Reduced Debtor Protection
Proposed Bankruptcy Reform — an interview with Michael S. McManus of U.S. Bankruptcy Court
Andrew Jacobson | Frayda Bruton Law
Posted Monday, January 10, 2005
5 U.C. Davis Bus. L.J. 11 (2004)

Michael S. McManus, Chief U.S. Bankruptcy Judge, Eastern District of California, was appointed to the bench on January 11, 1994 and designated Chief U.S. Bankruptcy Judge effective November 1, 2000. He received BA degrees in Criminology and Psychology from the University of California, Berkeley, in 1975, and his JD from the University of California, Los Angeles, in 1978. After practicing for one year in the Los Angeles and Orange county area, he practiced for approximately 15 years in Sacramento where he practiced bankruptcy law at Felderstein, Rosenberg & McManus and later at Diepenbrock, Wulff, Plant & Hannegan. Chief Judge McManus maintains his chambers in Sacramento but occasionally hears cases in Modesto.

Background Information

Since 1999, Congress has debated a number of bills that would make significant changes to the United States Bankruptcy Code. Now that the Republicans have succeeded in maintaining control of the White House and Congress, it is likely that proponents will, once again, introduce a bill during the upcoming 109th Congress. The most recent version of the bill, approved by the House of Representatives in March 2003, includes many proposals that would reduce protections for debtors and allow creditors more opportunities to recover secured collateral. If approved in this form, the overhaul would be the most extensive since Congress approved the current Bankruptcy Code in 1978.

The U.C. Davis Business Law Journal sat down with Judge Michael McManus, Chief Judge of the United States Bankruptcy Court for the Eastern District of California, to discuss the content of the 2003 House bill. To be sure, it is by no means certain that sponsors will reintroduce the entire content of the 2003 bill. Nevertheless, we asked Judge McManus to suggest what effect its adoption might have on debtors and creditors, both individual and corporate.

Q: What are some of the provisions of the proposed Bankruptcy Bill that will have the greatest effect on Chapter 11 corporate debtors?

A: One of the business provisions affects the time for the debtor to assume or reject non-residential real property leases. Under the current law, you have to assume or reject within 60 days or ask the court for additional time. The bill changes that to 180 days. But it also does not let you request any additional time unless the lessor consents. In a big Chapter 11, sometimes the real estate leases are one of the primary assets. If you assume a lease prematurely, you might be biting off a big administrative expense. By the same token, if you reject a lease prematurely, you might be letting a big asset go out the back door.

Also, there are proposed changes in the exclusivity period for a debtor in possession [the debtor who retains control of his own bankruptcy estate in lieu of the appointment of a trustee]. Right now the debtor in possession has an exclusivity period [in which only he or she can propose a Chapter 11 plan] of 120 days to propose a plan and an additional 60 days to confirm it. The bill limits the ability of the court to extend the exclusivity [period]. Currently, the court can extend exclusivity if there is cause without any outside limit. The bill permits the court to extend the 120-day period to a maximum of 18 months after filing and the 180-day period to a maximum of 20 months. Courts are willing to go along with extension in cases where the parties need to negotiate further and the debtor-in-possession does not want to lose exclusivity but does not want to force the issue while creditors are still negotiating. But absent a good faith negotiation, most courts are not going to extend exclusivity just because the debtor wants it.

Congress is also proposing to change the "ordinary course of business" exception to a preference suit [by the debtor seeking to recover a payment which benefits one creditor at the expense of others]. Currently, most courts apply a subjective and objective test to determine whether the expense was in the ordinary course of business. First, the creditor has to show that the payment received was ordinary in terms of his dealings with that debtor. Second, the creditor must show the payment was not unusual pursuant to certain relevant industry norms. I believe the new law will allow the creditor to satisfy his burden using either one of these tests.

Congress is also proposing to change the venue requirements for preference actions. The proposal will force a debtor to sue in the defendant's home district if the amount in controversy is less than $10,000. I imagine that has many debtors' attorneys alarmed, because they may file hundreds of preference actions. Now, they could be forced to file them all over the country. That is a big expense for someone who is suing for $9,000.

Finally, Congress will add some small business provisions. The House and Senate are still not in agreement on how to define a "small business." [The current proposal is to define a small business as having debts no greater than $4 million].

Q: Let's turn to consumer debt. A number of these provisions would seem to increase the ability of a secured creditor to safeguard the full amount of a loan rather than just limiting it to the value of the collateral. How would this fundamentally change the relationship between debtor and creditor?

A: First, there is a provision that limits a debtor's or trustee's ability to strip down claims to the value of their collateral. A debtor cannot strip down a purchase money security interest in vehicles purchased within 910 days of the bankruptcy filing. Also, you cannot strip down any other debt if it was secured within one year of bankruptcy. And if you do strip it down, you have to value the collateral at its current fair market value.

Also, they want to eliminate what we call the "retention" or "ride-through" option [by which a debtor can keep possession of a creditor's collateral without "reaffirming" his contract but instead voluntarily repaying the loan]. In the case of McClellan Federal Credit Union v. Parker (In re Parker) [1], the Ninth Circuit has held that the debtor can retain the collateral and voluntarily pay back the debt. For example, if you have a car loan and you are not in default of its terms, that is, you have kept the payments current and kept it insured and registered, can the car lender take your car back when the case is over? Many contracts include a clause providing that it is an event of default to file for bankruptcy. But, despite the bankruptcy discharge and the technical default, the debtor continues to pay the car lender. Can the lender repossess the car? The circuits are split on the issue.

Under the proposed legislation, there will be no retention option. Either the debtor must redeem [immediately pay the full fair market value], reaffirm [agree to remain personally liable for the contract], or surrender the vehicle. A debtor will not be permitted to retain the vehicle as long as the debtor voluntarily performs the contract. That's going to be a big change under current Ninth Circuit law.

Q: How is Congress proposing to prevent debtors from abusing the automatic stay (which prevents creditors from seizing assets from the bankruptcy estate unless permitted by the court)?

A: The provisions regarding the automatic stay and the ability to get in rem relief from the automatic stay will clear up some uncertainties when you have a serial filer. Sometimes a debtor will file petition after petition. The goal is not to get a discharge or to reorganize, but rather to reacquire the automatic stay and frustrate a creditor's attempt to repossess or foreclose. The automatic stay precludes a lender from enforcing its rights against its collateral. Sometimes the person abusing the Bankruptcy Code does not file a petition. Instead, that person transfers the property, or a fractional interest in it, to a third person, or a newly formed corporation, who then files a petition. By granting in rem relief, the court can insure that the secured creditor can foreclose on its collateral no matter how many times a debtor files a petition or transfers the property to other debtors. The new legislation will permit the court to issue in rem orders that are recorded against the property and that are effective for a period of up to two years.

Also, there are proposed safeguards against serial filers. When you file a second petition within two years of a prior case, the automatic stay will last for only 30 days. The debtor then has to go into court to extend the automatic stay. If you file a third petition, you have to get the court to issue a stay. You do not just get one automatically.

Q: Do you think this will be an effective remedy?

A: There are certainly some very abusive filers out there. Every court has them. I ran across a case not long ago where the debtor had filed eight petitions. The court should not have to stand for that kind of abuse. The legislation may establish some needed bright lines.

Q: Let's now talk about the consumer filing provisions under Chapter 7 (which results in liquidation of a debtor's bankruptcy estate in exchange for a discharge from most unsecured debts). Do you think the current bill reflects a belief in Congress that debtors are abusing Chapter 7 filings?

A: Apparently, a lot of Congressmen feel that many debtors in Chapter 7 could afford to pay some of their debts. They are designing a system that they believe will deter people from filing under Chapter 7 and send them into Chapter 13. Whether or not they are going to be successful is the question of the day.

Q: Certainly it appears that a number of the provisions attempt to limit a debtor's ability to simply liquidate his or her assets under Chapter 7 in exchange for a discharge. What steps is Congress taking in order to encourage debtors to seek bankruptcy protection under Chapter 13 rather than Chapter 7, which has long been the most popular type of consumer filing?

A: The most controversial decision has to do with "means testing." As I understand it, this could entail a great deal of court time. The court must look at each debtor's finances and determine whether the debtor's income and expenses are above some state or regional median. If a debtor's income is below the median income, then the means testing does not apply. But a general abuse test would apply. [The test includes a number of factors.] Is this a one-creditor case? Is this the latest in a long-line of cases filed to delay a creditor? Such a test currently applies to all cases.

But if you are over the median income, then the means test and the abuse test both apply. You are basically holding up Chapter 7 against Chapter 13 to compare the two. The means testing is quite complicated. You need to net out the cost of the Chapter 13. You calculate income by looking back at a six-month period, averaging out the debtor's income, and then deducting expenses from that. There are nine categories of expenses.

You can picture the form they are going to put together for this. It is going to be incredibly complicated. There is going to be a lot of litigation to determine whether people are really incurring some of these expenses. And then after you get all that done, you get two trigger points. If a debtor has at least $166.67 in disposable income per month, abuse is presumed regardless of how much debt the debtor owes. If the debtor has at least $100 per month in disposable income, abuse is presumed if disposable income is sufficient to pay 25% of the debtor's general unsecured debt over 5 years. If you owe $24,000 and you have $100 per month in extra income, you would be presumed to be an abuser because you could pay $6,000 back over five years.

[If the debtor is found to have income over the median, then the bill requires the United States trustee to file a motion to dismiss the case. In the event the decision is made to dismiss a Chapter 7 petition, the debtor would be able to convert it to Chapter 13 and propose a debt repayment plan.]

Many people are wondering whether this is going to flush many people out of Chapter 7. The Sacramento U.S. Trustee did a study not long ago. She took a sampling of Chapter 7 cases and tried to determine how many of those cases would not be in court if we applied these standards. I forget the exact percentage, but it was very low.

But in addition, Congress is placing more restrictions on Chapter 13 filing as well as Chapter 7.

Q: What are some of the proposed changes that debtors will have to contend with in filing a Chapter 13 debt repayment plan?

A: One possible hindrance on Chapter 13 is going to be the means test. It will determine how much disposable income the debtor must contribute to the plan. If the expense template required by the new legislation does not match the reality of a debtor's expenses, the debtor may not be able to actually generate the predicted disposable income. If that occurs, the debtor is likely to default under the terms of the Chapter 13 plan.

Under the current language of the bill, most Chapter 13 cases would probably end up being five years in length. [Currently, Chapter 13 plans last for a maximum of three years but a debtor may ask that a plan be extended to up to five years. The new legislation may require all plans to last five years.]

The limitations placed on stripping down secured debt I previously mentioned could also make Chapter 13 less desirable to debtors and may reduce the returns to unsecured creditors.

Also, Chapter 13 debtors will have to pay secured claims in equal installments over the life of the plan. Currently, most Chapter 13 plans do not require that creditors be paid in equal installments. Instead, creditors are grouped into classes with other similar claims. The plan specifies the order in which each group is paid. Within each group, the creditors filing proofs of claim receive a pro rata share of the plan payment. This is done because you are never sure how many of the creditors are going to file claims or how much they are going to claim. Under the legislation, a debtor will have to sit down and amortize claims over a five-year period. That's not an easy thing to do if you must take into account differing interest rates.

And then, there is a new requirement that debtors will have to make payments directly to secured creditors while awaiting the confirmation of their plans. In my experience, any time you depend on debtors to make payments directly to creditors, you will greatly increase the amount of court time needed to settle payment disputes. Even when they make payments, it is sometimes difficult to ascertain whether creditors have received them. Has the creditor properly credited them? When I have the [Chapter 13] trustee making the payments, I am likely to receive reliable evidence that a payment of a particular amount was sent on a particular date to a particular creditor. The evidence received from debtors, assuming any is received, tends not to be so reliable.

Q: Let's talk for a minute about the proposals to limit state homestead exemptions with a national cap. [The homestead exemption is the maximum amount of home equity that a debtor may protect in bankruptcy based on state law. Most judicial liens that impinge on this homestead equity are liable to be "avoided" or dissolved under current law.]

A: First you have to decide what exemption law you are going to follow. When you move to a state, you have to be in that state for 730 days before you can use the exemption laws of that state. Otherwise, the applicable law is going to be that of the jurisdiction where you were domiciled for the 180-day period preceding the 730-day period before the filing. For example, if you move from California to Michigan, you can still use the California exemption if you have not been in Michigan for more than 730 days. Once you claim the state exemption, then there would be a federal cap of $125,000. [The Chapter 7 trustee, the Chapter 13 trustee, or a creditor can challenge the exemption if it was acquired during the 1215 days preceding the bankruptcy petition]. Moreover, you can attack the exemption even after the 1215-day period has expired based on whether or not you have been convicted of a felony, committed a tort, committed securities fraud, or have in any way abused the Bankruptcy Code.

Q: In California, this won't have much effect?

A: Yes. In California, you max out at $125,000 [in equity exemptible under the homestead exemption. Most joint debtors under 65 years of age are limited to a $75,000 exemption].

Q: What effect do you think that might have in places like Florida and Texas?

A: I think this part of the Bill was designed to prevent debtors like Bowie Kuhn, the former baseball commissioner who moved to Florida after his law firm went bankrupt [from taking advantage of the state's generous exemption law]. He reputedly bought a huge, expensive house [and exempted all of the equity as permitted under Florida law]. The new legislation is designed to stop that kind of flight to a state with an unlimited homestead exemption.

Q: Finally, what impact do you think these reforms will have on the day-to-day function of bankruptcy courts?

A: Of course, it is up to Congress to determine what the bankruptcy laws are going to be. But what has some bankruptcy judges concerned is that this bill has a lot of litigation points. On the means testing, for example, if a trustee files a motion to dismiss a Chapter 7 case because the debtor flunked the means test, the debtor's attorney is potentially liable for the trustee's costs and maybe even their attorney's fees. Those provisions are very controversial with the consumer debtor bar. There is some concern that this will drive up the cost of bankruptcy consumer representation and even drive some attorneys out of this area of practice. Who knows whether that is true or not. But I can see a lot of potential litigation.

[1]McClellan Federal Credit Union v. Parker (In re Parker), 139 F.3d 668, 673 (9th Cir. 1997)