Individuals in Chapter 11 and Fraud: That Hybrid has a Hemi!
by R. Lee Barrett
Forshey & Prostok, LLP; Fort Worth, Texas
The chronically problematic individual chapter 11 bankruptcy was the focus of a portion of the October 2005 bankruptcy reform package, more affectionately known as BAPCPA. Over time, some individuals have discovered inherent benefits to filing chapter 11 as opposed to either chapter 7 or chapter 13.1 Often, these individuals have assets that cannot be protected in a traditional chapter 7, and may not be conducive to reorganization under chapter 13. It is not uncommon for an individual in chapter 11 to be self-employed, to be a business owner, or a “consultant” or independent contractor for interests controlled by the debtor.
While chapter 11 does provide certain additional flexibility, as well as greatly increased expense, an argument can easily be made that the individual chapter 11 bankruptcy is also rife with opportunity to commit bankruptcy fraud. The individual chapter 11 case, especially in its post-BAPCPA form, is truly a “hybrid” form of bankruptcy relief, bridging the gap between consumer and commercial bankruptcy.2 It does not appear that any bankruptcy court has yet had the apparatus to publish an opinion exploring the impact or effectiveness of the BAPCPA amendments. It remains to be seen whether or not this “hybrid” is a supercharged vehicle for fraud in disguise, or if BAPCPA will serve as a speed bump for the occasional ne’er-do-well.
BAPCPA resulted in a handful of changes to the administration of an individual chapter 11 bankruptcy in an obvious attempt to close some of the potential avenues for debtor fraud. The first of these changes was the addition of 11 U.S.C. §1115, which further defines property of the estate for an individual in a chapter 11 bankruptcy. In addition to the property specified in §541 of the code, §1115 also captures §541 property that the “debtor acquires after the commencement of the case but before the case is closed, dismissed or converted.”3 Moreover, §1115 also captures the earnings from services performed by the debtor following commencement of the case.4 With regard to the contents of an individual chapter 11 debtor’s plan, BAPCPA added §1123(a)(8), requiring that creditors be paid under the plan “all or such portions of earnings from personal services performed by the debtor” necessary to fund the plan.5 This provision also attempts to commit “other future income” of the debtor to service plan obligations.6
Additionally, two provisions were added regarding confirmation of a plan for the individual chapter 11 debtor. The first of these requires that, in the face of an objecting holder of an allowed unsecured claim, the value of property to be distributed in satisfaction of that claim must not be less than the amount of the claim itself; or the total value of the property ultimately distributed under the plan is not less than the projected disposable income of the debtor in the five-year period following confirmation.7 For these purposes, §1129 specifically adopts the definition of disposable income applied to chapter 13 debtors, found in §1325(b)(2).8 The second confirmation-specific amendment clarifies, by restricting, the absolute priority rule in the case of an individual chapter 11 debtor, at least to the extent that property is not otherwise subject to satisfaction of a domestic support obligation under §1129(a)(14).9
The final amendment of note delays the individual chapter 11 debtor’s discharge until completion of all payments under the plan.10 In the event the debtor has not completed payment under the plan, the discharge is still available if the value of the property actually distributed through the plan provides allowed unsecured claimants no less than the amount they would have received in liquidation.11 This also presupposes that it is not practicable to modify the plan under §1127.12
Beyond the issues inevitably to arise due to the further hybridization of the individual chapter 11, the amendments represent a logical attempt at creating more accountability for individual debtors. The fundamental weakness in these particular amendments, however, begins with §1115, a weakness that grows in proportion throughout the administration of the case.13
Section 1115 is vulnerable on two separate levels, but with similar outcomes. At the outset, the bankruptcy system has long relied on the honest and voluntary disclosure by debtors. As a practical matter, this may be especially true with the traditional consumer debtor given the absence of a creditors’ committee having both the background and self-interest to hold the debtor’s feet to the proverbial fire. Far more problematic, and seemingly unaddressed by BAPCPA, are those individual debtors who have engaged in sufficient pre-petition planning such that the post-petition sources of monthly cash flow continue to be diverted away from the debtor, and therefore away from the estate, often leaving creditors with nothing more than speculative or contingent sources of repayment.
Consider the following hypothetical.14 Pre-petition, the debtor is engaged in an altercation with a repo agent resulting in the repo agent being injured when he is thrown from his own motorcycle. Fearing litigation, the debtor transfers shares of stock in an otherwise defunct company to friends and family members, and at the same time gives as a “gift” certain equipment and contracts necessary to continue the business, which is the primary source of the debtor’s income. The debtor, in consideration for the transfer, enters into a consulting agreement whereby the debtor continues to provide the same labor and services, except now the debtor’s services are not being compensated. Meanwhile, the cash flow generated by the company is going to the insiders rather than creditors of the estate. The debtor produces few financial records, all of which he claims are stored in the office of his recently deceased CPA, thereby depriving him of the requisite control for purposes of production. The debtor does produce copies of bank records for a two-year old checking account, which has never had more than $200 in or out of the account in any given month.
As a threshold consideration, §541 and §1115 may encompass much more property than the debtor discloses to his attorney.15 Short of an aggressive creditor with a large enough war chest, the existence of substantial assets and property may never be captured for the benefit of creditors. From a systemic approach, nothing in §1115 alters the reliance of the bankruptcy system on the candor and transparency of those debtors seeking relief under the Code. At best, §§1115 and 1129(a)(15) can be said to represent a good start at providing additional fuel to get the estate firing on all eight cylinders.
However, with adequate care and attention, the well-intentioned amendments may be subject to subtle but significant manipulation. Numerous opportunities exist for a debtor to structure his affairs such that his lifestyle is unchanged, while receiving little, if any, “earnings from services performed” subject to either §1115(a)(2) or 1129(a)(15). One or more of the suspect entities may pay the debtor’s spouse, who is gainfully employed in an unrelated endeavor, for nebulous or nonexistent services. Given the proper assets, the debtor may also receive a stream of income from “exempt” assets that arguably are not property of the estate.
In order to provide creditors additional traction in making either provision meaningful, counsel needs to closely examine the source, type and necessity of expenditures related to the operation of the debtor’s “business”.16 If the debtor has structured his business affairs such that his projected post-petition income is largely consumed by servicing “select” business expenditures, creditors need to identify for the court the structure being used to undermine the intentions of the Bankruptcy Code.17
More importantly, creditor’s counsel needs to ensure that the debtor does not attempt to base projections of disposable income solely on §1325(b)(2). If the debtor is successful in limiting his projections solely on this formula, creditors will face an unnecessary battle in increasing the return on their claim. One need only look to §1325(b)(3) to further reduce the likelihood that the debtor can continue to conduct business as usual at the expense of the creditors.18 In addition, creditors’ counsel needs to be quicker off the line than the debtor by arguing that §1123(a)(7) requires the debtor to commit to the plan all income, regardless of nature, origin or claim of exemption.19
If applied properly, BAPCPA may indeed close several avenues of potential debtor fraud in relation to individual chapter 11 cases. In doing so, creditors’ counsel must negotiate the sometimes counter-intuitive results from this hybrid bankruptcy. Successfully doing so, however, may keep a crooked debtor from speeding off into the night with the creditors’ money.
1 Given that these cases often involve guaranties of commercial debt, which greatly exceed the debt limits in §109(e), these particular individuals often are ineligible for chapter 13 in any event.
2 An excellent examination of core constitutional issues regarding individual chapter 11’s and post-petition earnings can be found in a recent ABI Law Review article by Robert J. Keach. See Keach, Robert J., Dead Man Filing Redux: Is the New Individual Chapter Eleven Unconstitutional?, 13 Am. Bankr. Inst. L. Rev. 483 (2005).
3 §1115(a)(1). §541(a)(6) specifically excludes post-petition “earnings from services performed by an individual debtor after the commencement of the case.”
4 §1115(a)(2).
5 §1123(a)(8).
6 Id.
7 §1129(a)(15).
8 §1129(a)(15)(B).
9 §1129(b)(2)(B)(ii).
10 §1141(d)(5)(A).
11 §1141(d)(5)(B)(i).
12 §1141(d)(5)(B)(ii).
13 Notably, §1115(a)(2) refers not to disposable income but rather to earnings from services rendered. Unlike §1129, §1115 does not specifically adopt any other provision’s relevant definition, and earnings from services rendered is not defined in §101.
14 While this hypothetical is based on a cross section of numerous actual cases, this hypothetical is not intended to identify any individual chapter 11 debtor.
15 Although relevant, the duties of debtor’s counsel in this situation are beyond the scope of this article.
16 See §1325(b)(2)(B).
17 Given that the “election” to proceed as a small business is no longer an election under §101(51C) and (51D) in many cases, the truly cash-strapped creditor ought to ensure that the U.S. Trustee is treating the case as a small business case. The U.S. Trustee may be able to force greater disclosure from the debtor through §1116.
18 Section 1129(a)(15) specifically adopts only the definition of disposable income provided in §1325(b)(2). On its face, though, §1325(b)(3) indicates that those amounts “reasonably necessary” to be expended for purposes of §1325(b)(2) might be determined in accordance with §707(b)(2)(A) and (B) depending on the debtor’s household income.
19 If timely raised as an objection to the proposed plan, creditors should have a much better chance of convincing a bankruptcy judge that the more expansive requirement under §1123 trumps §1129, which can be far more favorable to a clever debtor.