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.