The New Supreme Court: a Discussion of Recent Bankruptcy Decisions

The New Supreme Court: A Discussion of Recent Bankruptcy Decisions

Article contributed by: George Klidonas of Baker Hostetler LLP

With the advent of the Bankruptcy Abuse prevent bankruptcy abuse, Justice Sotomayor held Prevention and Consumer Protection Act of 2005 that such debt relief agencies cannot advise clients (“BAPCPA”), Congress intended to deter debtors to incur more debt in contemplation of bankruptcy.7 from abusing the bankruptcy system when they had Additionally, attorneys who advertise must state the actual ability to repay their creditors the that they are a “debt relief agency” and that they maximum that they could afford.1 Obeying the spirit “help people file for bankruptcy relief under the of congressional intent, the Supreme Court has Bankruptcy Code.” 8 added its own patina through various decisions this past year. Specifically, the Supreme Court has A case involving a Minnesota-based law firm, addressed debtors’ methodology in calculating their Milavetz, Gallop & Milavetz (“Milavetz”), illustrates projected disposable income and reasonably the point. Milavetz sought a declaratory judgment necessary expenses for the purpose of funding their that it was not bound by the provisions of BAPCPA plans2 and in scheduling their exempt property.3 because attorneys are not “debt relief agencies.”9 Recognizing that bankruptcy abuse may harm Milavetz also did not want to be bound by the debtors as well, the Supreme Court has placed statutory restrictions on advising debtors with more stringent requirements on consumer respect to debts incurred in contemplation of filing bankruptcy attorneys4 and has required creditors to for bankruptcy10 and attorney advertisements.11 pay more attention to non-dischargeable debt in The Supreme Court accepted the case to resolve a chapter 13 plans.5 The following will explore the conflict between the Fifth and the Eighth Circuits.12 effects of these rulings on debtors and creditors alike. As a preliminary matter, Justice Sotomayor concluded that attorneys who provide bankruptcy Regulation of Attorney Speech under BAPCPA assistance are debt relief agencies.13 A debt relief agency is defined as “any person who provides any In order to correct certain perceived abuses in the bankruptcy assistance to an assisted person.”14 The bankruptcy system, part of the reform term “bankruptcy assistance” includes several accomplished by BAPCPA included regulating the services provided by attorneys, including “legal conduct of debt relief agencies, defined as representation with respect to a case or professionals who provide bankruptcy assistance to proceeding.”15 Congress also delineated exceptions consumer debtors.6 Because attorneys who provide to the definition of “debt relief agency” and bankruptcy assistance to consumers constitute debt attorneys were not specifically listed.16 Finally, the relief agencies, in order to protect debtors and legislative record indicates that attorneys were ______

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Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy. meant to be included in the definition of “debt Maintaining the concept of finality in bankruptcy relief agency” to address misconduct by attorneys.17 court orders, Justice Thomas decided that non- dischargeable student loan debt can be discharged The next question before the Supreme Court was under a plan where a creditor fails to object. In whether attorneys, as debt relief agencies, could doing so, the Court concluded that a finding of advise clients to incur more debt immediately undue hardship was not necessary and that the before filing for bankruptcy.18 Rejecting the Eighth undue hardship requirement can be waived where a Circuit's view, Justice Sotomayor concluded that a creditor sleeps on its rights. debt relief agency violates 11 U.S.C. § 526(a)(4) only when the impetus of the advice is to incur more Francisco Espinosa ("Espinosa") was the recipient of debt in contemplation of bankruptcy.19 There must student loans who later filed for chapter 13 relief be a valid purpose to the advice.20 For example, and listed his student debt as his only specific attorneys may discuss with their debtor-clients the indebtedness.28 He proposed to pay only the consequences of incurring debt in contemplation of principal on the student loan debt and to discharge filing for bankruptcy.21 The Court’s conclusion is the interest.29 The clerk of the bankruptcy court consistent with Model Rule of Professional Conduct mailed a copy of Espinosa’s plan to the student loan 1.2(d), which states that a lawyer cannot counsel a creditor, United Student Aids Fund, Inc. (“United”). client to engage in conduct that the lawyer knows is The plan clearly stated underneath the caption: criminal or fraudulent and that a lawyer may, “WARNING IF YOU ARE A CREDITOR YOUR RIGHTS however, discuss the legal consequences of any MAY BE IMPAIRED BY THIS PLAN.”30 Even though proposed conduct.22 United filed a proof of claim at the beginning of the bankruptcy case, it did not object to the plan and Finally, the Supreme Court concluded that the the court subsequently confirmed the plan.31 advertising requirements under 11 U.S.C. § 528 are constitutional,23 holding that the government can Five years later, Espinosa completed the principal regulate commercial speech to “directly payments under his plan and received a discharge advance*e+” a substantial governmental interest for the unpaid interest from the bankruptcy court.32 and be “n*o+ more extensive than is necessary to Almost a decade after Espinosa filed the petition serve that interest.”24 Section 528 requires debt and years after he received a discharge, United relief agencies to state in their advertisements that attempted to collect on the unpaid interest.33 The their services relate to bankruptcy relief and that debtor then reopened the case and filed a motion they “are a debt relief agency” helping “people file with the bankruptcy court seeking to enforce the for bankruptcy relief.”25 Milavetz’s advertisements discharge. United cross-moved under Federal Rule were not found to be misleading. At the same time, of Civil Procedure 60(b)(4) to set aside the however, “*w+hen the possibility of deception is confirmation order as void.34 self-evident . . . we need not require the State to ‘conduct a survey of . . . the public before it *may+ The Supreme Court granted certiorari to determine determine that the [advertisement] had a tendency whether a confirmation order, which discharges to mislead.’”26 Because the congressional record student loan debt in the absence of undue hardship reflected a “pattern of advertisements that hold out or an adversary proceeding (or both), is a “void” the promise of debt relief without alerting judgment under Rule 60(b)(4).35 The Supreme Court customers to its potential cost,” the likelihood of held that such an order was not void, reasoning that deception was not speculative.27 Accordingly, § 528 a judgment will not be deemed void “simply was upheld as constitutional. because it is or may have been erroneous.”36 Instead, orders are considered void if the court Dischargeability of Student Loans lacked jurisdiction to enter the order or if there was a lack of due process that deprived the party of notice or the opportunity to be heard.37 In sum, the

© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 22 edition of the Bloomberg Law Reports—Bankruptcy. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. bankruptcy court did not lack jurisdiction to enter plans. In cases where a creditor has slept on its an order approving confirmation despite the rights and a debtor seeks to discharge non- discharge of the student loan debt. dischargeable debts such as student loans, domestic support obligations, and specified tax debts, courts The Court also examined Federal Rule of Bankruptcy may, in the future, place the burden on creditors to Procedure 7001(6) and the dischargeability object.45 provision of 11 U.S.C. § 523(a)(8), and held that those provisions are non-jurisdictional in nature.38 Calculating “Income” Portion of Disposable Income The student loan discharge provision merely requires a bankruptcy court to make a finding of Consideration of economic realities motivated the undue hardship as a precondition to discharge; it is Court to adopt a “forward looking approach” rather not a limitation on the court’s jurisdiction.39 than a “mechanical approach” to determining a Furthermore, the requirement under Bankruptcy debtor’s “projected disposable income” for chapter Rule 7001(6) that the undue hardship finding must 13 plan purposes. Debtors must use their post- be made in an adversary proceeding does not petition disposable income in chapter 13 to fund implicate the bankruptcy court’s jurisdiction.40 their plans. BAPCPA changed the definition of the Because § 523(a)(8) and Bankruptcy Rule 7001(6) term "disposable income" by modifying the do not implicate the court’s jurisdiction, the meaning of income and expenses.46 For income, the Supreme Court held that a debtor may obtain a definition of “current monthly income” was used, discharge of its student loans without commencing i.e., average monthly income from all sources an adversary proceeding or procuring from the during the six months prior to filing.47 In calculating bankruptcy court a finding of undue hardship, and a the debtor’s expenses, Congress imported the new student loan creditor may not collaterally attack categories of allowable expenses from the chapter 7 that order under Federal Rule of Civil Procedure means test, along with allowances for charitable 60(b)(4). The creditor’s right to collect on that debt contributions and business expenses.48 is essentially forfeitable. In Hamilton v. Lanning, the income of the debtor If Espinosa, however, failed to provide adequate ("Lanning") was inflated six months prior to filing notice to United, the result would have been because the debtor received a one-time buyout different. The Court explained that due process from her employer.49 As such, under the requires “notice ‘reasonably calculated, under all “mechanical approach,” the debtor's disposable the circumstances, to apprise interested parties of income was much higher than her actual post- the pendency of the action and afford them an petition income, requiring her monthly payments to opportunity to present their objections.’”41 A be $756 per month rather than $144.50 Lanning judgment will always be deemed void where there could not afford to make the higher plan payments is a due process violation or lack of adequate notice. based on an obsolete income level. Nonetheless, In this case, due process was not violated. Even the chapter 13 trustee objected to confirmation of though Espinosa failed to serve United with a the debtor’s plan, advocating for the “mechanical summons and complaint pursuant to a procedural approach.”51 The debtor, on the other hand, argued rule,42 United received actual notice of Espinosa’s for a “forward looking approach.”52 plan.43 A creditor is not allowed to raise a Rule 60(b)(4) argument after it has slept on its rights.44 Justice Alito rejected the “mechanical approach,” The failure to commence an adversary proceeding explaining that it could lead to unjust outcomes for did not deprive United of due process. debtors and creditors.53 Courts that use the mechanical approach simply multiply the debtor’s The ruling in Espinosa promotes finality in current monthly income by the number of months bankruptcy courts’ judgments and encourages of the plan, without taking into account whether creditors to pay closer attention to chapter 13 the debtor’s income will likely increase or decrease

© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 22 edition of the Bloomberg Law Reports—Bankruptcy. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. during the plan.54 In analyzing the term “projected Exempting Property of Debtor disposable income,” the Court focused on the term “projected.”55 While the Bankruptcy Code does not The Supreme Court recently decided that where a provide guidance regarding what precisely debtor states a dollar amount for exempt property, "projected" means, the term should be given its a trustee need not necessarily object to the ordinary meaning by taking into account both past exemption in order to preserve the estate’s right to and future events.56 Although courts interpreting retain any value in the property. Specifically, in the term pre-BAPCPA used a "mechanical Schwab v. Reilly, the debtor filed for chapter 7 relief approach," they had “discretion to account for after her catering business failed.63 The debtor known or virtually certain changes in the debtor’s exempted her catering equipment as “business income.”57 As the Court reasoned, if Congress equipment” with a market value of $10,718.64 The intended to abrogate such an approach, it would trustee did not timely object to the exemption. The have done so expressly in BAPCPA. chapter 7 trustee, however, later determined that the value of the catering equipment could be as The Court also focused on the unrealistic nature of high as $17,200 and that she intended to sell the the “mechanical approach.” In cases in which the equipment.65 When the trustee sought to sell the debtor’s disposable income is higher during the plan equipment, the debtor objected and argued that period, the "mechanical approach" would the trustee had failed to timely object.66 effectively deny creditors higher payments that debtors could easily make.58 In the alternative, The bankruptcy court, the district court, and the where a debtor’s disposable income is much lower Third Circuit all found in favor of the debtor.67 in the six months prior to filing, the “mechanical Justice Thomas, however, disagreed with the lower approach” would deny chapter 13 protection to courts. The Supreme Court concluded that a trustee debtors who meet the eligibility requirements.59 can infer that, regardless of the debtor’s valuation of the exempted property, the debtor is only Justice Scalia was the lone dissenter, arguing that claiming an interest of a specific dollar amount in the “forward looking approach” was not supported property rather than an in-kind exemption in the by statutory language and that the practical property.68 Where the debtor’s exemptions are justifications were unfounded.60 The statutory facially valid, the trustee need not object in an argument relied upon the definition of the term effort to avoid losing the property back to the “disposable income” under 11 U.S.C § 1325(b)(2), debtor.69 concluding that it required the use of the “mechanical approach” and is applicable to all of 11 By its decision, the Court sought to eliminate U.S.C. § 1322(b).61 Moreover, from a practical needless and time-consuming objections by standpoint, Justice Scalia explained that Congress trustees and to prevent debtors from removing had already granted flexibility on the expense side, from their bankruptcy estates more property than allowing courts to account for future changes.62 the statutory exemptions allow. As the Court explained, the decision would encourage debtors to The “forward looking approach” is more in tune “declare the value of *the+ claimed exemption in a with the primary purpose of BAPCPA and protects a manner that makes the scope of the exemption debtor whose income was unrealistically higher six clear.”70 For example, a debtor could list the value months prior to the filing. In this respect, the as “full fair market value” or “100 percent of fair “forward looking approach” addresses the market value,” in which case a trustee would have economic reality and financial hardship facing to object, or else the entire property would be debtors at the time that they file for bankruptcy exempt.71 This suggestion addressed the Court’s protection. Debtors benefit by having a confirmable concern that a lack of finality in the process could plan, and the creditors benefit by receiving the create uncertainty after the case had been filed by highest possible payments.

© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 22 edition of the Bloomberg Law Reports—Bankruptcy. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. enabling a trustee to sell property that a debtor had Here, the debtor owned his car free of any debt or intended to exempt.72 obligation. Accordingly, he was barred from claiming the allowance where he did not have any The opinion essentially advises debtors to use the corresponding expense.83 Justice Scalia dissented, language “full fair market value” or “100 percent of concluding that the fairest meaning of the plain fair market value” in order to assure that the entire language is that the applicable monthly expense value of the property will be exempt. Trustees and amounts for operating costs under the Local creditors are now forewarned of the “magic” Standards is the amount specified in those exemption language that, if used by debtors, should Standards, regardless of whether the debtor be an alert that an objection must be filed to actually incurs the expense.84 In keeping with the protect their rights. policies of BAPCPA, however, Justice Kagan explained that the rule set forth in Ransom v. FIA Calculating “Expenses” Portion of Disposable promotes maximum recovery by creditors.85 The Income majority’s decision was relatively straightforward: if a debtor does not have a car payment, the debtor In the most recent Supreme Court decision, Justice cannot deduct the amount of the allowance. Kagan decided whether a debtor may claim an allowance for car ownership costs where the debtor Policies Underlying BAPCPA owns a car but makes no actual loan or lease payments. In Justice Kagan’s maiden bankruptcy As discussed above, Congress enacted BAPCPA to opinion, the Court held that a debtor may not take prevent abuse in the bankruptcy system and to the car ownership deduction when there are no maximize prospects for repayment to creditors. actual loan or lease payments. At the time of his Over the past year, the Supreme Court has arguably petition filing, the debtor owned a 2004 Toyota fostered the policies underlying BAPCPA. For Camry with no debts or liens on the car.73 example, Justice Sotomayor required attorneys to Nonetheless, he claimed a $47174 “car ownership include certain language in advertisements and deduction” in calculating his “projected disposable refrain from encouraging clients to incur more debt income.”75 A creditor objected to the car ownership in contemplation of bankruptcy.86 Justice Thomas, deduction because there was no actual loan or on the other hand, put the burden on creditors to lease payment for the car.76 monitor debtors’ chapter 13 plans to avoid dischargeability of debts that may be non- A debtor must use disposable income to repay dischargeable.87 Justice Alito took a “forward creditors under a chapter 13 plan.77 As mentioned looking approach” to determining a debtor’s above in the Hamilton v. Lanning case, disposable projected disposable income where, arguably, a income is “currently monthly income” less mechanical approach would likely lead to a windfall expenses.78 Although Hamilton focused on the for debtors.88 Justice Thomas, in his second definition of “currently monthly income,” the bankruptcy opinion in one year, clarified the law on Ransom v. FIA case focuses on the definition of exemptions and thereby promoted the effective use “reasonably necessary” expenses.79 Specifically, the of objections to exemptions.89 The final bankruptcy Court focused on whether the car ownership cost opinion by the Supreme Court, authored by Justice was “applicable” to the debtor under 11 U.S.C. § Kagan, embraced the economic reality that debtors 707.80 A deduction under the National or Local cannot deduct an automobile expense where there Standard Internal Revenue Service table is is no lien or loan.90 In these collective decisions, the appropriate only if a debtor has corresponding Supreme Court has reinforced Congress’ intent costs.81 As such, if a debtor will not have a particular under BAPCPA and sent a message to detractors of cost during the plan, an allowance to cover that BAPCPA who claim that it went too far in imposing cost is not “reasonably necessary” within the unnecessary burdens on debtors and creditors alike. meaning of the statute.82

© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 22 edition of the Bloomberg Law Reports—Bankruptcy. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. George Klidonas is an associate at Baker Hostetler, 18 Id. at 1334. The more debt that a debtor incurs, LLP. His primary focus is corporate restructuring, the more likely that the debtor will qualify for a chapter 7 creditors’ rights, and bankruptcy. Mr. Klidonas also liquidation, which would allow a debtor to obtain a discharge of all dischargeable debt. received an LL.M. in Bankruptcy from St. John’s 19 University. He can be reached at Id. at 1339. 20 Id. at 1336. [email protected]. 21 Id. at 1337. 22 Id. at 1337-38 (citing ABA MODEL RULES OF PROF’L The views expressed herein are solely those of the CONDUCT R. 1.2(d) (2009)). author. 23 Id. at 1341. 24 Id. at 1340 (quoting Central Hudson Gas & Elec. Corp. v. Public Serv. Comm’n of N.Y., 447 U.S. 557, 566 1 H.R. Rep. No. 109-31(1), pt. 1, at 2 (2005), (1980)). 25 reprinted in 2005 U.S.C.C.A.N. 88, 89. §§ 528(a)(3)-(4). 26 2 Hamilton v. Lanning, 130 S.Ct. 2464 (2010); Milavetz v. U.S., 130 S.Ct. at 1340 (quoting Ransom v. FIA Card Servs., N.A., 131 S.Ct. 716 (2011). Zauderer v. Office of Disc. Counsel, 471 U.S. 626, 652-53 3 Schwab v. Reilly, 130 S.Ct. 2652 (2010). (1985)). 27 4 Milavetz, Gallop & Milavetz, P.A. v. United Id. at 1340. 28 States, 130 S.Ct. 1324 (2010). United Student Aid Funds, Inc. v. Espinosa, 130 5 United Student Aid Funds, Inc. v. Espinosa, 130 S.Ct. at 1373-74. 29 S.Ct. 1367 (2010). Id. at 1374. 30 6 11 U.S.C. §§ 101(3) and (12A). Id. 31 7 Milavetz v. U.S., 130 S.Ct. at 1336. Id. 32 8 Id. at 1341. Id. 33 9 Id. at 1331. Id. 34 10 11 U.S.C. § 526(a)(4) (stating that a debt relief Id. at 1374. 35 agency shall not “advise an assisted person . . . to incur Id. at 1376. 36 more debt in contemplation of such person filing a case Id. at 1377 (quoting Hoult v. Hoult, 57 F.3d 1, 6 under this title or to pay an attorney or bankruptcy (1st Cir. 1995)). 37 petition preparer fee or charge for services performed as Id. at 1377. 38 part of preparing for or representing a debtor in a case Id. at 1378-79. 39 under this title.”). Id. at 1379 (citing Arbaugh v. Y & H Corp., 546 11 11 U.S.C. §§ 528(a)(3)-(4) (requiring that debt U.S. 500, 515-516 (2006)). 40 relief agencies must “clearly and conspicuously disclose Id. at 1379 (citing Kontrick v. Ryan, 540 U.S. 443, in any advertisement of bankruptcy assistance services or 454 (2004)). 41 of the benefits of bankruptcy directed to the general Id. at 1378 (quoting Mullane v. Central Hanover public . . . that the services or benefits are with respect to Bank & Trust Co., 339 U.S. 306, 314 (1950)). 42 bankruptcy relief under this title” and that the Id. at 1378 (emphasis added). 43 advertisement must state, “*w+e are a debt relief agency. Id. 44 We help people file for bankruptcy relief under the Id. at 1380. 45 Bankruptcy Code.”). An argument can be made that a number of 12 Milavetz v. U.S., 130 S.Ct. at 1331 n.2. non-dischargeable provisions are jurisdictional in nature 13 Id. at 1333. and, as such, can never be discharged, even where a 14 Id. at 1332 (citing § 101(12A)). creditor sleeps on its rights. See George Klidonas, Are 15 Id. at 1332 (citing 11 U.S.C. § 101(4A)). Nondischargeability Provisions Jurisdictional? The Effect 16 Id. at 1332 (citing 11 U.S.C §§ 101(12A)(A)-(E)). of United Student Aid Funds v. Espinosa on 17 Id. at 1332 n.3. Justice Scalia’s concurrence Nondischargeable Debts, XXIX AM. BANKR. INST. J. 22, 70-71 focused on the fact that interpretation of legislative (June 2010). 46 intent is improper where the language is clear, and that Prior to BAPCPA, 11 U.S.C. § 1325 defined the the legislative intent does not necessarily reveal that term "disposable income" as “income which is received Congress was concerned with attorney misconduct. Id. at by the debtor and which is not reasonably necessary to 1341-43. be expended.” 11 U.S.C. §§ 1325(b)(2)(A)-(B). 47 11 U.S.C. § 101(10A)(A)(i).