|February 26, 2014|
Previously published on February 20, 2014
Heralded by debtor’s attorneys as “a wonderful loophole”1 in the Bankruptcy Code, a debtor who has primarily business, rather than consumer, debts can qualify for a speedy Chapter 7 discharge despite a high earning capacity that would permit the debtor to repay some, or even all, of her debt. Though rarely used, banks faced with a high-income debtor’s Chapter 7 case can move to convert the case to Chapter 11 under 11 U.S.C. §706(b) to force the debtor to repay some of her debt prior to receiving a discharge.
What the loophole is, how it can be closed, and when you should consider devoting the resources to close it are explored below.
What Debtors Fall into the Loophole?
The means test ordinarily forces high-income debtors out of Chapter 7 and into a chapter which would require the debtor to devote his or her income to a repayment plan to pay creditors some or all of the debt before receiving a discharge. The means test does not apply to debtors whose debts are primarily (more than fifty percent) non-consumer debts. Non-consumer debt is not just guaranty debt on a commercial building or other similar, purely “business” debts. Instead, tax debts, personal injury claims and other tort debts fall within the ambit of “non-consumer” debt.
As an example, under this loophole, a medical doctor with significant net income can file for bankruptcy under Chapter 7 and receive a speedy discharge where more than half of her debt is owed to the IRS; thus, she is a non-consumer debtor and the means test is inapplicable notwithstanding her financial ability to fund a Chapter 11 plan.
How Can Creditors Close the Loophole?
Section 706(b) provides an appropriate remedy (conversion to Chapter 11) under these facts and has been recently utilized by courts. Under §706(b) of the Bankruptcy Code, a court can utilize its discretion to convert a Chapter 7 case to Chapter 11 based upon what will “most inure to the benefit of all of the parties,” including the debtor and his or her creditors. Courts have developed a number of factors to assist it in this discretionary analysis, but the debtor’s ability to pay is one of the most widely considered and heavily weighted factors. Thus, under the right facts, §706(b) can be a very powerful tool to close this “wonderful” loophole for debtors, and force them to repay some, or all, of the debt owed to creditors, including financial institutions.
For example, in December 2013, a Florida Bankruptcy Court converted the case of a high-earning medical doctor from Chapter 7 to Chapter 11 and thereby prevented the complete discharge of a creditor’s $500,000 deficiency judgment against the debtor. See In re Baker, No. 3:13-bk-00196-PMG (Bankr. M.D. Fla. Dec. 10, 2013) (order granting bank’s motion to convert pursuant to 11 U.S.C. §706(b)).
When Should You Consider Trying to Close the Loophole?
Unlike conversion after a failed means test, a party-in-interest must move to convert the Chapter 7 case to Chapter 11. A motion to convert is a contested matter and, considering the stakes, is often fiercely fought by the debtor. Prior to making the decision to convert the case, creditors and their attorneys should carefully review the debtor’s schedules of assets and liabilities. A mock plan can be created to determine whether conversion will produce sufficient payments under a Chapter 11 plan to justify the time and expense of moving to convert the case (which can be substantial). Doing so will also ensure that the creditor stands to gain substantially more in a Chapter 11 than in a Chapter 7.
Moving to convert a high-income debtor’s Chapter 7 case to Chapter 11 under §706(b) may not be the perfect fit for every case; however, banks and other creditors should always consider it as an option to close this “wonderful” loophole for high-income debtors.
1 Ruff & Cohen. "Florida Bankruptcy Income Limits Web.” 19 Jan. 2014. http://www.bankruptcylawhelp.com/Bankruptcy/Florida-Bankruptcy-Income-Limits.aspx