Tuesday, January 30, 2007

Houston Judges Find Method to Avoid Unnecessary Filing of Means Testing Form in Cases That Have Mostly Business Debt

While means testing is supposed to be self-effectuating, Congress failed to specify a clear mechanism for separating those debtors required to pass through the analysis and those who were exempt. In a new opinion, Judges Marvin Isgur and Wes Steen have developed a test to help debtors navigate the straits between Scylla and Charibidis (complete with a footnote explaining who Scylla and Charibidis were). No. 06-37157, In re David Michael Beacher, (Bankr. S.D. Tex. 1/26/07) and No. 06-35550, In re Michael Antonio Pena (Bankr. S.D. Tex. 1/26/07).

Means testing is one of the hallmarks of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). It was meant to ensure that debtors who could afford to pay their debts did not take the easy way out by filing chapter 7. Means testing only applies to debtors with "primarily consumer debts." This may have been because Congress figured that business debtors would fail in a big way so that they wouldn't be able to repay their debts or it might have been intended to promote entrepreneurship or it just may have been a consequence of the fact that BAPCPA was championed by the consumer credit lobby. Whatever the reason, means testing applies to individuals with primarily consumer debts but not other individuals.

Means testing is enforced through a regime which requires debtors to file a statement of current income and expenditures, which in the case of an individual debtor with primarily consumer debts must include a calculation to determine whether the presumption of abuse arises. See 11 U.S.C. Sec. 521(a)(1) (requiring filing of statement of income and expense unless the court orders otherwise) and 11 U.S.C. Sec. 707(b)(2)(C) (requiring additional calculation if primarily consumer debts are involved). If a debtor fails to file the information required by Sec. 521 within 45 days, then the case is subject to mandatory dismissal. 11 U.S.C. Sec. 521(i)(1).

Form 22A contains a detailed analysis of income and expenditures under the means test. However, judges have disagreed on whether it must be filed by all chapter 7 debtors or just those with consumer debts. Compare In re Moates, 338 B.R. 716 (Bankr. N.D. 2006)(only consumer debtors need file the form) with In re Copeland, 2006 Bankr. LEXIS 2200 (Bankr. S.D. Tex. 2006)(all debtors must file).

Judges Isgur and Steen disagreed with their Southern District colleague and ruled that requiring all debtors to file the form was neither "reasonable or acceptable." They cited Lord Coke for the maxim that "The law requires no one to do vain or useless things." 5 Coke 21.

With that out of the way, the judges had to decide what to do if a debtor failed to file the form. If the debtor was required to file the form but did not do so, then mandatory dismissal was the penalty. On the other hand, if the debtor was not required to file the form, they could hardly complain about its absence. The two cases consolidated in their opinion illustrate two different ways to approach the problem. In the first case, the debtor filed a motion to be excused from filing Form 22A on the ground that it was not required. In the second case, the court issued a show cause order as to why the case should not be dismissed for failure to file the form. When the debtor did not respond, the case was dismissed, leading to a motion to reconsider. In both cases, someone, whether the debtor or the court, had to take a proactive step to tee up the issue.

Further, the consequences of guessing wrong were serious, since they would result in automatic dismissal. In the Beacher case, the debtors contended that 58% of their debts resulted from their failed business. However, what if it turned out that only 49% fell in the business category? If the decision was made 46 days into the case, they would be dismissed.

To solve this problem and avoid "vain and useless expenditure of resources," the judges have developed a new form for requesting waiver of the requirement to file Form 22A. Based on the certification of the debtor and counsel that debts are not primarily consumer, the court will issue a provisional order excusing the form. If no party objects to the order within 90 days, it will become final and compliance will be excused. According to an email from the Southern District, Judges Bohm, Isgur, Schmidt and Steen plan to use the form.

It is good to see judges who care about making the system work. This is a case where Congress drafted an extensive statutory scheme but failed to address an important detail as to its practical application. There may have been a simpler answer however. Form 1, the Voluntary Petition, requires debtors to indicate whether their debts are primarily business or consumer. The form is signed by the debtor under penalty of perjury and is also signed by counsel. As a result, it contains basically the same information as the new form. When a debtor checks the business box it should presumptively excuse the debtor from filing Form B22A unless a party objects. Of course, there is no rule which says this. As a result, there is no time frame for objecting. Therefore, checking the petition box does not eliminate the 45 day dismissal problem. This distinction may be the factor which commends the new Southern District procedure.

Note: All of this discussion pertains to chapter 7 debtors only. While the means test obviously does not apply to chapter 11 or chapter 13 debtors, they are still required to complete an Official Form of income and expense which can be used to determine amounts payable under a plan. Fed.R.Bankr. Pro. 1007(b)(5)requires chapter 11 debtors to file the appropriate Official Form setting forth their current monthly income. Rule 1007(b)(6) requires chapter 13 debtors to file the Official Form reflecting their monthly income, and if their income exceeds the median, they must also file a calculation of disposable income as set out in Sec. 1325(b)(3).

Wednesday, January 10, 2007

Judge Rejects Defense of The Computer Made Me Do It

A volume creditors' practice is facing sanctions after the court rejected its explanation that faulty computer coding caused it to file erroneous pleadings. The opinion illustrates the tension between the requirements of Rule 9011 and the need to rely on automation in a volume practice. While the final sanctions to be awarded have not yet been decided, the court in this case was clearly exasperated.

The Plan and the Original Objection

A debtor filed chapter 13 and included a debt with respect to a property he was leasing to his brother. The debtor's schedules plainly stated that the property was NOT the debtor's principal residence. The debtor's counsel also claimed to have informed the lender's counsel of this fact prior to bankruptcy.

The debtor proposed a plan which sought to pay the lender the value of its collateral plus interest through the plan. The payments to be made to the lender under the plan exceeded the amount of the rents being received by the debtor. The creditor filed a proof of claim in which it adopted the debtor's valuation of the property.

The lender's attorney filed an objection to confirmation which the court characterized as "grossly erroneous, and to anyone familiar with bankruptcy law, the objection is clearly legal nonsense." Among other things, the objection claimed that:

* The debtor's attorney, rather than the debtor had executed the note;
* That the plan did not pay the arrearages in full (despite the fact that the plan proposed a cram-down rather than a cure of arrearages);
* That the plan impermissibly modified a loan on a principal residence;
* That the lender's administrative claim was deferred over 36 months (despite the fact that the lender did not have an administrative claim); and
* That the plan impermissibly proposed to pay interest on the lender's non-dischargeable unsecured claim (despite the fact that the lender did not have a non-dischargeable claim).

The Debtor responded and pointed out the errors in the objection.

The First Hearing

At the first hearing on confirmation on October 3, local counsel for the lender argued that the plan impermissibly modified a loan on a principal residence. When the debtor responded that the property was not the debtor's principal residence, "local counsel replied that he had been instructed by (the lender's counsel) to ask for a continuance if Debtor made that contention."

This choice of tactics was not good. As the court later found, the objection relating to the principal residence violated Rule 9011 because the lender had no evidence that the debtor's statements were wrong. However, it got worse.

"As clear as that violation as, it is even more egregious that Countrywide continued to advocate that position in open court on October 3, notwithstanding Debtor's written response on September 28. Countrywide obviously had considered Debtor's response, knew that the argument had no validity, and was prepared to abandon the argument by asking for a continuance to implement 'Plan B,' which apparently had not yet been devised. . . . (T)he court believes that the request for a continuance was not made in good faith but was intended simply for delay."

Of course, the Court had not made these findings yet on October 3. However, the court did warn the lender's counsel that it should scrutinize its position in light of Rule 9011.

The Lender Withdraws Its Objection But "Discovers" A New One

After the hearing, Debtor's counsel sent the lender's counsel a letter demanding that the lender cure the violation of Rule 9011. In response, the lender filed a withdrawal of its objection. Unfortunately, this pleading violated Rule 9011 as well. The withdrawal stated that the lender was withdrawing its objection because the Debtor had filed an amended plan which proposed to cure the arrearage. Of course, this was just plain wrong. The Debtor had not filed an amended plan and was still seeking to cram-down the value on the rental property.

To further complicate matters, just four business days prior to the re-scheduled hearing, the lender filed a new objection which asserted that it just "discovered" that it held an absolute assignment of rents and that because the rents belonged to Countrywide, the Debtor could not use them in the plan. The absolute assignment of rents theory used to be a standard weapon used by lenders in single asset real estate cases during the 1980s and caused a lot of controversy at that time. However, the theory had major practical difficulties (such as how the rents could be conveyed to the lender without reducing the debt) and has not been seriously advocated for many years.

The First Opinion

At the continued hearing on November 14, lender's counsel abandoned all of its original objections and argued the absolute assignment of rents. Debtor's counsel objected that she had been sand-bagged. This was a legitimate complaint because the local rules required any objections to be filed five business days before confirmation. As a result, the court continued the hearing once again. However, at this point, the court's displeasure took written form. On November 28, the Court wrote the first of three written opinions in the case. Case No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 11/28/06)(Order for Memoranda and for Rule 7016 Conference And Order for Hearing on Sanctions Under Rule 9011). In this opinion, the court required the parties to brief the absolute assignment of rents issue and to advise the court as to the witnesses and exhibits they planned to introduce. The court also stated that it appeared that the lender's counsel had violated Rule 9011. The court required both local counsel and lender's primary counsel to attend the hearing.

The Second Opinion

After the pre-trial conference on the absolute assignment of rents issue, the court concluded that there were not any disputed issues of fact. The court wrote its second opinion which concluded that the assignment of rents was intended for purposes of security rather than as an absolute assignment. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 12/20/06)(Memorandum Opinion Findings of Fact and Conclusions of Law Concerning Order Denying Motion for Turnover & Accounting And Concerning Confirmation of Chapter 13 Plan). As a result, the court confirmed the plan. The court reserved the issue of sanctions for a subsequent opinion.

The Third Opinion

After all of this prologue, the court finally reached the issue of sanctions in a hearing on December 13. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 1/9/07)(Memorandum Opinion Regarding Sanction of Creditor's Attorneys). Prior to this hearing, the Court was aware of what had happened. The important factual issue was why it happened, and whether this would serve to mitigate or explain away the erroneous pleadings. The testimony received on December 13th provided a window into the internal workings of a volume practice.

The initial attorney who handled the file testified that she recognized that the property was not the debtor's homestead. Based on this determination, none of the pleadings raising homestead-related issues should have been filed. Despite this conclusion, a clerical person apparently coded the file as a homestead case. Under the law firm's computer system, certain codes are entered which are then used to generate pleadings. In this case, a clerical employee apparently entered the wrong codes which then generated the wrong pleadings. Thus, garbage in, garbage out. The Court concluded that no meaningful review was given to the computer generated pleadings.

"There was no testimony that anyone at (lender's counsel) reviews the computer-generated pleadings (with the level of care required by FRBP 9011) before they are filed. It was the Court's sense of the testimony that either there is no review, or else the review is so superficial that it is meaningless."

The firm's response to the Court's initial warning about sanctionable conduct was also dictated by the computer system. When local counsel contacted the initial lawyer about the Court's concerns, she testified that she "could not believe the document that was filed under [her] password." However, because the file was coded as a homestead case, the instruction to withdraw the objection generated a pleading geared to a homestead case. The frightening thing is that the computer generated a pleading which might have been appropriate in a particular type of homestead case. However, the pleading would not be appropriate in all circumstances. Thus, even without the erroneous coding, the pleading could well have been wrong.

The Inconclusive Result

The Court found that the lender's principal law firm should be sanctioned for its conduct in the case. However, the Court did not enter a sanction at this time. The Court noted with frustration that he had previously reprimanded the firm and had ordered it to address quality control issues. Two other judges in the Southern District had published opinions about the firm's conduct, including one case where the firm was required to pay $65,000. The Court noted that sanctions under Rule 9011(c)(2) should be sufficient to deter further repetition of the conduct. The Court went on to state:

"Although the Court has concluded that there is sanctionable conduct, after two warnings and a $65,000 monetary sanction, the Court is at a loss to determine the appropriate sanction in this case. If the prior warnings and sanction have not worked, what will?"

The Court ordered the managing attorney of the firm's Houston office to appear at a hearing to be held and to "report to the Court what sanctions would deter further repetitions of this conduct."

This Order places the firm in an unusual position. It is being asked to recommend its own punishment. If the firm suggests too light of a sanction, it may invite severe penalties for failure to appreciate the gravity of its actions. But what is sufficient?

While the Court may well consider monetary sanctions, and will likely award attorney's fees to debtor's counsel, the Court appears to be looking for more of a structural solution. The problem here appears to be a law firm subservient to its computer system. In an atmosphere where codes entered by clerical employees can generate nonsensical pleadings, it is difficult to comply with the responsibilities of a professional. In this case, even the attempt to withdraw an erroneous pleading generated another factually defective document. Perhaps Judge Steen, like another judge before him, will sanction the computer. However, it seems more likely that he will order the humans to take control of the computer. Failing that, he may require that all future pleadings be written with a quill pen and bear the cursive penmanship of the attorney submitting the pleading.

Post-script: Local counsel, who had the unenviable task of presenting the flawed pleadings to the court, escaped sanctions. Although Local Rule 11.2 required local counsel to be fully informed and prepared, the court noted that this rule had not been strictly enforced in the past. Based on the hope that local counsel had "a much greater appreciation of his responsibilities to the Court," the Court declined to assess sanctions against him.

Tuesday, January 09, 2007

Exemptions and the Mobile Debtor

Most states do not allow their residents to choose federal exemptions. However, a new opinion from Judge Leif Clark points out that BAPCPA may have expanded the reach of federal exemptions for a limited number of mobile debtors. In re Battle, No. 06-50545 (Bankr. W.D. Tex. 12/12/06).

Exemptions were a major concern for Congress when it passed the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA). Among other things, Congress was worried about wealthy debtors moving to states with generous exemptions, such as Texas and Florida, for the purpose of filing bankruptcy. One provision enacted to limit this practice imposed a residency requirement of 730 days before an individual could claim under a state's exemption laws. If the person had not resided in one state for the entire 730 day period, then exemptions would be determined under the law of the state where the debtor had resided for the greater portion of the 180 days prior to the 730 days. See 11 U.S.C. Sec. 522(b)(3)(A). If the effect of Sec. 522(b)(3)(A) is that no exemption law applies (for example, if the person resided out of the country during the relevant time period), then the person would be allowed to take federal exemptions under 11 U.S.C. Sec. 522(d). The application of Sec. 522(d) as exemption of last resort is of little solace, since it only applies in the case where no exemptions whatsoever would be allowed.

While the legislation may guard against abuse, it also operates as a trap for the unwary. Each year, about 3% of the population changes states. See Allison Stone Wellner, "The Mobility Myth," Reason Magazine (April 2006). If these individuals wind up in bankruptcy court, they may find their property rights defined by the laws of a state they had long left behind and which are unfamiliar to their counsel. This extraterratorial application of exemption laws may lead to strange results. For example, the Texas homestead exemption applies to "all homesteads in this state whenever created." Tex. Prop. Code Sec. 41.002(d). Thus, if a Texas resident moves to Florida (both states with high homestead exemptions), purchases a Florida homestead and files bankruptcy 729 days later, then the debtor would arguably not be able to claim a homestead exemption under either law. Sec. 522(b)(3)(A) would mandate application of Texas law. However, the Texas law appears to apply only to homesteads within the state of Texas. Thus, even though both states allowed comparable homestead exemptions, a move for a legitimate reason, such as to take a new job, may lead to loss of the exemption.

The federal exemption option under Sec. 522(d) offers limited protection to some debtors. It allows each debtor to exempt $18,450 of equity in a home and includes a wild card provision as well. One problem is that when Congress created the federal exemption scheme, it also allowed states to opt out. See 11 U.S.C. Sec. 522(b)(2). Thirty-six states prohibit their residents from claiming federal exemptions.

In the case of In re Battle, No. 06-50454 (Bankr. W.D. Tex. 12/12/06), Judge Clark considered whether a former Floridian filing bankruptcy in Texas could claim federal exemptions. Because the debtor had lived in Texas for less than 730 days and had lived in Florida during the 180 days prior to the 730 days, the parties agreed that Florida law would apply. Florida is an opt out state. As a result, the Trustee argued that federal exemptions were not available under Florida law. However, Judge Clark noted that the relevant Florida statute provided that "residents of this state shall not be entitled to the federal exemptions." On the date of filing bankruptcy, the Debtor was not a Florida resident. Although the choice of law was determined by where the Debtor resided during the 180 days prior to 730 days, the facts of the exemption were determined as of the petition date. Because the Debtor was not a resident of Florida on the petition date, the opt-out provision did not apply and the Debtor was able to use the federal exemptions.

This is a case of two restrictive statutes canceling each other out. Both Sec. 522(b)(3)(A) and Sec. 522(b)(2)'s opt-out language restrict debtors' exemption choices. However, it appears that an unintended consequence of Sec. 522(b)(3)(A) is to allow most debtors whose exemption choices are governed by the law of another state to choose federal exemptions regardless of whether they could have chosen federal exemptions in either the original state or the new state. Thus, if a debtor moves from one opt-out state to another opt-out state and files bankruptcy less than 730 days later, the result may be to make federal exemptions available where they would not otherwise have been. If State A's exemption laws prohibit its residents from choosing federal exemptions, but the debtor is no longer a resident of State A, State A's prohibition does not apply. If State B's exemption laws prohibit its residents from choosing federal exemptions, but exemptions are determined under State A's law, then State B's prohibition is inapplicable. Thus, the result is to frustrate the policies of both states and make the federal exemption available. This would be little consolation to a debtor with a million dollar homestead who moves between high exemption states. However, it was enough to protect the Debtor in Battle.