United States: Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

Introduction

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (sometimes referred to as the "Amendments") which is perhaps the most sweeping change to the Bankruptcy Code (the "Code") since the Amendments of 1994. While the legislation modifies the Code in many ways, most notable are the changes to provisions related to individual consumer bankruptcies.

The new statute makes it much more difficult for individuals to utilize chapter 7 of the Code in order to eliminate many of their debts. Under chapter 7 of the Code, the debtor gives up most of his or her assets (other than those which are exempt) to repay his/her creditors. Secured creditors are paid first and thereafter unsecured creditors are paid in the order of their claim’s priority as designated by the Code. Generally, the debtor then receives a discharge and essentially can start anew without any lingering debts (other than certain debts which are non-dischargeable). Under the Amendments, many individuals that would ordinarily seek to wipe away their debts under chapter 7 will no longer qualify for the protections of chapter 7, and will have to pay back a large part of their obligations over a period of time under chapter 13. Under chapter 13 of the Code a debtor formulates a plan of repayments pursuant to which secured debt and a portion of unsecured debt is repaid over a period of five years (but in some instances three years). Remaining debts are then discharged and the individual receives a "fresh start".

The Amendments also seek to frustrate "serial filings" by individuals by limiting the number of times that bankruptcy relief may be invoked within a specified period and by limiting the applicability of the "automatic stay" should several filings occur by the same debtor(s) within a prescribed time period. The legislation contains noteworthy changes to provisions pertaining to treatment of secured claims in individual bankruptcies, treatment of tax liabilities in individual bankruptcies, exemptions, executory contracts and unexpired leases, treatment of financial contracts such as derivatives, swap and hedge agreements, and duties of attorneys and other professionals who assist persons seeking bankruptcy protection.

In addition to the changes to the Code, the Amendments include certain changes to the federal Truth in Lending Act ("TILA") which are summarized below. These changes will require additional disclosures to be made by lenders to consumers in connection with consumer credit, including mortgage loans and home equity lines of credit.

Set forth below is a summary of some of the changes brought about by the new legislation. For additional details, a separate notice will be emailed to you in a few days providing information on a Reed Smith teleseminar scheduled for noon (EST) on Wednesday, May 4, 2005. The forum will allow for a question and answer session. If you should have any questions, please contact kbarauskas@reedsmith.com. A complete description of the changes to the Code brought about by the Amendments, please visit the website of the American Bankruptcy Institute at http://www.abiworld.org.

Generally, the Amendments to the Code become effective as to new cases filed 180 days or more from the Enactment Date (April 20, 2005). There are numerous exceptions to this general rule. Most of the changes do not affect pending cases; but some do.

The Amendments preclude many individuals from seeking the protection of chapter 7 of the Code. Prior to the effective date of the Amendments, any individual, regardless of his or her ability to repay creditors and current income level, can utilize chapter 7 where assets (other than those that are exempt) are liquidated to pay creditors in the order of priority set forth in the Code. Typically, however, unsecured creditors of chapter 7 debtors receive little, if any, payment on account of their claims and their claims are essentially wiped away.

Under the Amendments, fewer individuals will qualify to file under chapter 7 due to the size of their income. Chapter 7 debtors will have their income compared with their domicile state’s median income for a family of the same or smaller size. If the debtors’ income falls below the median, they will generally be able to utilize chapter 7 of the Code. If their income exceeds the median, there will be a presumption that the filing was made in bad faith. The presumption will need to be overcome by the debtor(s) in order to prevent a dismissal of the chapter 7 case or a conversion of that case to a chapter 13 case. It is anticipated that these changes will dramatically reduce the number of chapter 7 cases and increase filings under chapter 13. It is also anticipated that many creditors, such as those holding claims related to credit card obligations, who were previously paid little, if anything, under chapter 7, will now be included in the debtor’s repayment plan and will likely recoup a larger portion of their claims pursuant to a chapter 13 plan.

The Amendments employ a "means test" to determine whether an individual qualifies to file a case under chapter 7 of the Code and to determine whether, once filed, a chapter 7 case is subject to dismissal or conversion based upon abuse of the bankruptcy system. Means testing will be employed to determine whether an individual debtor’s average "current monthly income"¹ is more or less than the median income (of a family which is the same size or smaller) in the state where the debtor resides. If, after computing current monthly income, and deducting therefrom certain allowed living expenses, including secured debt payments and priority unsecured debts, and multiplying that amount by 60, the product of that multiplication exceeds the lesser of (i) $10,000 or (ii) the greater of 25% of the debtor’s unsecured nonpriority claims or $6,000, then the debtor is presumed to be abusing the bankruptcy process by filing a chapter 7 case. This presumption, unless successfully rebutted, may lead to the dismissal of the case or its conversion to a case under chapter 13.²

Examples of the types and amounts of expenses that can be deducted from an individual’s gross monthly income to derive the individual’s "current monthly income" are mortgage payments, utility payments, payments on account of secured debt which are necessary for the support of the debtor and his or her dependants (including car payments), payments for food and clothing, school, support and alimony, health insurance, disability insurance, expenses paid for the care of an elderly, chronically ill or a disabled member of the household and other types of expenses. All expenses of a type and nature which are not enumerated in the statute must be itemized and documented and deemed necessary and reasonable. Limits on the applicable amounts of certain expenses are contained in the National and Local Standards and actual Other Necessary Expenses as provided in the Collection Financial Standards issued by the Internal Revenue Service.

• Prior to the Amendments, lien stripping permitted a debtor to reduce a claim which is secured by personal property to the value of that property on the petition date. Since most personal property (including automobiles) is often worth less than the debt which it secures, the debtor was able to pay less for the item of collateral than the amount owed under the contract, while retaining the item. Amendments now disallow "lien stripping" with respect to a purchase money security interest if the collateral is a motor vehicle (if the debt was incurred within 910 days of the petition date) and other personal property acquired within one year of the petition date.

• Prepetition arrearage on account of mortgage and auto loans can be cured over 60 months.

• A secured claimant holding a lien on a debtor’s residence retains the lien until the balance of the debt is repaid. The periodic payments must be monthly, and the payment amounts may not be reduced below an amount needed to provide the creditor with adequate protection.

• Debtor’s failure to file tax returns or pay domestic support payment is grounds for dismissal of case. A plan will not be confirmed unless debtor is current in filing of tax returns and payment of support obligations.

• Chapter 13 plan length is either three years or five years depending on size of the family’s current monthly income (at time plan is filed) multiplied by 12 compared with median annual income of similar size family in state where debtor’s family is domiciled. If the income is less than state median, the plan length is three years, and if the income is greater than the state median, the plan length is five years.

• A chapter 13 plan cannot alter loan terms when loans are made by pension plans

• If the trustee or an unsecured creditor objects to a chapter 13 plan, all disposable income over plan period must be applied to repay unsecured debt

• Within 30 days of the earlier of the petition date or the filing of a plan, debtor must commence making plan payments, post-petition lease payments and adequate protection payments to holders of purchase money security interests

• Within 60 days of the petition date, debtor must provide lessors and holders of secured claims (secured by personalty) with proof of insurance

• Discharge is disallowed if debtor has received a discharge in case filed under chapter 7, 11 or 12 within four year period preceding filing of petition.

• A discharge is also disallowed if the debtor has received a discharge from a chapter 13 case filed within two years preceding the filing of the petition. Debtor must complete a course in personal financial management to obtain discharge

• Discharge is delayed if action pending in which debtor may be found guilty of felony or liable for debt arising from violation of securities laws or an intentional tort or willful or reckless misconduct causing serious bodily injury or death to another individual. This provision affects all individual debtors.

The Amendments require that within 180 days prior to filing a bankruptcy case, the prospective debtor is to receive credit counseling from an accredited nonprofit credit counseling agency. This requirement will be waived only in limited circumstances. Credit counseling agencies must be pre-approved by the U.S. Trustee’s office. Counseling must include assisting the client in a plan to repay creditors over time, an analysis of client’s current financial condition, factors that caused condition and how to develop a plan to respond to condition without negatively amortizing debt. If the debtor can show that a creditor unreasonably refused to negotiate a repayment schedule with a credit counseling agency, unsecured consumer claims can be reduced by the court up to 20% of such claims. The debtor is required to file with the court a certificate from the credit counseling agency that provided services certifying that services were provided.

• A debtor may now make the following additional exemptions:

• Most retirement funds irrespective of whether state or federal exemptions are elected

• Up to $1 million in an IRA or SEP and

• Not more than $125,000 of equity in homestead under state homestead exemption for home acquired within 1215 days of petition date

• New disclosures required of creditor whose debt is to be reaffirmed

• New requirements governing content of reaffirmation agreements

• Requirement that an attorney certify lack of hardship resulting from reaffirmation

• Broad definition includes any person who provides bankruptcy assistance to an assisted person (individual whose nonexempt property is valued at less than $150,000) for compensation and includes, among others, a creditor who assisted person in the restructuring of a debt owed to creditor

• Debt relief agencies must make certain disclosures and must comply with additional requirements or risk having fines and other sanctions imposed against them

• Debt relief agencies must advertise themselves as such. These are not the same as nonprofit credit counseling agencies.

Debtors are now required to surrender, reaffirm or redeem debt secured by property of the estate within 30 days following first date set for meeting of creditors. In a chapter 7 case, if the debtor fails to reaffirm secured debt or redeem property subject to secured debt within 45 days after the first meeting of creditors, then such property is no longer property of the estate and the automatic stay no longer applies with respect to such property.

A debtor’s failure to file information required under Section 521(a) of Code on or prior to the 45th day following the petition date results in automatic dismissal of the case unless within 45 days the court extends the deadline or upon motion of trustee, court declines to dismiss.

Attorneys representing individual debtors are required to make reasonable inquiry to verify that the information contained in the petition, pleadings or motions (including schedules) are grounded in fact. Signature of the attorney on the petition or pleading constitutes a certification that the attorney has performed reasonable investigation as to circumstances giving rise to petition or pleading, and has no knowledge after a reasonable inquiry, that the information set forth therein is incorrect. If information is found to be inaccurate, the attorney may be subject to various fees and fines.

• A debtor may seek relief under chapter 7 (assuming the debtor meets all other qualifications) only once every eight years

• A debtor may seek relief under chapter 13 only once every two years

  New Consumer Credit Disclosures

The Amendments include a number of changes to the federal Truth in Lending Act (the "TILA Amendments"). While credit cards were a primary focus of many of the TILA Amendments, the TILA Amendments will require new disclosures to be given in connection with home equity lines of credit and other revolving credit not associated with a credit card and in connection with certain mortgage loans.

The TILA Amendments include two new disclosures for monthly billing statements. First, billing statements will need to include a new "minimum payment warning" which informs the consumer that making the minimum payment will increase the interest the consumer pays and the time to repay the balance. The warning must also include a prescribed minimum payment example and direct the consumer to call a toll-free number for an estimate of the time it would take the consumer to repay the balance when making only the minimum payments. A consumer who calls the toll-free number will receive standardized information based on a table to be established by the Federal Reserve Board ("FRB") containing examples of minimum payments for different account balances at different annual percentage rates. These requirements are modified for creditors that maintain a toll-free number which provides consumers with the actual number of months to repay the consumer’s outstanding balance. Second, if late payment can result in imposition of a late fee, billing statements must include the payment due date or, if different, the earliest date on which a late fee may be charged and the amount of any late fee that would be imposed if payment is made after such date.

Also included in the TILA Amendments are new disclosures advising the consumer of the nondeductibility for federal income tax purposes of interest on the portion of a mortgage loan or home equity line of credit that exceeds the property’s fair market value. For home equity lines of credit, this disclosure must be included with the disclosures already required to be given at application. For mortgage loans, the TILA Amendments will require a new disclosure to be given at application. For both types of credit products, the new nondeductibility disclosure must be included in certain advertisements for programs where the credit extended can exceed the property’s fair market value.

The TILA Amendments impose new disclosure requirements in connection with credit card applications and solicitations offering reduced introductory rates and for internet solicitations. The TILA Amendments also include a new provision that prohibits creditors from terminating an open-end account prior to its expiration date because a consumer has not incurred finance charges. This provision would not prohibit a creditor from terminating an account due to inactivity for three or more consecutive months.

The TILA Amendments direct the FRB to promulgate regulations to implement all of the above provisions and provides that none of these provisions will be effective earlier than 12 months after the FRB publishes final regulations.

• Most tax liens are not avoidable

• Warehousemen’s liens are not avoidable

• Preferences: (1) The Amendments clarify the ordinary course defense. Now a creditor sued for a preference can raise the defense that the alleged preferential transfers was made in ordinary course of its dealings with debtor or made according to business terms customary in industry. Previously a defendant had to prove both. (2) No preference liability if amounts are de minimis-under $5,000. (3) If a lien is perfected within 30 days of giving value (rather than 10 days under current statute) then transfer is perfected and is not subject to avoidance as a preference. (4) No avoidance of payment made pursuant to an alternate repayment plan approved by credit counseling agency. (5) No longer any risk to creditor who is not an insider of debtor with respect to prepetition transfers made which benefit both creditor and insider and are made between 90 days and one year prior to petition date.

• Look back period for fraudulent transfers extended from one to two years (effective one year after Amendments are enacted)

• Transfers to self-settled asset protection trusts are avoidable if transfer made within ten years of the petition date, if the debtor is a beneficiary under trust and the transfer was made with actual intent to hinder, delay or defraud creditors, which includes a transfer made in anticipation of a money judgment, settlement, fine, penalty, etc.

• Debtor’s exclusive right to file plan may not be extended to a period beyond 18 months after petition date

• Creditors Committee Membership: Court may order U.S. Trustee to change membership of creditors committee upon request of party in interest and to insure adequate representation of creditors or equity security holders

• Committee must provide access to information to creditors who hold claims of the type represented by the Committee and who are not already members thereof

• Committee must solicit and receive comments from creditors who are not members of the Committee whom the Committee represents

• Timing Issues: 120 day Exclusive Period for filing plan of reorganization/ liquidation may not be extended by more than 18 months and 180 day exclusive period for seeking plan acceptances may not be extended beyond 20 months

• If valid written reclamation demand is made by reclaiming creditor within 45 days after debtor receives goods, appears that debtor must pay for or return goods and that the substitution of a lien or administrative expense claim in lieu of payment is no longer sufficient. Further, if the 45 days extends beyond the petition date, then the deadline for the receipt of the notice by the debtor is 20 days following the petition date. If the reclaiming creditor fails to give timely notice to the debtor, it retains an administrative expense claim so long as the goods were received by the debtor within 20 days prior to the petition date.

• Tax claims (which are either secured or priority in nature) must be paid within five years of petition date and in a manner not less favorable than most favored unsecured creditor claims

• Disclosure statement must include analysis of tax consequences of plan

• Expanded grounds for dismissal/conversion of case or appointment of trustee or examiner include: gross mismanagement of estate, failure to maintain appropriate insurance, unauthorized use of cash collateral; failure to comply with court order; failure to comply with reporting requirement, failure to attend creditors meeting or Rule 2004 examination or as requested by U.S. Trustee; failure to timely pay postpetition taxes or file return; failure to pay domestic support obligation. U.S. Trustee to move for the appointment of a chapter 11 trustee if there are reasonable grounds to suspect that debtor’s current board members, CEO or CFO participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or the debtor’s public financial reporting.

• Retiree Benefits: In the event a retiree committee is appointed, the appointment of its members is to be made by U.S. Trustee, not court. Also, court may reinstate retiree benefits that are modified by debtor within 180 days prior to petition date unless the court finds that the equities support the modification.

• New limitations on amounts that can be paid to insiders for purpose of "inducing insider to remain with debtor’s business." Insider needs to have competing offer from another business at higher salary in order to justify payment of payments and amount of payments are limited. Amendments also impose limitations on level of severance that can be paid to insiders.

• Discharge of individual chapter 11 debtor does not occur until plan payments are completed except in hardship cases. Discharge delayed if individual chapter 11 debtor is subject of a pending felony action or is liable for debt arising under violation of securities laws or is liable for willful or reckless misconduct causing serious physical injury or death to individual.

• Amendments contain various specific provisions targeted at health care businesses, which is defined as a private or public entity offering the general public services and facilities for the diagnosis and treatment of injury, deformity or disease, surgical, drug treatment, psychiatric or obstetric care. Amendments deal with privacy concerns and protections of patients in the event of closure of such health care facility.

• Amendments contain various changes to chapter 11 rules governing small business debtors which are defined as businesses with noncontingent, liquidated debts, both secured and unsecured (exclusive of debts to insiders or affiliates) of $2 million or less

Under the Amendments, the automatic stay is not available to debtors, or is easily lifted in situations where debtors are deemed to have abused the bankruptcy process by seeking relief thereunder more frequently than permitted by the statute. Under the Amendments, there is no automatic stay with respect to an individual debtor under chapters 7, 11 or 13 if two or more bankruptcy cases involving that individual were pending within one year of the bankruptcy filing and were dismissed, unless a court orders otherwise. Further, the automatic stay terminates 30 days following the petition date in a case filed by an individual if another bankruptcy case was pending within one year preceding such current case and such other case was dismissed (unless the current case was refiled under Section 707(b) of the Code) unless the court orders otherwise. Serial filings (filings by individuals under chapter 7, 11 or 13) are filings which occur within a one year period and are presumed not to be made in good faith if earlier case was dismissed because of debtor’s failure to take an action ordered by the court.

In a chapter 7, 11 or 13 case involving an individual debtor, the automatic stay may be terminated with respect to creditor holding perfected lien on real property if the court finds the bankruptcy filing was designed to hinder, defraud or delay creditors. The stay automatically terminates 60 days after motion to lift stay is filed unless such 60-day period is extended by agreement of parties, or by the court for a specific length of time upon showing of good cause.

Certain changes to the automatic stay were also made in connection with certain types of financial services contracts so as to make it easier for nondebtor parties to such contracts to liquidate those contracts and net out mutual obligations.

Leases of nonresidential real property are deemed rejected if not assumed by the earlier of the date a plan is confirmed or 120 days following the petition date. Court may extend 120 day period for up to 90 additional days; any further extension requires lessor’s consent.

In a chapter 7 case of an individual, the debtor may assume a lease of personalty if written notification of debtors desire to assume is given to lessor, and lease is assumed within 30 days of notification- lessor may condition assumption on curing arrearages; automatic stay is not violated by negotiation of cure. In a chapter 11 or 13 involving an individual, if the debtor or trustee has not assumed or rejected a lease by the time the plan is confirmed, it is deemed rejected and the automatic stay is terminated.

A creditor whose claim is subject to a bona fide dispute as to liability or amount may not be a petitioner in an involuntary bankruptcy case.

Purchaser of interests in consumer credit transactions governed by the TILA or other consumer protection statutes remains subject to all claims and defenses which consumer could assert against original lender or its assignee, notwithstanding that the purchaser purchased such interest pursuant to a sale under Section 363 of the Code.

Generally, the automatic stay enjoins creditors from pursuing their legal rights against a debtor arising from prepetition obligations unless the creditors obtain relief from the stay. Currently the Code contains some exceptions to this rule for nondebtor parties to certain types of financial contracts such as derivatives, forwards contracts, hedges, swaps, repos, commodity contracts and the like. These provisions are deemed necessary to preserve the sanctity of the capital markets.

The Amendments expand the types of financial products included within the types of contracts providing nondebtor parties with the ability to exercise remedies and "net" amounts due, without having to obtain permission of the court. The Amendments recognize the enforceability of master netting agreements and include within the scope of nondebtor parties subject to the protections, counterparties to contracts with debtor municipalities. Expanded "safe harbor" provisions permit qualifying creditors to exercise their liquidation and setoff rights notwithstanding the bankruptcy of the other party to their contract.

The Amendments insert a new chapter in the Code to replace § 304 and implement the Model Law on Cross-Border Insolvency. The provisions of chapter 15 are designed to replace the need for courts in the United States and in foreign countries to issue joint protocols to address cross-border issues. It also establishes a uniform set of regulations to govern the commencement, effect and operation of cases where companies affiliated with a U.S. debtor, that may or may not be subject to another country’s insolvency laws, are domiciled in a country other than the United States.

This article is presented for informational purposes only and is not intended to constitute legal advice.