not independently important.

At the end of the day, Judge Clark found that abstention was not appropriate.

It is refreshing to see Judge Clark take on some of the dogma surrounding abstention doctrine. So many of the opinions about abstention (and the briefs citing those same opinions) are long and self-important. However, abstention is really just about whether a particular choice of forum would be unfair. Although he did not use this specific formulation, his concept of not losing the forest amongst the trees could be summed up in two questions (which are arguably a multi-factor test themselves, but are certainly more direct and to the point):

(1) Is the Plaintiff trying to obtain an unfair advantage by its choice of forum?
(2) Is the Defendant being unfairly prejudiced by the choice of forum?

The answers to those questions should generally result in an answer as reliable as the multi-pronged tests.

(Note: In fairness to the promulgators of multi-factor tests, this approach is at least implied by the statute, which lists the interest of justice, comity with state courts and respect for state law as factors to be considered).

Wednesday, September 13, 2006

More Lawyer Problems in Houston

Judge Letitia Clark has added an entry to the growing list of opinions dealing with attorney problems in the Southern District of Texas. In In re John M. Diaz, No. 05-95123, 2006 Bankr. LEXIS 2008 (Bankr. S.D. Tex. 8/28/06), the Debtors' attorney in a chapter 13 case filed a fee application requesting $4,132.00 in fees and $301.50 in expenses. Apparently the Court had been tipped off as to problems with the case because both Debtors and several employees from the attorney's law firm testified at the fee application hearing. The picture painted by that testimony was not pretty.

According to the Debtors, they met with their attorney once for 30-40 minutes before filing the initial schedules and plan. They were not asked any questions about their budget. However, the documents filed under penalty of perjury included a detailed budget which contained just enough disposable income to pay secured claims and 7% to unsecured creditors. The Debtors then amended their plan and schedules five times with the result that under the final confirmed plan unsecured creditors were to receive a dividend of 100%. One of the amended schedules included an expense item of $800 per month despite the fact that the debtors had not made charitable contributions in several years. The Debtors testified that they did not understand the various changes to their schedules and plans and that all of their communications with the law firm were through secretaries and paralegals.

When Debtors' counsel realized that he was in trouble, he offered to reduce his fee to $500. However, the Court did not accept this offer. Instead, the court denied all fees. The court stated:

"In the instant case, (attorney) presented false schedules to the court, without adequately counseling his clients as to what the schedules represented, and without conducting any investigation into their veracity. It appears that the schedules contained figures invented by (attorney) or his subordinates, and filed for the improper purpose of evasion of Debtor's obligations to pay creditors. These services violated counsel's duty to instruct and supervise the Debtors, and violated (attorney's) ethical duty of candor to the tribunal. The services rendered by (attorney) and his subordinates were of zero value, no matter how much time was spent on such services, and irrespective of the ultimate confirmation of the plan in the instant case. In addition, (attorney) has imposed considerable burdens of time and detailed attention on his clients, the Trustee, and the court system, through his inadequate client counseling, filing of false documents, and lax supervision of staff."

Slip Op. at 13-14.

The facts of this case, if accurately found by the Court, are shocking. The Court found that the law firm made up numbers to minimize the Debtors' disposable income, did not bother to obtain actual expense figures and did not tell the Debtors what they were signing. It strains credibility a little bit to assume that Debtors making $11,000 a month were not sophisticated enough to know that something was not right with their filings, especially after the trustee requested amendments at the creditors meeting and filed several motions to dismiss based upon the inaccurate schedules. It also seems foolish at best that the attorney would risk being caught and exposed (as he ultimately was) just to earn a fee in a chapter 13 case.

On a certain level, this opinion is good because it points out that there are consequences for bad behavior. However, in a world of trial by anecdote, it gives fuel to the bankruptcy reformers who believe that all debtor's lawyers are unethical and out of control. This case is noteworthy precisely because it is an aberration. This was a case where the system worked. Therefore, it should not be viewed an an indictment of the system or the vast majority of the participants within that system.

Tuesday, August 15, 2006

Southern District Judge Gets Judicial Estoppel Right

Judicial estoppel is intended to protect the integrity of the bankruptcy system by encouraging parties to play straight with the court. Parties who successfully convince the court to take one position can not come back later with an inconsistent position. While the doctrine is intended to preserve the integrity of the court, it is frequently used by litigants as a get out of court free card. In a recent opinion by Judge Wesley Steen of the Southern District (and current president of the American Bankrutpcy Institute), the court declined to enforce judicial estoppel against the bankruptcy trustee based on the debtor's failure to disclose an asset.

A Common Fact Pattern

In James Lewellyn Miller, II (Case No. 04-31214 Bankr. S.D. Tex. 8/7/06), the debtor filed for chapter 7 and failed to disclose a cause of action against Merck relating to the drug Vioxx. The Trustee issued a no asset notice after the creditors' meeting. Subsequently, the debtor remembered that he had a claim and filed suit in state court. The vigilant trustee, upon learning that his asset was being hijacked by the debtor, asked the court to re-open the case. Merck did not want to be sued, so it asked Judge Steen to reconsider his order re-opening the case. Merck argued that it would be futile to re-open the case because judicial estoppel would prevent the trustee from pursuing the case. Thus, while this was ostensibly about whether to re-open a case, the underlying issue was whether judicial estoppel would apply. However, it was not Merck's day.


First, Judge Steen questioned whether Merck even had standing to question the re-opening. Judge Steen pointed out that Merck was not a creditor and had not participated in the case prior to it being closed originally. He rejected the notion that being sued gave Merck standing.

"The Court understands that Merck is a party to a state court lawsuit. Merck has cited no authority that being a defendant in a lawsuit brought by the Trustee, without more, makes Merck a party in interest that has a right to be heard on bankruptcy case administration. Estates are administered for the benefit of creditors and the debtor(s), not for the benefit of entities who may owe money to the estate.

* * *

"Giving Merck a voice in whether the chapter 7 trustee can sue Merck is a very strange idea, a little like putting the fox in charge of the hen house. The Court sees no authority for that in the Bankruptcy Code. Merck is not a party in interest merely on showing that the Trustee will sue Merck."

Slip op. at 4.

Juducial Estoppel

However, the Court did not stop there. It proceeded to analyze the merits of Merck's judicial estoppel arguments and found them wanting. Thus, Merck got the worst of both worlds. The court rejected its standing to appear in bankruptcy court but also ruled on the merits of the argument that it didn't have standing to make in the first place. (However, as explained later, the Court did limit the extent of its ruling).

There are three elements to judicial estoppel:

1. The party took a clearly inconsistent position.
2. The court accepted that position.
3. The party took the prior position intentionally and not inadvertently.

The Court did not get past the first element in finding that judicial estoppel would not apply, since the Trustee did not take an inconsistent position.

"It is not clear what 'contrary position' Merck asserts as the operative 'contrary position' that might judicially estop the Trustee. Possibly Merck contends that Debtor's failure to list the claim against Merck is a 'contrary position.' If that is Merck's contention, then judicial estoppel might apply to the Debtor. but the party seeking to reopen this bankruptcy case is the Trustee, and the Trustee did not make the statement about which Merck complains. The Trustee did not file the schedules. The Trustee is not judicially estopped from reopening the case by a 'contrary position' taken by the Debtor."

Slip Op. at 6.

The Court rejected Merck's argument that the Debtor and the Trustee were essentially the same party, stating:

"Merck asserts ... that ... the distinction between Debtor and the Trustee is a distinction without a difference. But there is a vast difference between a trustee in a chapter 7 case and a debtor in a chapter 7 case. The trustee acts as representative of creditors. The debtor represents no one but himself."

Slip Op. at 9.

The Court contrasted its case with In re Walker, 323 B.R. 188 (Bankr. S.D. Tex. 2005), an opinion by his colleague Judge Bohm. In Walker, it was the Debtor who sought to reopen the case and the Trustee was nowhere to be found. In that case, the Court was concerned that the Trustee would simply abandon the asset back to the Debtor and noted that the result would likely be different if the Trustee were likely to pursue the claim. In Miller, on the other hand, it was the Trustee who sought to reopen the case and who was already taking steps to pursue the asset.

The Court makes a very important distinction here. The Trustee and the Debtor are different parties who serve different roles. Indeed, in the case of Debtor misconduct or failure to perform his duties, the Trustee is an adverse party to the Debtor. Thus, it is particularly insidious to suggest that the creditors (who are the Trustee's constituency) should be punished for the Debtor's failure to file an accurate set of schedules. This is a case where the integrity of the system demands that the cause of action be disclosed to the Trustee so that it may be pursued for the benefit of the creditor body. To say that judicial estoppel should apply against the Trustee (and by extension the creditors) in order to preserve the integrity of the bankruptcy system is a bit like burning down a village in order to save it.

Judge Steen also addressed the possibility that Merck was contending that the Trustee took an inconsistent position by filing the no-asset report. The Court pointed out that since the Trustee did not know about the lawsuit at the time he filed the no-asset report, it would not count as an intentional inconsistent position so that judicial estoppel would not apply.

After having addressed judicial estoppel at some length, the Court clarified the scope of its ruling. The Court stated that it was merely determining that the Trustee was not judicially estopped from reopening the case and that Merck could assert judicial estoppel in response to a suit brought by the Trustee. While the Court prudentially saved the ultimate issue for another day (and perhaps another court), the logic would seem to apply equally to the merits as to the procedural issue determined here.

Practice Tip

The best way to avoid judicial estoppel claims is to make sure that potential claims and causes of action are properly scheduled in the first place. Of course, the next best thing is to amend the schedules when the issue first arises (and preferably well before any state court action is filed). However, assuming that the issue doesn't surface until way down the road, there is likely to be a race to the courthouse between the debtor-plaintiff and the defendant. If the plaintiff is willing to fall on his sword and surrender the cause of action to the trustee and the trustee is willing to pursue that cause of action for the benefit of the creditors, then judicial estoppel should not apply. The Debtor may still be able to benefit from the Trustee's pursuit of the claim if a portion of the claim is exempt, if there are excess proceeds or if part of the claim arose post-petition and is not property of the estate. On the other hand, if the defendant is able to raise the issue before the debtor realizes that the claim is in peril, then the defendant may prevail. Once the trustee is involved, the defendant would be well served by trying to settle directly with the trustee rather than pursuing a scorched earth policy. If the state court lawsuit is large and the claims in the bankruptcy case are small, then the trustee might be willing to settle for an amount which will pay the claims.

Thursday, August 10, 2006

Means Testing Opinions Strictly Construe Statute While Identifying Problems

Four recent opinions from the Northern and Western Districts of Texas have addressed the mechanics of means testing. The trend from this group of cases is that the courts have not been receptive to overly creative arguments and have tried to remain faithful to the spirit of the means testing. The courts have managed to do this while pointing out specific instances in which the law is an ass. The recent opinions include In re Oliver, No. 06-10134, 2006 Bankr. LEXIS 1992 (Bankr. W.D. Tex. 8/8/06); In re Barraza, 2006 Bankr. LEXIS 1536 (Bankr. N.D. Tex. 8/1/06); In re Lara, 2006 Bankr. LEXIS 1170 (Bankr. N.D. Tex. 6/28/06); and In re Hardacre, 338 B.R. 718 (Bankr. N.D. Tex. 2006).

Introduction to Means Testing

Means testing under 11 U.S.C. §707 is a three part process. First, the Court looks to see whether the debtor’s income based upon the previous six places him above or below the median income. If the debtor is below the median income, the formal part of the process ends. 11 U.S.C. §707(b)(6) and (7)(providing that no motion to dismiss may be filed under means testing provision if annualized income is below the median). If the debtor’s income is above the median, then the means testing formula of §707(b)(2) applies. If the result of that process is that the debtor’s hypothetical net income exceeds $10,000 (or between $6,000-$10,000 if such amount exceeds 25% of the debtor’s unsecured nonpriority debts), then abuse is presumed. 11 U.S.C. §707(b)(2)(a)(i). If the presumption of abuse arises, it may be rebutted by “special circumstances, such as a serious medical condition or a call or order to active duty in the Armed Forces.” 11 U.S.C. §707(b)(2)(B). The test is quite complex and has justifiably been described as arbitrary. As a result, there is both the incentive and the opportunity for lawyers to test its boundaries.

Timing Your Income

Determining income under the means test is the first of many artificial provisions which apply. The debtor must take the previous six months income divide by six and multiply by twelve. Thus, if the previous six months income is not representative, the means test will yield a skewed starting point. As Judge Monroe pointed out in the Oliver case:

“The ‘means test’ attempt to create a formula to apply to all situations. However, the average of the last six months of income may or may not be an accurate picture of any person’s real financial situation. It is merely a snapshot as of the petition date. For instance, a debtor may have made $5,000 a month for 4 months and then lost his job; but he may still qualify under the means test presumption as an abusive filer [and have his case either dismissed or converted to Chapter 13] even though because of his job loss he has not current ability to pay a dime to his creditors. Another debtor, however, may not have worked for the first 5 months and then obtained a job making $5,000 per month; yet no presumption of abuse would arise even though this debtor would probably have the ability to repay his creditors a substantial amount.”

In re Oliver, slip opinion at 7-8.

In the Oliver case, the debtor filed his petition on February 7. He had previously received a $1,500 bonus, but claimed that he might not be receiving a bonus again in the future. Because the debtor filed within six months after receiving his bonus, his annual income was increased by $3,000 ($1,500/6 x 12) even though he might not receive the same bonus again. If the debtor had waited to file until July (assuming that the bonus was received at year end), his means test generated income would have been lower because the bonus would not have been in the six month look back window.

The Trouble With Transportation

Transportation costs have been a recurrent theme in the recent cases. The IRS Collection Standards, which form the basis for the means test, allow both an ownership allowance and an operating allowance for vehicles. The ownership allowance is set at $475 for the first car and $338 for the second car. BAPCPA also provides that the means test “shall not include” the amount of secured debt payments averaged over a 60 month term. These transportation allowances have already given rise to several published opinions.

In Hardacre, Judge Nelms addressed the problem of double dipping. The debtor in that case argued that BAPCPA “compelled” him to include both the ownership allowance and the amount of his car payment. Finding that statutory construction was a holistic endeavor, Judge Nelms found that the debtor was entitled to deduct the greater of the secured debt payments or the IRS allowances but not both. In the Lara case, Judge Houser was faced with another type of double dipping. In that case, the debtors each sought to claim the $475 ownership allowance. However, Judge Houser ruled that they were one unit for purposes of means testing so that they received only one allowance.

Under the Collection Standards, a debtor with a car payment of less than $475 would receive an overly generous allowance. However, what about a debtor with no car payment? Apparently, this debtor does not fare as well, as shown by the recent opinions in Oliver, Barraza and Hardacre. All three opinions held that an ownership allowance is only available to a debtor with an ownership expense. In Oliver, the debtor claimed his $475 ownership allowance on Form B22A and included an anticipated future car payment of $500 on Schedule J. Judge Monroe pointed out (as did Judge Nelms in Lara), that the IRS Collection Standards grant an additional operating expense of $200 for a debtor with a vehicle which is more than six years old or which has over 75,000 miles on it. Because the Collection Standards have granted an allowance for older vehicles in one place, it is not necessary to allow an ownership expense where there is not one.

These cases highlight an important practice point. The conventional wisdom has held that it is better for a potential debtor to replace an aging vehicle prior to filing bankruptcy rather than waiting until afterwards. This view was based in part on (1) the fact that a bankruptcy filing could impair the debtor’s credit and make it more difficult or more expensive to finance a replacement vehicle and (2) in a chapter 13 case, the debtor would need to request permission to incur post-petition credit. There is now a third reason. Under the means testing formula, an inchoate need to replace a paid for vehicle in the near future is given no credit, while an actual secured debt is given full value.
Thus, if a debtor had $275 per month in excess income and had an imminent need to replace a paid for vehicle, he would fail the means test and be pushed into a chapter 13 plan which would likely be doomed to failure based on the need to replace the vehicle within the five year life of the plan. On the other hand, if the same debtor traded in his vehicle and purchased a new one with a payment of $200, he would pass the means test and be able to file for chapter 7. (This is based on the fact that eliminating the older vehicle would reduce the operating expense by $200 but would increase the ownership allowance by $475 resulting in a net reduction of $275 in excess income). The economic reality of both debtors would be the same. However, the timing of the vehicle purchase would determine their eligibility for chapter 7 relief.

It should be noted that BAPCPA prohibits a debt relief agency from advising an assisted person “to incur more debt in contemplation of such person filing a case under (title 11).” 11 U.S.C. §526(a)(4). On its face, this statute would appear to prevent an attorney from advising his client to make the sensible choice of incurring new debt to replace an aging vehicle. However, as discussed in a previous post (See BAPCPA Found to Unconstitutionally Limit Attorney Speech), this provision has been found to be unconstitutional by a judge in the Northern District of Texas. Of course, the opinion in Hersch v. United States is still interlocutory and is not binding precedent, but it offers some comfort. An additional measure of comfort is contained in the Brief filed by the United States in Connecticut Bar Association v. United States (See The Empire Strikes Back) in which the government contended that “in contemplation of” meant “because of” filing bankruptcy rather than “while contemplating” bankruptcy. This is a little bit tricky because under the government’s position, a lawyer may advise a client to incur more debt in pursuit of a goal unrelated to bankruptcy (such as obtaining reliable transportation). However, an attorney might not be able to advise the same client that the same decision would dramatically affect their eligibility to file chapter 7.

No Deduction For 401k Loan Repayments?

One of the more bizarre rulings in the recent opinions related to 401k loan repayments. Prior to BAPCPA, there was a difference in opinion as to whether loan repayments to a 401k plan could be deducted from disposable income in a chapter 13 case. BAPCPA provides that 401k plan loan repayments shall not be considered as disposable income under chapter 13, 11 U.S.C. §1322(f), and provides that they are not subject to the automatic stay, 11 U.S.C. §362(b)(19). Therefore, it should be apparent that these payments are a deduction for means testing purposes as well, right? Apparently this is not the case in Ft. Worth. When Judge Nelms was faced with this issue in Barraza, he pointed out that §707(b)(2)(A) does not incorporate either of these sections and that the Court must assume that Congress did this intentionally. The Court stated:

“(W)hy would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13? The court confesses that it does not know. Nevertheless, the court’s lack of prescience as to Congress’s reasoning does not permit it to revise a formula that is otherwise clear on this particular point.”

In re Barraza, slip op. at 17.

Unfortunately, the Court in Barraza missed a potential explanation for the apparent inconsistency or perhaps did not have the right evidence before it. In the author’s experience, most 401k plan loans are secured by the assets in the 401k plan. If that is the case, then they would be excluded from the means test by the provisions relating to secured debts. 11 U.S.C. §707(b)(2)(A)(iii). Instead, the Court considered whether these debts could be considered as other necessary expenses for unsecured debts. Other practitioners faced with this issue would do well to obtain the documentation on the 401k plan loans and, if appropriate, to schedule such debts as secured claims. This will allow for appropriate treatment under the means test.

Deviation From National Local Standards

At first glance, a “national local” standard sounds like a contradiction in terms. However, it is one of a few areas where judges have discretion to deviate from the “plugged” numbers. A national local standard is one where standards are set on an area by area basis. Thus, the cost to operate a vehicle in the Dallas region is higher than in the Houston region. The national local standards include housing, utilities and vehicle operating (but not ownership) costs. The Collection Standards allow deviation from these amounts when it is reasonable to do so. According to Judge Monroe, “The National local expenses are the only guidelines from which this Court can deviate when it is reasonable to do so under the facts of a particular case.” In re Oliver, slip op. at 12.

In the Oliver case, the debtor’s standardized operating expense was $242 per month. However, the debtor testified that as part of his job that he drove 3,000 per month and that his truck averaged 15 miles per gallon. The Court concluded that at $3.00 per gallon for gas, this would allow an operating expense of $600 per month. Thus, the debtor was entitled to an operating expense which was over double the standard amount. The Court allowed the additional operating expense based upon the debtor’s testimony without requiring specific documentation.

Special Circumstances Are Not Special Unless They Are Documented

Several of the debtors sought to establish “special circumstances.” Section 707(b)(2)(B) allows the Court to consider “special circumstances, such as a serious medical condition or a call or order to active duty in the Armed Forces.” To qualify as a special circumstance, three requirements must be met:

1. It must be documented.
2. There must be a detailed explanation.
3. It must be attested to under oath.

In Oliver, the debtor filed a Declaration of Debtor Regarding Special Circumstances in which he claimed the following:

1. He had previously been unsuccessful in making payments under a debt consolidation plan.
2. The cost of replacing his vehicle would consume a chapter 13 payment.
3. His anticipated future income and expenses as reflected on Schedules I and J were more accurate than the means testing form and indicated that he did not have the ability to pay.

The Court rejected these special circumstances. It found that failure under a prior consolidation plan was simply irrelevant. The Court also noted that the Debtor had failed to document his claimed expenses.

“Further, and problematic for the Debtor, he provided no documentary evidence to substantiate the changes in his income and expenses that he testified were anticipated. He merely testified that his income will likely decrease due to an anticipated job change with his current employer within six months, and that in that position he will not receive as significant a bonus as in the past. He did not provide any specific amounts of any decrease in salary or bonus. And, at the time of the hearing, the Debtor had not changed positions.”

In re Oliver, slip op. at 4.

This language raises an interesting question as to what would sufficient documentation of a pending decline in income. Would a note from his employer be adequate? If the debtor was unlikely to receive a bonus based on his company’s declining finances, would it be necessary for a corporate official to bring in the corporate books and records to show that sales and profits were down significantly?

In Barraza, the debtor offered several other circumstances, including:

1. That payment under a chapter 13 plan would be zero.
2. That he was paying his girlfriend $400 per month to live with her in addition to paying housing costs for his ex-wife and child.

Both of these arguments were rejected for lack of documentation.

The Means Test Can Be Mean

The Barraza case provides a potent example of how the means test can operate to punish the diligent and hardworking while rewarding the slothful. Mr. Barraza worked two jobs totaling about 80 hours per week. In return for doing the work of two men, he brought home the princely sum of $5,410 per month. He drove an eight-year old pickup truck which was paid for. Out of his income, he paid the mortgage note on the house where his wife and children lived, paid $700 per month in child support and also contributed $400 per month toward the expenses of his girlfriend’s household where he lived. In considering Mr. Barraza’s circumstances, the Court observed:

“(I)t is a mistake to view the means test as a formula for measuring the culpability of a particular debtor for the circumstances which led him into bankruptcy, and, hence, whether the debtor is worthy of one form of relief rather than another. The means test does not distinguish those who have tried hard from those who have hardly tried. It is a blind legislative formula that attempts to direct debtors to a chapter that provides for at least some measure of repayment to unsecured creditors over a period of years. Like any other effort at social or economic legislation, it is not perfect. Consequently, the fact that the debtor can hypothesize examples in which the means test operates unfairly does not, by itself, serve as a basis for the court to refuse to apply it here.”

In re Barraza, slip op. at 10-11. The unfortunate truth here is that if Mr. Barraza had only worked one job and had spent his spare time sitting in front of the TV and drinking beer, he would have been eligible for chapter 7 relief. Because he worked more than most people and did not live extravagantly, he worked himself out of eligibility for chapter 7.

Monday, July 31, 2006

BAPCPA Found to Unconstitutionally Limit Attorney Speech

In one of the first decisions construing the Debt Relief Agency provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the U.S. District Court for the Northern District of Texas has held that one specific provision of the statute is unconstitutional but denied relief on several other claims. No. 3:05-CV-2330-N, Susan B. Hersch vs. United States of America, et al (N.D. Tex. 7/26/06).

Attorney Susan B. Hersch of Dallas filed suit seeking a determination that attorneys did not fall within the definition of Debt Relief Agencies and that several provisions of BAPCPA were facially unconstitutional. On July 26, 2006, District Judge David C. Godbey released a 15 page Memorandum Opinion and Order. The Court’s ruling was a mixed bag for debtor’s attorneys. On the one hand, the Court found that Sec. 526(a)(4), which prohibits attorneys from advising clients to incur debt in contemplation of bankruptcy, was unconstitutional. However, the court rejected a challenge to the compelled disclosures required by Sec. 527 and held that attorneys were clearly within the scope of Debt Relief Agencies.

Attorneys Are Debt Relief Agencies

The Court found that the plain meaning of Sec. 101(4A) and 101(12A) provided that attorneys were included within the meaning of debt relief agencies. Debt relief agencies were defined as persons providing “bankruptcy assistance” in return for money, while bankruptcy assistance was defined as including “providing legal representation with respect to a case or proceeding under this title.” The court stated:

“A reading of the text for plain meaning indicates that the term ‘debt relief agency’ includes bankruptcy attorneys such as Hersch. Plain meaning is the preferred method for interpreting statutory language (citation omitted). Here, as only attorneys are authorized to provide legal advice and ‘providing legal advice’ is part of the definition of bankruptcy assistance, it seems clear that bankruptcy attorneys such as Hersch fit within the definition of ‘persons providing bankruptcy assistance.’ Attorneys also provide most of the other functions defined as ‘bankruptcy assistance.’”

It is hard to argue with the judge’s plain meaning analysis. While some courts have tortured the language into a conclusion that attorneys are not covered, In re Attorneys at Law and Debt Relief Agencies, 332 B.R. 66 (Bankr. S.D. Ga. 2005), this argument is probably a dead letter.

Section 526(a)(4) Impermissibly Limits Free Speech

Section 526(a)(4) was found unconstitutional under the First Amendment. However, this part of the opinion was a little procedurally confused. The plaintiff apparently did not plead that Sec. 526(a)(4) was unconstitutional. However, both parties briefed this issue extensively. As a result, the court ruled on the substantive issue subject to the plaintiff amending her pleadings to raise the issue which had already been decided.

Section 526(a)(4) states that a debt relief agency shall not “advise an assisted person . . . to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title.” The plaintiff argued that the statute should be subject to strict scrutiny, which is the standard generally applied to content based restrictions on speech. The government, on the other hand, argued that Sec. 526(a)(4) was an ethical restriction and should be reviewed under the more lenient standard contained in Gentile v. State Bar of Nevada, 501 U.S. 1030 (1991). The District Court noted that there was nothing in Sec. 526(a)(4) which would indicate that it was an ethical prohibition. However, it noted that even under the more lenient standard, that the statute was not constitutional.

Under the Gentile standard, the statute must (1) serve “the State’s legitimate interest in regulating the activity in question” and (2) “impose only narrow and necessary limitations on lawyer’s speech.” The Court noted that both the strict and lenient standards require that the restriction be narrowly tailored. Here, the court found that Sec. 526(a)(4) was not “narrow and necessary.” In this respect, the government was hoist on its own petard. The government argued that taking on additional debt “may” harm a debtor in some cases. As a result, the Court concluded that in other cases, it may not. The Court stated: “Section 526(a)(4), therefore, is overinclusive in at least two respects: (1) it prevents lawyers from advising clients to take lawful actions; and (2) it extends beyond abuse to prevent advice to take prudent actions.”

Section 527 Is Constitutional

Section 527 requires attorneys to give mandatory discloses to clients. The Plaintiff argued that this section unconstitutionally compelled speech. The court dismissed this argument finding that it was permissible to require the disclosure of accurate information. In this case, the court noted that even though the disclosures could be misleading in certain specific circumstances, the attorney was allowed to tailor the disclosure so long as it contained the required substance.

Final Thoughts

This appears to be a cogent and well-reasoned opinion. The court rejected weak arguments from both parties and cut to the heart of the issues. Judge Godbey was appointed by the current President Bush so that he cannot easily be dismissed as a liberal activist. This opinion is merely persuasive authority rather than binding precedent. However, until the circuit courts weigh in, Hersch is likely to be very persuasive.

Tuesday, July 18, 2006

Opinions Regarding Failure to Obtain Credit Counseling Underscore Dissatisfaction With Law

Mandatory pre-bankruptcy credit counseling was one of the reforms enacted by BAPCPA. Its drafters intended for credit counseling to be a prophylactic step which would prevent avoidable bankruptcies. In practice, it has become a formality for some and a stumbling block for others. Several recent opinions from the Western District of Texas highlight differing approaches to this issue.

Approach One: This Is Stupid, I’m Going to Say It’s Stupid, But I Am Going to Enforce This Stupid Law

On December 22, 2005, Judge Frank Monroe from the Austin Division of the Western District of Texas released his opinion in In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005). Judge Monroe did not mince words about the wisdom of the credit counseling requirement.

"One of the more absurd provisions of the new Act makes an individual ineligible for relief unless such individual, 'has during the 180-day period preceding the date of filing of the petition by such individual, received from an approved nonprofit budget and credit counseling agency described in §111(a) an individual or group briefing (including a briefing conducted by telephone or on the Internet) that outlined the opportunities for available credit counseling and assisted such individual in performing a related budget analysis.' See 11 U.S.C. § 109(h)(1). No doubt this is a truly exhaustive budget analysis."

Judge Monroe goes on to describe the circumstances in which a certificate of exigent circumstances can be filed and approving, concluding:

"Simply stated, if a debtor does not request the required credit counseling services from an approved nonprofit budget and credit counseling service before the petition is filed, that person is ineligible to be a debtor no matter how dire the circumstances the person finds themselves in at that moment.

"This Court views this requirement as inane. However, it is a clear and unambiguous provision obviously designed by Congress to protect consumers."

Approach Two: This Is Foolish But Congress Gave Me Room to Avoid a Foolish Result

Judge Monroe seemed pretty definitive, but things were not so clear in San Antonio. On June 27, 2006, Judge Leif Clark released his Order on Motion for Exigent Circumstances in In re Navarro, No. 06-51007 (available at Judge Clark was faced with a pro se debtor who “was unable to obtain counseling within the five day window because she did not know that she needed to obtain counseling as a prerequisite to filing for bankruptcy.”

Judge Clark, like Judge Monroe, did not view the credit counseling requirement as particularly helpful Judge Clark stated:

"The credit counseling briefing is superficially designed to discourage people from filing for bankruptcy on the theory that, if they but knew of the alternatives, they might pursue those instead. In practice, however, the briefing has little or no effect on the actual decision to file because, by that time, the person’s financial condition has deteriorated too far for any alternative other than bankruptcy to be effective. The 'briefing' called for by section 109(h)(1) does little more than make the debtor aware of credit counseling as an alternative. But credit counselors attempt to negotiate a payment plan with the consent of the debtor’s creditors, for a fee, and their success will depend on whether they can get all creditors to cooperate…The actual negotiation of an alternative thus requires a voluntary “standstill” by the creditors while an arrangement is worked out. In practice, that will not happen. (citation omitted). What is more, the debtor may well be actually discouraged from filing when filing might be the right thing to do—by a credit counselor who is not lawyer effectively giving the debtor legal advice. (citation omitted). The result is that the credit counseling briefing ends up being a useless formality.

"It also operates as a trap for the unwary, potentially causing the dismissal of so-called 'ineligible' debtors from bankruptcy. (citation omitted). While certain private financial interests may be rewarded as a result, (citation omitted), no genuine public interest appears to be served."

Judge Clark then turns his thoughtful mind to the court’s role in policing eligibility. Judge Clark notes that eligibility is not jurisdictional. Thus, an ineligible debtor may proceed in bankruptcy unless someone timely objects. In this case, the court is appointed as gatekeeper. The clerk may not refuse to accept a petition which is not accompanied by a certificate of credit counseling. The clerk may bring any deficiency to the attention of the court, which, under Rule 1007(e) “may” dismiss the case, but is not required to. If the debtor files a certificate of exigent circumstances, the court “may” conduct a hearing, but is not required to. Further, “If the court finds the certificate of exigent circumstances to be satisfactory, then the issue of eligibility under section 109(h) is deemed resolved for all purposes, and the debtor is henceforth eligible for relief as a debtor under title 11, no further questions asked.”

Judge Clark seems to be saying that he has the discretion to ignore a failure to obtain credit counseling as well as the discretion to accept any explanation of exigent circumstances. In a footnote, he states:

"Section 707(a) permits (but does not require) the court to dismiss a case for failure to file the information required by section 521(a)(1), but the certificate of credit counseling briefing is not one of the documents required to be filed by section 521(a)(1). …Thus, while some courts have elected to dismiss cases that do not comply with Interim Rule 1007(b)(3)(including my colleague in this division), they apparently do so as a matter of judicial housekeeping, but not as a matter of statutory or rule construction."

Judge Clark concludes that not knowing about credit counseling was an exigent circumstance in the case before him.

"The court finds that this debtor, a non-lawyer, was justified in not knowing about the credit counseling briefing requirement as a pre-condition to eligibility for bankruptcy. That justifiable lack of knowledge, in turn, satisfies the court as an exigent circumstance."

While Judge Clark’s logic is elegant and his heart is clearly in the right place, the result seems to be a bit off. The exigent circumstances provision is part of a clause which has three parts connected by an “and.” Judge Clark’s ruling appears to state that a person may be a debtor if they submit a certificate describing exigent circumstances which is satisfactory to the court. While this satisfies the first and third requirements, it appears to read out the second one. The middle provision requires that the “debtor requested credit counseling services from an approved non-profit budget and credit counseling agency, but was unable to obtain the services … during the five-day period beginning on the date on which the debtor made that request.” If the debtor did not request credit counseling at all, the debtor would not be able to establish that credit counseling was not available within five days. Therefore, the debtor would not be able to establish exigent circumstances. However, in the Navarro case, that is exactly what happened.

Approach Three: The Law Seems Clear to Me

The final salvo in this round of cases comes from Judge Ronald King from San Antonio, who weighed in with an opinion on July 7, 2006. Like Judge Clark, Judge King was faced with a pro se debtor. In In re Gallardo, No. 06-50724 (available at, the debtor sought to reconsider dismissal of his case. The debtor contended that he had looked on the internet for requirements to file bankruptcy but did not discover the credit counseling provision. Judge King was not impressed. He said:

"This Court cannot control publication of the United States Code on internet websites. The fact that the Debtor could not locate section 109(h) of the Bankruptcy Code on a particular website does not make the amendments made by BAPCPA inapplicable to this Debtor. Section 109(h) of the United States Bankruptcy Code, as amended by BAPCPA effective October 17, 2005, requires that credit counseling must be taken prior to the filing of a new bankruptcy case by an individual debtor and certification of such credit counseling must be filed with the petition. There are certain exceptions for exigent circumstances, incapacity, disability or active military duty which are not applicable in this case. This Court must follow the law as enacted by Congress and signed by the President."

It seems obvious that Judge King considers dismissal of a non-complying case to be mandatory rather than a matter of judicial housekeeping. The fact that Judge King would publish this scant 1 ½ page opinion just ten days after Judge Clark’s opinion in Navarro could be read as an attempt to stake out his own position on this issue.

Defying Congress

Both Judge Monroe and Judge Clark seem intent on lecturing Congress. By referring to the credit counseling requirements as absurd, inane and a useless formality, the judges have made it clear what they think. They have also expressed what a sizeable contingent of the practicing bar (including this author) thinks. By lending the prestige of their office to the critiques voiced by many, the judges may spur corrective action by Congress (although this is probably wishful thinking). However, Judge Clark’s ruling is a bit more troubling. By claiming that he is the gatekeeper who may admit whom he finds worthy and by stating that he can make a debtor eligible “no further questions asked,” Judge Clark appears to take a very aggressive position. No party filed a timely appeal from Navarro, so that the debtor in that case will likely be able to complete her case without pre-petition credit counseling. It remains to be seen whether a creditor or the U.S. Trustee will take up the gauntlet in a future case.

Monday, July 17, 2006

The Empire Strikes Back: The Government Files Its Reply Brief in the Suit Over BAPCPA's Debt Relief Agency Provisions

I have previously written about the suit filed by the Connecticut Bar Assocation and the National Association of Consumer Bankruptcy Attorneys seeking to overturn the debt relief agency provisions of BAPCPA.

Blaming Attorneys

The United States has now responded to that suit and its defense of BAPCPA focuses largely upon the perceived ethical shortcomings of consumer debtors’ attorneys.

“In enacting the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Congress found that there was ‘abuse by attorneys and other professionals.’ (citation omitted). To correct this abuse, Congress included in BAPCPA ‘provisions strengthening professionalism standards for attorneys and others who assist consumer debtors with their bankruptcy cases.’”

Memorandum in Support of Motion to Dismiss and in Opposition to Plaintiff’s Motion for Preliminary Injunction, p.1, filed on June 30, 2006 in Case No. 3:06CV729 (U.S. District Court for the District of Connecticut).

The USA goes on to quote from the legislative history to BAPCPA:

“Looking for the source of this meteoric increase in bankruptcy filings, Congress determined that the bankruptcy system “ha[d] loopholes and incentives that allow[ed] and—sometimes-- even encourage[d] opportunistic personal filings and abuse (citation omitted) and that attorneys sometimes played a role in exploiting these “opportunities.”

Memorandum, pp. 8-9.

The U.S. Trustee program is quoted for the proposition that “[a]buse of the system is more widespread than many would have estimated.” Another witness testified that some debtors are told that they are consolidating their debts and do not know that they have filed bankruptcy, while the Fifth Circuit’s own Judge Edith Jones is cited for the statement that “many” bankruptcy lawyers never talk to their clients; another witness testified that bankruptcy practices are run like mills and that clients do not receive adequate disclosures. Finally, Bankruptcy Judge Carol Kenner is cited for the proposition that many debtors sign reaffirmation agreements without adequate disclosure.

The picture painted here is one of out of control lawyers causing a national bankruptcy crisis. It is disheartening that a Congress full of lawyers found it necessary to blame lawyers for the level of bankruptcy filings. Of course, neither the Justice Department nor the legislative history discuss the studies finding a direct correlation between the amount of consumer debt in the economy and the number of consumer bankruptcies filed.

Tempering the Language of BAPCPA

However, the news is not all bad. In several instances, the lawyers for the Justice Department argue that the provisions applicable to attorneys are not really as bad as they appear.

BAPCPA prevents attorneys from advising prospective to incur debt “in contemplation of” bankruptcy. The plaintiffs (the Connecticut Bar Association, the National Association of Consumer Bankruptcy Attorneys and others) argued that this gagged attorneys from advising their clients about how to beneficially structure their debts, such as refinancing a high interest loan. The USA contends that “in contemplation of” bankruptcy means because of filing bankruptcy. Under this construction, the only advice which would be prohibited would be to incur debt for the sole purpose of having it discharged in bankruptcy.

In another instance, BAPCPA requires attorneys to state, “We are a debt relief agency. We help people file for bankruptcy under the Bankruptcy Code” in certain advertisements directed to the general public. While this requirement is patently offensive in any circumstance, the attorneys for the government try to minimize its effect, claiming that it only applies to advertisements directed to prospective consumer debtors. If the government is correct, then attorneys who represent debtors, creditors and trustees would not be required to place this disclaimer on their websites or other material generally promoting the firm. However, this is still a silly requirement. When an attorney says “We are a debt relief agency,” it suggests that he is affiliated with a government or non-profit agency.

The irony with the mandatory debt relief agency statement is that Congress identified a legitimate problem and then failed to fix it. There are some persons who advertise credit repair or debt consolidation when they mean bankruptcy. I would suspect that many of the people doing this are not lawyers and will not be affected by the statute. Congress could have fixed a legitimate problem by simply prohibiting deceptive advertisements. Instead, it mandated a silly slogan which does little to fix the problem while dissuading legitimate attorneys from representing consumer debtors.


The District Court heard oral argument on July 13 and has taken the matter under advisement.