Understanding the New Bankruptcy Changes

The Bankruptcy Reform movement, which has been on the Congressional agenda for eight years, culminated on February 1, 2005, when Senator Grassley introduced S.256, the "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005," better known as the Bankruptcy Reform Act (the "Act"). Under the approximately 500 page Act, debtors will have greater difficulty filing for bankruptcy and eliminating, as opposed to, paying off their debts. The Senate voted to approve the bill on March 10, 2005, followed by House approval on April 14, 2005. President Bush signed the bill on April 20, 2005. Generally, the new changes to the Bankruptcy Code will be effective on October 17, 2005, and will not apply to cases commenced before that date.
 

Personal Bankruptcy

The changes to the Bankruptcy Code strengthen the position of creditors while making it more difficult for debtors to walk away from their debts. The most talked about changes to personal bankruptcies include a means test, limitations on the homestead exemption, and mandatory credit counseling.

MEANS TESTING

Under the means test, if the combined gross income of a debtor exceeds the median income in his state, then the trustee or the court may force conversion of a Chapter 7 bankruptcy, which allows debtors to eliminate their debts, to a Chapter 13 repayment plan or a Chapter 11 reorganization proceeding. Under Chapter 13, the debtor would have to commit disposable income for a period of 36-60 months to repay debts.

HOMESTEAD EXEMPTION

Congress also limited the availability of states' homestead exemptions to individual debtors, effective immediately upon the bill being signed into law. In order to claim a state's homestead exemption, a debtor must reside in the state for two years prior to filing bankruptcy. If he moved into the state during the two years prior to filing bankruptcy, then the exemptions from the state where he resided for the majority of the 180 days before the two year period applies. The most notable change to the homestead exemption is that it will be capped under certain circumstances. If the homestead is acquired within the 1,215 day period prior the bankruptcy filing, then the amount of the exemption is capped at $125,000 unless it was transferred from another homestead in the same state or the homestead is the primary residence of a family farmer. If the debtor has owned the homestead for longer than 1,215 days prior to the bankruptcy filing, then the debtor is, generally, entitled to the full state exemption. However, if the debtor has violated security laws or engaged in certain criminal conduct during the five years prior to filing bankruptcy, then the cap applies, or if the homestead was acquired through the fraudulent conversion of non-exempt assets during the 10-year period prior to the filing, the exemption is reduced by the amount of such fraudulently converted non-exempt assets used to acquire the homestead.

CREDIT COUNSELING

The Act also requires credit counseling before filing a Chapter 7, 11, or 13. The debtor must receive a certificate from an approved non-profit credit counseling agency that states he has been informed of the opportunities available through credit counseling and has performed an individual budget analysis with the court. The debtor must file the certificate and the repayment plan from the approved credit counseling agency. Further, to receive a discharge under Chapter 7 or 13 of the Bankruptcy Code, the debtor must complete a personal financial management course.

ADDITIONAL ADJUSTMENTS

Other changes impacting personal bankruptcies include:

• Chapter 7 debtors may be denied discharge if the debtor received either a Chapter 7 or 11 discharge in a case filed within eight years of the filing of the pending case.
• The calculation of permissible monthly expenses is based upon the National Standards and Local Standards, with "other necessary expenses" being dictated by the IRS in the area in which the debtor resides.
• The automatic stay terminates 30 days after commencement of a Chapter 7, 11, or 13 case if a previously dismissed case was pending within one year of the present case. Furthermore, the stay does not go into effect if two or more cases were pending within one year of the present case.
• Greater priority is given to child and spousal support.
• If the Statement of Intentions required under §521(a)(2) is not filed within 45 days of commencing a Chapter 7 or 13 case, the case is dismissed. If the debtor does not file and perform under the Statement of Intentions, then the automatic stay will terminate as to personal property that secures a claim.
• The plan must pay the full balance of purchase money loans incurred within one year prior to filing or, when the loan was used for the purchase of a vehicle, within three years prior to filing.
• A Chapter 13 plan must be a 5 year repayment plan if the debtor's income for the 6 months prior to filing bankruptcy is greater than the median income in the state.
• Bankruptcy does not affect the withholding of a debtor's pay for pension, profit-sharing, stock bonuses, 401K, etc.
• Debtors are required to provide additional documentation during the bankruptcy process.
• Additional exclusions from preferences have been added, including credit counseling payments and domestic support payments.
• The time to perfect security interests and purchase money security interests is lengthened.
• Transfers affecting less than $5,000 of property, when the debtor's debts are not primarily consumer debts, are excluded from preference avoidance. Furthermore, the language regarding the exclusion for payments in the ordinary course has changed to allow for more exclusions. (See the discussion below concerning business bankruptcies.)
• More items have been added to the list of property excluded from the bankruptcy estate and the exceptions to discharge are expanded.
• Additionally penalties and limits may apply to bankruptcy petition preparers, including attorneys for bankruptcy debtors.
   

Business Bankruptcy

In addition to the more talked about changes in personal bankruptcies, the Act also makes many key changes affecting commercial bankruptcy proceedings. These changes impact preferences, payments for retention bonuses and severance pay, and small business bankruptcies.

PREFERENCES

The Act liberalizes the rules for exceptions to a trustee's power to avoid preferences. Specifically, it broadens the ordinary course of business preference exception. Previously, the Bankruptcy Code required that in order to be entitled to the ordinary course defense, the defendant had to show that "the transfer was in payment of debt incurred by the debtor in the ordinary course of business or financial affairs," that the transfer was made in the ordinary course of business of the debtor and the transferee, and that it was made according to ordinary business terms. Under the amendments, after establishing that the transfer was in payment of a debt incurred in the ordinary course of business, the defendant need only to establish either that the payment was made in the ordinary course of business of the debtor, or that the payment was made according to ordinary business terms. Since only one of these two elements needs to be established (previously both were required), the ordinary course of business exception to preferential transfers may become a more effective defense. The Act also creates a new preference exception for aggregate transfers of less than $5,000.

RETENTION BONUSES

Another change added through an amendment in the Senate establishes limits on the payment or allowance of claims for retention bonuses or severance pay to key personnel of the debtor. Payments used to retain insiders as employees of the debtor are not allowed unless the payment is essential to keep a person who has a "bona fide job offer from another business at the same or greater compensation" and the payment does not exceed ten times the amount of a similar transfer to a non-management employee during the same year, or if no transfer has occurred, then not more than 25% of the amount of any similar transfer to an insider within the year before the case. Severance pay may not exceed ten times the amount of the mean severance pay provided to non-management employees, unless it is part of a program that applies to all employees.

ADDITIONAL AMENDMENTS

Other changes impacting business bankruptcies include:

• The court may dispense with the first meeting of creditors if the debtor has filed a plan and solicited acceptances prior to the commencement of the case.
• The Act recognizes the court's authority to order the trustee to adjust the number of members and the composition of the committees under Chapter 11, including a possible addition to the committee for a small business creditor when that creditor's claim, when compared to its annual gross revenue, is disproportionately large.
• The Act sets an absolute deadline for the exclusivity period (that period of time in which only the debtor may propose a plan) of 18 months. Bankruptcy Code §1121 still contains a 120 day exclusivity period which can be extended for cause shown; however, under the Act, the 120 exclusivity period cannot be extended beyond 18 months from the petition date.
• The rights of reclaiming sellers have been enhanced by requiring that if a valid reclamation demand is made within 45 days of a debtor's receipt of goods, the debtor must either pay for, or return the goods. The practice of substituting an administrative claim in lieu of payment or return is not allowed.
• Unless unexpired leases of nonresidential real property in which the debtor is a lessee have been assumed, they will now be deemed to be rejected and must be immediately surrendered to the lessor by the earlier of 120 days after the commencement of the case, or the date of confirmation of the plan. The court may extend the deadline for an additional 90 days. Any further extension requires the consent of the lessor.
• The look back period for fraudulent transfers has been extended from a 1 year to a 2 year look back period.
• Chapter 11 is amended by restating examples of causes for conversion or dismissal.

The Act also contains the following amendments dealing exclusively with small business bankruptcy:

• For small business bankruptcies, the court may determine that the plan contains sufficient information and, thereby, not require a disclosure statement.
• Trustees must conduct initial interviews with small business debtors prior to the meeting of creditors.
• The automatic stay may be limited in cases where a small business debtor has previously filed for bankruptcy.
• For Chapter 11 purposes, a "small business" is defined as a business with debts under $2,000,000. The period of exclusivity to file a reorganization plan in a small business case is 180 days. Further, a small business debtor has 300 days after its initial filing to file both a plan and a disclosure statement. Within 45 days of filing the plan in bankruptcy, the plan must be confirmed.
   

Conclusion

The Act contains many changes to the Bankruptcy Code that affect both consumers and businesses. Bankruptcy experts have both adamantly opposed and supported this legislation. At this time, the true effect of each change is unclear; however, Congress clearly acted to force more debtors to repay their debts and, thereby, strengthen the position of creditors.

     
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