The Bankruptcy Reform Act of 2005: A New Landscape

By Roxane DeLaurell and Robert Rouse

NOVEMBER 2006 - The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the Act) was signed into law on April 20, 2005, with the explicit intent of discouraging filings under the Bankruptcy Code. As a result, assumptions about filing for bankruptcy, unchanged in U.S. law for more than 25 years, are likely to be challenged.

Not only was the Act highly debated, but all stakeholders also argued that the final version could have accomplished more. Whether the Act will achieve the goal of reducing bankruptcy filings is as yet unknown, but it should be noted that a previous attempt to reduce bankruptcy filings, the 1984 Amendments to the Bankruptcy Code, actually produced a threefold increase in such filings.

It has long been thought that filing for bankruptcy represented a last resort for financially struggling businesses and individuals who would have preferred to avoid the filing if at all possible. The provisions of the Bankruptcy Code, however, had strayed from the simplicity of that logic. For example, the law provided that creditors may force a business entity or individual into bankruptcy via a petition for involuntary bankruptcy.

It is apparent, however, that federal legislators had come to believe that filing for bankruptcy was no longer considered a stigma to be avoided, but rather had evolved into an attractive alternative to fully repaying one’s creditors. In fact, some commentators argued that the Bankruptcy Code had become a means to elude creditors and escape unwanted financial obligations, hence the need for a change in the law. The 2005 Act provided for some major changes in the Bankruptcy Code, and CPAs should examine it carefully when dealing with parties in bankruptcy.

Major Changes

The Bankruptcy Code has provided for two general types of petitions through which debtors could voluntarily file for protection from creditors. These petitions applied to three classes of debtors: individuals, family farmers, and businesses. Those eligible to file could receive an order to stay the collection efforts of creditors, to receive a discharge of their unsecured debts, or to obtain a “reorganization” of their outstanding debt as well as a reduction in interest payable on secured loans.

The Act alters the bankruptcy process from the prepetition stage to liquidation. The greatest changes will apply to the establishment of eligibility for filing and to the discharge of individual indebtedness under Chapter 7. A few of these areas are examined below.

Chapter 7

The number of filings by individuals under Chapter 7 of the Bankruptcy Code, which provides for the complete liquidation of indebtedness, has indeed been on the rise. According to statistics kept by the U.S. bankruptcy courts ( have reported that individual, “nonbusiness” bankruptcies rose from 1.3 million in 1999 to 1.625 million in 2003. The number of business-related bankruptcies during the same period, however, did not show a discernable trend, averaging around 38,000 bankruptcies per year.

The bulk of indebtedness held by individuals increasingly consists of credit card debt, which carries high rates of interest and is generally short term in nature and unsecured by interests in the property of the borrower. The Act creates new responsibilities and new liabilities for the debtor/assisted person, as well as any bankruptcy professional who advises the assisted person. It reduces the protections offered to the debtor/assisted person and limits the amounts and types of exemptions the individual may use to preserve equity or ownership in any assets.

A major reform of the Act was an increase in the responsibilities of individuals seeking Chapter 7 liquidation. Such filings are usually undertaken by persons who have little or no equity in any assets and who have mostly unsecured debt. While it has always been the case that creditors must show documentation of indebtedness—“proof of claim”—it is now incumbent upon the debtor to demonstrate that there is no reasonable alternative to the bankruptcy process.

The result has produced a shifting of the burden of documentation from creditors to debtors. The debtor seeking liquidation must now prove an inability to pay his debts as they are due and demonstrate a good-faith attempt to resolve such a crisis without the court’s help.

Means Testing

The most controversial reform in the Bankruptcy Code lies in the creation of a “means test” for eligibility to file under Chapter 7. The Act requires a comparison of the debtor’s income to the median income in the individual’s domiciled state. If the debtor’s income is above the median and he is able to pay at least a minimal amount per month to creditors, he is now barred from Chapter 7 filing and must be so informed by any “debt relief agency” or legal counsel he has retained.

The Act also incorporates IRC provisions for calculating the debtor’s reasonable deductions from gross income for monthly living expenses. In the past, the debtor’s self-reporting of expenses was usually allowed.

If the debtor fails this test for filing under Chapter 7, there may now arise a presumption of bad faith. The presumed bad faith is rebuttable only by documentation showing extreme “special circumstances” that leave no reasonable alternative to the relief offered by liquidation.

The means test should reduce the number of Chapter 7 filings and force a larger percentage of debtors into Chapter 13, or lead them to reorganize their debt privately. In either case, repayment of at least principal indebtedness is the desired outcome.

Serial Filers

The Act also addresses the situation of multiple and serial filings by the same debtor. In the past, liquidations for individuals under Chapter 7 were frequently combined with a subsequent filing for reorganization of personal debt under Chapter 13. The result of this combination frequently produced a complete discharge of consumer credit-card debt and a preservation of home equity. Many repayment plans often left the debtor in possession of assets, and any secured obligations stripped of interest payments.

Bankruptcy courts have traditionally allowed this type of serial filing based upon the policy goal of preserving employment, both in terms of individuals as income-earners and business entities as employers. It was reasoned that conversion of cases from Chapter 7 to 13 and interest stripping of secured loans for debtors would permit persons to remain employed and therefore able to complete repayment plans.

The combination of Chapter 7 filings with later conversion to Chapter 13 has become so common that it became known as a “Chapter 20” filing. In an effort to discourage Chapter 20s and similar forms of serial filings, the Act states that Chapter 13s may be filed only once every two years, and three years must pass between the filing of a Chapter 7 and a subsequent Chapter 13. The period allowed between Chapter 7s has also been extended from six to eight years.

Credit Counseling

The Act further calls for the debtor to show a documented, good-faith effort to obtain and implement debt counseling. The burden for documenting that effort rests with the debtor and any legal counsel. Law firms specializing in bankruptcy practice must create and streamline new forms of recordkeeping and procedures for conducting investigations into an individual’s assets. These changes will increase the costs of filing any type of bankruptcy action, and some have projected that related legal fees will more than double.

The Act also addresses the contentious issue of the homestead exemption. The Act now requires that a debtor reside in a state for 720 days prior to filing in order to take advantage of state homestead exemptions. It was thought that this would prohibit opportunistic individuals from forum shopping for bankruptcy filings in states like Florida and Texas, which have generous exemptions. A cap of $125,000 has been placed on what a debtor may claim as a homestead exemption on a home purchased within the last 40 months.

In the past, the Code has allowed the debtor to choose between state and federal statutory monetary guidelines to be used to exempt personal and real property from the bankruptcy estate. Several states have provided unlimited homestead exemptions, but federal regulations provided a fixed-dollar amount of equity that a debtor could claim as a homestead and therefore as exempt from the bankruptcy estate used to repay creditors.

Retirement Funds

The Act reinforces the protection offered by tax-exempt, Employee Retirement Income Security Act (ERISA)-qualified retirement funds. While retirement funds have been ruled exempt from bankruptcy on a number of occasions, the new law makes that exemption explicit. Repayment of loans from retirement funds is nondischargeable, and contributions to retirement funds are not considered part of disposable income and thus are removed from the repayment plan equation. All retirement accounts are now subject to exemption by the debtor under either federal or state exemptions.

‘Super Discharge’

Another important change is the Act’s repeal of the so-called “super discharge” of tax liability, which had been offered by Chapter 13. Previously, debtors who were permitted to choose Chapter 13 over Chapter 7 were granted a complete discharge of all claims once a repayment plan had been completed.

Several courts interpreted this discharge to include any tax indebtedness due to failure to pay, as well as penalties for evasion and nonpayment. Chapter 7, however, specifically denied a debtor relief from tax-related claims and indebtedness. It was argued that the super discharge encouraged debtors to file under Chapter 13 and thereby provided greater levels of repayment to creditors. The super discharge is no longer permitted.

The Act also addresses “consumer protection” and related abuse by bankruptcy professionals. This consumer protection part of the Act is intended to reduce the quasi-professional nature of agencies and persons providing counseling and legal assistance in bankruptcy matters. The Act put into effect sanctions against these “debt relief agencies.”

International Bankruptcy

One of the most important amendments for businesses is the addition of Chapter 15 to the Bankruptcy Code. This new chapter addresses cross-border or international bankruptcies as an entirely separate category of filing. Chapter 15 incorporates the Model Law on Cross-Border Insolvency that was drafted by the United Nations Commission on International Trade Law (UNCITRAL) in 1997. Previously, section 304 of the Bankruptcy Code addressed “cases ancillary to foreign proceedings.” The Act repeals section 304 and replaces it with Chapter 15.

The greatest impact of Chapter 15 is likely to come from the provision under section 362 of an automatic stay protection to cross-border filings. Previously only court-ordered relief was available to debtors. Actions under Chapter 15 are now supposed to be “ancillary” to bankruptcy proceedings begun in a debtor’s home country. Ancillary cases that are based on cross-border, treaty-regulated transactions could involve bringing the United States into court as a party. As a result, Chapter 15 may become contentious if the United States is found to be the guarantor of any indebtedness.

Business-Related Issues

The time period for the reclamation of goods by companies that have sold on credit has been expanded from 20 to 45 days. Creditors may now ask a debtor in bankruptcy for the return of inventory shipped but for which no payment has been received, for up to 45 days after the date of filing. This provision is most likely to affect businesses that operate on the basis of requirements contracts but generally take delivery of inventory on a monthly basis. For example, in the refining industry the demand for automotive and airplane fuels tends to fluctuate with temporal factors such as season, holidays, or even the coincidence of days of the week with the first day of a given month. As a result, the value of inventory on hand also tends to fluctuate widely and frequently.

Payments made to creditors 90 days prior to a bankruptcy filing, if cumulatively under $5,000, will not be subject to repayment as preferences (i.e., insider payments made by debtors just prior to filing bankruptcy). Trustees have generally allowed the recovery of these preferences, thus increasing the debtor’s estate and making available more in payout for creditors. The rationale is that allowing recovery to creditors encourages the extension of credit to a company in danger of bankruptcy. Under the old rule in place, a three-month “dead zone” was created in which a business in need might not be able to continue operations or meet obligations such as payroll. In all matters, the goal of the Bankruptcy Code is to maximize economic benefit to creditors; promoting the continuation of a going concern, including the retention of a debtor’s employment base, helps to ensure creditors’ full return, rather than the “cents-on-the-dollar” payout expected in bankruptcy.

Similarly, trustees seeking preferences totaling less than $10,000 claimed against non-insiders must now file in the court where the creditor is located, as opposed to having the power to hail such parties into a court of the trustees’ own choosing. This should reduce creditors’ litigation expenses in their efforts to secure these payments and give them greater leave to extend credit to companies on the brink.

Defending a preference generally requires that a creditor demonstrate that the payment was made in the “ordinary course” of business. The Act now allows a defending creditor to focus on the specific course of dealings between the creditor and the debtor and not be required to generally defend an existing industry standard. This change tends to bring the Bankruptcy Code closer to the principles of general contract law, such as the Uniform Commercial Code (UCC), where the previous course of dealings is a significant part of formation and interpretation.

For transfers deemed fraudulent, trustees can now go back two years rather than one to recover these funds. While most of the Act’s provisions apply to cases filed after October 17, 2005, this particular provision became effective on April 20, 2006. Once a company files bankruptcy, creditors should review the history of their receivables, payments, and goods shipped, and also be aware of the timelines involved, in order to protect their interests.

Another important deadline businesses should be aware of is the time period for assumption or rejection of commercial leases by a debtor. A debtor must assume or reject a lease within 120 days of filing for bankruptcy or of the date that the reorganization plan is confirmed, whichever is shorter. While one extension of 90 days is permitted, all future extensions must be agreed to in writing by the lessor/creditor. If the debtor rejects the lease, the lessor becomes a general unsecured creditor. If, however, the debtor assumes the lease, all past rent payments are due, and the lessor/creditor will have a postpetition priority claim in the event the debtor liquidates. This may create an eight-month “eviction-by-bankruptcy” process that commercial lessors may find onerous. Such lessors’ counsel may seek to create agreements that contract around these rules, because courts have become increasingly more inclined to read commercial leases as contracts than they were in the past.

The Act classifies the small business debtor as one engaged in commercial or business activities (real estate excepted) with no more than $2 million in nonaffiliated debt. The purpose of this classification is to streamline the Chapter 11 bankruptcy process for small businesses. The rules now require a small business debtor to file both a disclosure statement and a reorganization plan at the same time. A small business debtor is also now required to meet with the trustee prior to the first creditors’ meeting, to determine the viability of the debtor and the proposed reorganization plan. At such time, a small business debtor must present a balance sheet, a statement of operations, a cash-flow statement, and a federal income tax return; the debtor must also continue to make all tax payments.

General Observations

Some broad conclusions with implications for business may be drawn from a summary review of the Act.

The number of defaults will likely increase, because debtors may find themselves unable to meet obligations related to personal property and then choose to surrender the property to holders with secured interests. Access to the interest-stripping provisions is now more limited.

Secured creditors will now likely lobby for changes in the Tax Code to address deductions and credits for uncollectible debts, business-related losses, and defaults. The repeal of the “super discharge” provision is highly likely to discourage business owners from commingling their individual assets and liabilities with those of the business.

The new bars to individual filings under Chapter 7 may encourage proprietors of small businesses to choose incorporation or limited-liability-entity forms on a much wider basis. Incorporation allows an individual’s personal assets to remain intact while exposing only the corporate assets to the risk of business failure.

The impact of Chapter 15, which will permit asserting claims across national and political boundaries, may result in boundaries being drawn more sharply as the interests among countries and their domiciled businesses begin to surface. It may be that cross-border litigation costs will ultimately outweigh any benefits received from increased commerce.

The Bankruptcy Act of 2005 may indeed change the landscape of dealing with and filing for bankruptcy. Only time will reveal just how much. A creditor may now more actively pursue collection from the debtor/assisted persons, and can expect fewer bad debts in the future. Creditors must become more aware of their relationships with particular debtors and their payment histories. Whether the Act will reduce bankruptcy filings and limit the writing off of debt is open to debate. Some have argued that the pre-filing credit requirements will amount to nothing more than the creation of another hoop for debtors. Others view the Act as a far-reaching attempt to help the U.S. economy more effectively and efficiently manage its debt and hold accountable those who are capable of repayment. Time will tell.

Roxane DeLaurell, PhD, JD, LLM, is an assistant professor, and Robert Rouse, PhD, CPA, a professor, both in the department of accounting and legal studies in the school of business and economics at the College of Charleston, Charleston, S.C.