Bankruptcy Newsletter

Loan Payments Not Deductible Under Means Test
A Chapter 7 debtor could not deduct the payments on his retirement plan loan in performing the means test, either as a monthly payment "on account of secured debts," or as an "other necessary expense," the Ninth Circuit Court of Appeals has ruled as a matter of first impression in its circuit.

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A debtor's obligation to repay a loan from his or her retirement account is not a "debt" under the Bankruptcy Code. Therefore, a debtor could not deduct the payments made on his retirement plan loan in performing the means test under Chapter 7 as a monthly payment "on account of secured debts," the Ninth Circuit Court of Appeals ruled as an issue of first impression in its circuit, on direct appeal from the bankruptcy court. Moreover, the Court of Appeals ruled, again as an issue of first impression in its circuit, the loan payments made by the debtor, being the functional equivalent of voluntary contributions to the retirement plan, were not deductible under the means test as an "other necessary expense."

When the debtor filed his Chapter 7 petition, he had been employed by a grocery store for 27 years. He was single and had no assets, and his only secured property was an automobile used for work and a timeshare. Approximately two years before seeking bankruptcy protection, the debtor had taken a loan from his 401(k) plan. The plan automatically deducted funds from the debtor's payment on a monthly basis to repay the loan, which was scheduled to be fully repaid less than two years after the debtor's petition filing. The debtor's schedules reflected that he had monthly disposable income of $15.31 after the 401(k) loan payment.

The United States Trustee (UST) moved to dismiss the debtor's petition. The UST contended that the debtor could not include the 401(k) plan repayment in his necessary expenses, and that, without this deduction, the debtor's case gave rise to a presumption of abuse under the means test of 11 U.S.C.A. § 707(b)(2). The UST also asserted that the dismissal of the case was warranted, regardless of whether the presumption of abuse applied, under the totality of the circumstances, based upon the debtor's ability to repay a meaningful portion of his debts.

The California bankruptcy court did not agree with the first argument, and instead considered the 401(k) loan as a "secured debt" the payments for which were deductible under the means test. Under this reasoning, no presumption of abuse arose in the debtor's case. The bankruptcy court agreed, however, that dismissal was warranted based on the totality of the circumstances under § 707(b)(3). At the time of its order, the bankruptcy court noted, only approximately one year remained before the 401(k) loan was repaid, leaving $525 a month to repay unsecured creditors. The court gave the debtor the option to convert his case to one under Chapter 13, but the debtor did not do so.

The debtor filed a notice of appeal and obtained certification of the bankruptcy court's decision for direct appeal. The Court of Appeals granted the debtor's resulting petition for direct appeal, staying the district court appeal pending circuit review.

The Court of Appeals began its analysis by explaining that the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) had "produced a sea change" with respect to the availability of relief under Chapter 7. Before the BAPCPA was enacted, a presumption favored the granting of relief to a Chapter 7 debtor, and a finding of a substantial abuse of Chapter 7, under the totality of the circumstances, was required to overcome that presumption. Following the enactment of the BAPCPA, however, no such presumption favors Chapter 7 relief. Instead, the emphasis is on repaying creditors as much as possible, the Court of Appeals explained. To this end, the BAPCPA introduced a mathematical formula, generally called the "means test," to determine whether the debtor's financial circumstances give rise to a presumption of abuse under § 707(b)(2). The presumption can be rebutted upon a showing of "special circumstances," pursuant to § 707(b)(2)(B). Even without a presumption of abuse, however, a debtor's petition can be dismissed for abuse, pursuant to § 707(b)(3), if the petition was filed in bad faith or if the totality of the circumstances demonstrates abuse.

Following the statutory framework, the Court of Appeals turned first to the presumption of abuse. It looked first to whether the debtor's retirement account loan repayment was deductible under the means test as a secured debt payment. Under § 707(b)(2)(A)(iii), the court explained, a debtor may deduct "the average monthly payments on account of secured debts" in calculating his or her current monthly income. Noting the coextensiveness of the terms "claim" and "debt" under the Bankruptcy Code, and the Code's broad definition of "claim," the court reasoned that the debtor's loan was a "debt" only if the retirement plan administrator had a "claim" for repayment. Agreeing with the "vast majority of courts," in deciding this issue of first impression in its circuit, the Court of Appeals ruled that the debtor's obligation to repay a loan from a retirement account is not a "debt" under the Bankruptcy Code. Elaborating, the Court of Appeals noted that the loan obligation was essentially a debt owed by the debtor to himself, since he borrowed his own money in taking a loan from his retirement account. If the debtor failed to repay the loan, the plan administrator had no personal recourse against him. The plan would deem the outstanding loan balance to be a distribution of funds, the court explained, reducing the amount subsequently available to the debtor from his account. "This deemed distribution will have tax consequences to [the debtor]," the Court of Appeals said, "but it does not create a debtor-creditor relationship." Because the loan repayment obligation was not a debt under the Code, the Court of Appeals continued, it could not be deducted by the debtor in performing the means test as a payment on account of a secured debt.

The Court of Appeals pointed out that its conclusion was supported not only by the Code's definitions of "claim" and "debt," but also by canons of statutory construction. Given the extensive pre-BAPCPA case law providing that 401(k) loans were not "debts" under the Code, Congress was presumed to have left that treatment intact when it did not legislate otherwise. Moreover, Congress allowed Chapter 13 debtors to deduct 401(k) payments from the disposable income calculation, under the BAPCPA, while not making the same provision for Chapter 7 debtors, and also provided that the automatic stay does not apply to automatic deductions to repay retirement plan loans, but expressly indicated that this provision could not be construed to treat such a loan as a "claim" or "debt." The omission in the Chapter 7 context was thus presumed to be intentional. The Court of Appeals rejected the debtor's contention that its construction of the statute created anomalous results, reasoning that Congress could have intended, through the differing treatment of Chapter 7 and Chapter 13 debtors, to steer persons who otherwise would become Chapter 7 debtors to Chapter 13.

The Court of Appeals next considered whether the 401(k) loan payments were an "other necessary expense" deductible under the means test. Under the means test, the Court of Appeals explained, debtors may deduct, pursuant to 11 U.S.C.A. § 707(b)(2)(a)(ii), the "actual monthly expenses for the categories specified as Other Necessary Expenses issued by the Internal Revenue Service." The IRS defined a "necessary expense," the court indicated, as one providing for the health and welfare of the debtor and/or his family, or for the production of income. The debtor argued that his monthly 401(k) loan payments were a "necessary expense" due to the need to replenish his 401(k) plan in light of his approaching retirement and lack of other significant assets. The IRS guidelines precluded this argument, the Court of Appeals said. Those guidelines, incorporated into § 707(b)(2)(A)(ii) by Congress, specifically stated that contributions to voluntary retirement plans were not a necessary expense. The initial contributions, the debtor admitted, were voluntary, as was the loan taken from the plan. Likewise, the loan repayments were voluntary, in that the debtor could simply ask for the outstanding loan balance to be treated as an early withdrawal from the plan, relieving himself of the payment obligations. There would be tax consequences, but the debtor would retain the use of most of the loan funds. "In short," the Court of Appeals said, the debtor's "monthly 401(k) repayments are the functional equivalent of voluntary contributions to a retirement plan. Per the IRS's guidelines, such contributions are not deductible [o]ther [n]ecessary [e]xpenses under § 707(b)(2)(A)(ii)." The Court of Appeals distinguished the cases cited by the debtor, which pre-dated the BAPCPA or applied pre-BAPCPA law.

The bankruptcy court erred by allowing the debtor to deduct his payments on his loan from his retirement plan account, and the presumption of abuse thus arose in his case under the means test. The Court of Appeals thus considered the bankruptcy court's alternative holding that the debtor's repayment obligation to his retirement plan was a "special circumstance" rebutting the presumption of abuse. The case relied upon by the bankruptcy court, however, had been reversed on appeal, and most courts refused to treat a 401(k) loan repayment obligation as a special circumstance. The Court of Appeals agreed. It noted that the examples provided by Congress of "special circumstances" in § 707(b)(2)(B), which included a serious medical condition and a call to military service. Both examples, the Court of Appeals noted, were ones that were imposed outside a debtor's control and would strain a debtor's household budget. The court concluded that it was unnecessary for it to consider the special circumstances provision's outside parameters, however, since 401(k) loans were not extraordinary or rare, and the obligation to repay them could not, without more, be considered "special circumstances."

The court acknowledged that situations prompting a debtor's 401(k) loan could establish special circumstances, but that was not the case with the debtor before it, who indicated only that he had sought to avoid bankruptcy by taking the loan to pay off bills. Although this was "a commendable goal," it did not present the type of life-altering circumstance contemplated by the special circumstance exception. "Indeed," the court said, "if the original unsecured consumer obligation could not be considered a special circumstance, it would seem problematic to find `special circumstances' for the 401(k) loan that merely replaced those debts." Thus, the Court of Appeals agreed with the result reached by the bankruptcy court, concluding that since the debtor had not rebutted the presumption of abuse arising in his Chapter 7 case, the bankruptcy court properly dismissed his petition. In re Egebjerg, 2009 WL 1492138 (C.A.9-Cal.).

A mortgagee was not entitled to in rem relief from the automatic stay based solely upon the debtor-mortgagor's history of repeatedly filing for bankruptcy relief on the eve of mortgage foreclosure sales. The debtor had made substantial payments on the mortgage debt in a prior case that was dismissed only because health problems impacted on his earning capacity. The mortgagee merely made conclusory allegations and failed to make any concrete showing that these repeated filings were motivated by any fraudulent intent. In re Poissant, 2009 WL 1402269 (Bkrtcy.N.D.Ohio, Judge Baxter).

The filing of a proof of claim to collect a debt, the recovery on which was allegedly time-barred, did not violate a provision of the Fair Debt Collection Practices Act (FDCPA) prohibiting harassing, oppressive, or abusive debt collection practices, the making of a false representation as to the legal status of a debt, the use of false or deceptive means to collect a debt, or attempts to collect any debt not permitted by the law. Because the Bankruptcy Code, in providing that the running of a prescriptive period was grounds for the disallowance of a claim, specifically contemplated the filing of time-barred claims, the debtor's sole remedy for the creditor's filing of an allegedly time-barred claim was under bankruptcy law, and any FDCPA remedy was precluded. B-Real, LLC v. Rogers, 2009 WL 1405844 (M.D.La., Judge Brady).

A Chapter 7 debtor's student loan debt presented an undue hardship to the debtor, even if she could make payments under the income contingent repayment program (ICRP), warranting the discharge of the debt. The debtor's income was not likely to increase in the foreseeable future, and her total reasonable and necessary living expenses left her with a minimum deficit of $160 per month, and thus without funds to pay the student loan debt. In addition, the stress caused by the loan obligation would negatively affect the debtor's mental health and sobriety to a real and meaningful ongoing detriment. Finally, payments under the ICRP would not reduce the debt, or even achieve a meaningful payment of the loan obligation. The debtor, the Minnesota bankruptcy court observed, was not the type of debtor that Congress was attempting to thwart when it enacted the undue hardship discharge exception for student loan debt. In re Brooks, 2009 WL 1448938 (Bkrtcy.D.Minn., Judge O'Brien).