The popular wisdom says that an individual or a married couple can file for bankruptcy under either chapter 7 to discharge debts without paying them, or chapter 13 to pay back some of the debts through a court-administered, multi-year, partial debt repayment plan, while a business files under chapter 7 if it is going out of business, or chapter 11 if it needs to reorganize. There is some truth to this wisdom, but it fails to take into consideration the personal chapter 11 bankruptcy. This post looks briefly at just a few characteristics of personal chapter 11 bankruptcy.
I. Qualifying for Chapter 7 Bankruptcy
While it is true that most personal bankruptcies are filed under chapter 7, not everyone who wants to do a chapter 7 is eligible. We determine chapter 7 eligibility by using a two-part test. If you pass the first part of the test, the analysis is over: you’re in. If you fail the first part of the test, passing the second part is crucial. In both parts of the test we start with a quantity called “current monthly income,” (CMI) and it’s not what you think it is unless you’ve already looked into it, or unless you think like Congress (which, if you do, then you probably need therapy and strong anti-psychotic drugs).
The slightly folksy and imprecise definition of CMI is: the six-month arithmetic average of gross household income from all sources (except social security), for the six full calendar months immediately preceding the month in which you file your bankruptcy case.
In the first part of the chapter 7 qualification test, we annualize CMI by multiplying by twelve to get the annualized CMI (ACMI), and we compare the ACMI to the median income for a family the size of yours in the State of California. If your ACMI is less than the relevant median income you’re in. Otherwise, we have to go to the second part of the test. By the way, the median income chart is updated approximately every eight months. I just gave you a link to the median income chart for cases filed after March 15, 2011. Depending on when you’re reading this, the chart might have been updated, so the numbers might not be accurate any more.
The second part of the chapter 7 test is a bit more complicated, so for purposes of this post I’m going to strip away the technicalities and get to the heart of the matter. The result will be a bit imprecise, but will give you the gist of the idea without getting bogged down in the minutiae.
We start with CMI, but we do not annualize it. Instead, we do some subtracting to calculate “disposable monthly income.” The big picture goal in the calculation is to answer the question: Suppose you didn’t have those pesky unsecured debts; how much money would you have left over each month to pay your creditors? If the answer is: “none,” you’re in the chapter 7 (provided there isn’t some other reason for chapter 7 ineligibility, such as a relatively recent previous bankruptcy). If you have money left over, then the Bankruptcy Court takes the position that you should use that excess money to pay your creditors something in a chapter 13 plan.
In sum, chapter 7 has income limits that are designed to exclude debtors if they have the resources to pay something to their creditors.
Another “by the way”: secured debts are those in which there is tangible collateral that can be repossessed in the event of default. Examples include car loans and home mortgages. Unsecured debts are debts where there is nothing that can be repossessed in the event of default.
II. The Chapter 13 Debt Ceilings
Unlike chapter 7, chapter 13 has no income ceiling. You can make as much money as you’re able to in chapter 13, though if your plan is less than 100% – i.e., you propose to pay less than 100% of your total general unsecured debt through the plan – then you’ll end up paying any excess into the chapter 13 plan.
However, chapter 13 has a sort of flip side of chapter 7’s income ceiling: debt ceilings. You cannot qualify for chapter 13 if you have too much debt, i.e., you exceed the chapter 13 debt ceilings. Once again, for purposes of this post I am going to strip away the technical language and give you the gist of the limits. If either your unsecured debts total more than $360,475, or your secured debts total more than $1,081,400, you are ineligible for chapter 13. As with the median income values, these amounts are subject to periodic change.
Some debtors in Southern California don’t qualify for chapter 13 because they have a lot of mortgage debt. Perhaps they bought several pieces of real estate during the boom years of the early 2000s, and have mortgages on each property. When you add the mortgages up the total is more than $1,081,400, so chapter 13 is unavailable. And if such a debtor has significant income – though not enough to be able to service all of the debt outside of bankruptcy – then chapter 7 is also out. In that situation what should the debtor do?
For those of you who answered, suicide, shame on you. Your sense of humor is obviously as bad as mine, and that’s pretty bad.
On the other hand, if you answered, chapter 11, then you must have read the title to this post. Yes, chapter 11 is an option.
III. Chapter 11
Chapter 11 is usually not recommended for individuals or married couples because it’s much more complicated than either chapter 7 or chapter 13, and as a result it is concomitantly more expensive. Here are four of the many reasons for its complexity.
A. Four Sources Of Chapter 11 Complexity
First of all, chapter 11 was originally designed for business reorganization. For example, when GM and Chrysler filed their bankruptcies, they did so under chapter 11. You would not expect bankruptcies as large as those to be simple. And since the documentation is basically the same in a personal chapter 11 – though admittedly not as voluminous – the personal chapter 11 is not simple.
Second, unlike chapter 13, in a chapter 11 the creditors get to vote on the plan. This can create special difficulties if large creditors refuse to vote in favor of the plan.
Third, there are many more hearings involved in chapter 11 than in either chapter 7 of 13. And there are a lot more documents that must be filed in a chapter 11.
Fourth, the chapter 11 debtor is required to file regular reports with the U.S. Trustee, and make regular administrative payments to the U.S. Trustee.
B. The Absolute Priority Rule
There is an important idiosyncrasy in chapter 11 that, depending on who the judge is, may create a problem for the individual debtor. To understand it, it helps to know something about the business chapter 11.
1. The Business Chapter 11 Absolute Priority Rule
In bankruptcy not all debts are treated equally. We’ve already noted that the law distinguishes linguistically between secured and unsecured debts. Secured debts are not treated the same as unsecured debts because the secured creditor has special rights attached to the collateral securing the debt.
Even among unsecured debts there are distinctions. Some are given priority over others, and the various priority classes are listed in 11 U.S.C. § 507(a). This distinction sets the stage for the so-called absolute priority rule for chapter 11 (there is no analogue in either chapter 7 or chapter 13).
If a class of similarly situated creditors do not vote in favor of the plan, then the Court will only confirm the plan if either:
b. No one with a claim or interest that is junior to the claims of the dissenting creditor will get or retain anything under the plan, pursuant to § 1129(b)(2)(B)(ii). This second provision is referred to as a “cram down.”
In simple terms, if a class of creditors is not getting paid in full, then any lower priority class gets nothing. This is somewhat analogous to the idea in real estate law, where after a foreclosure sale the first mortgage holder gets paid in full before the second gets a penny, the second gets paid in full before the third gets a penny, etc.
In practical terms this usually means that if there is a cram down, then the owners – i.e., the shareholders – of a company in chapter 11 will see their interest become worthless. For example, when GM went into chapter 11, the common GM stock was wiped out. The only way for an owner of the old stock to have an ownership interest in the new company in a cram down is to add new value to the reorganized company. Then the new ownership interest is equal to the new value added.
Keep in mind that if the dissenters all get paid in full, then there is no cram down, so the old equity holders may still retain some value in the reorganized company. However, because equity is at the bottom of the barrel on the priority scale, it is usually wiped out.
2. The Personal Chapter 11 Absolute Priority Rule
One hot topic in chapter 11 jurisprudence is the question of whether or not the absolute priority rule applies in a personal chapter 11. There is a lack of unanimity among bankruptcy judges on this question, so until the appellate courts – and ultimately the Supremes (and as I’ve said before, I must emphasize that Diana Ross is not a part of this group) – resolve the question, the application will depend on who the judge is.
Some judges take the position that when the Bankruptcy Code was amended in 2005 to include the new § 1115, it created an exception to the absolute priority rule in the individual chapter 11. This is because the aforementioned § 1129(b)(2)(B)(ii) provides (with emphasis added):
. . . the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115 . . .
When this is coupled with § 1115:
(a) In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541—
(1) all property of the kind specified in section 541 that the debtor acquires after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first; and
(2) earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first.
(b) Except as provided in section 1104 or a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate.
it appears to this blogger that there is no absolute priority rule in an individual chapter 11. This has been the conclusion of several bankruptcy courts. See, e.g., In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007).
On the other hand, a few bankruptcy courts have asserted that the absolute priority rule does apply in a personal chapter 11. See, e.g., In re Gbadebo, 431 B.R. 222 (Bankr. N.D. Cal. 2010). Since the 2005 Code amendment, courts that have seen an absolute priority rule in the individual chapter 11 have at least accepted that the debtor gets to keep any exempt assets. Even this is an improvement over the law prior to the enactment of BAPCPA, the 2005 amendment, where courts held that the individual chapter 11 debtor could keep nothing. See, e.g., In re Gosman, 282 BR 45 (Bankr. S.D. Fla. 2002).
Why do we care about the absolute priority rule in a personal chapter 11? The judge’s position will be crucial in determining what the debtor gets to keep in a crammed down chapter 11. If it looks like the debtor will lose most or all of his/her possessions, that debtor may decide not to use chapter 11 at all. Some relevant cases are up on appeal. Stay tuned.