In re Fridley: No Shortcuts in the Race to Early Discharge

At the beginning of a chapter 13, the playing field is essentially level. The chapter 13 Trustee and the creditors have an equal opportunity to review the debtor’s schedules and object to a debtor’s plan, making sure the debtor meets the specific requirements outlined by the Bankruptcy Code and applicable case law. Among other considerations, a debtor’s disposable income is usually analyzed in order to determine the actual amount the debtor is able to pay into his/her plan. If all requirements are met, a plan is confirmed and becomes a final order of the court, modifiable only be a noticed motion under 11 U.S.C. ~ 1329 through Bankruptcy Rule of Procedure 3015(g). [1]

However, a debtor’s “projected” income is rarely a concrete figure and is almost certain to change during the life of the plan depending on various factors. While in most instances, a debtor seeks to reduce plan payments to creditors (using 11 U.S.C. ~ 1329(a) plan modifications) due to a decrease in income, an often overlooked scenario is where a debtor obtains a substantial increase in income (i.e. new employment, inheritance, gifts or proceeds from the sale or refinance of real property), and then seeks to obtain an early discharge based on their previous financial condition and without an upward adjustment based on the newly added income. This is unfair to unsecured creditors who will only obtain a nominal dividend under the plan, based on the debtor’s income before the changed circumstances occurred despite the debtor’s current ability to make increased payments. Recent case law and the amendments to the Bankruptcy Code through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) have addressed this issue and have provided additional tools for certain creditors and the chapter 13 Trustee to avoid windfalls to the debtor and force increased payment in this exact situation.

The competing interest between the debtor’s ability to obtain an early discharge and the rights of creditors to seek readjustment of the debtor’s plan to take into account an increase in the debtor’s income was resolved by the United States Bankruptcy Appellate Panel decision in Fridley v. Forsythe (In re Fridley), 380 B.R. 538 (B.A.P. 9th Cir. 2007). This case holds that a debtor who obtains a post-bankruptcy increase in income must comply with the requirements of 11 U.S.C. ~ 1329 plan modifications when requesting an early discharge and as a result may be required to increase the dividend paid to unsecured creditors.

In Fridley, the debtors filed and confirmed a 36 month plan that called for payments of $125/month and provided for either 100% to unsecured creditors or payment of disposable income for no less than the commitment period of 36 months. The debtors’ disposable income was listed at $0 in the plan, so no payments were contemplated to the unsecured claimants whose claims totaled almost $50,000.

The debtors subsequently filed tax returns after the plan was confirmed (as required by the plan and by 11 U.S.C. ~ 521(f), discussed infra), which showed that their yearly income had increased by almost $15,000. Shortly thereafter, in month 14 of the plan, due to the increase in income, the debtors made a lump sum payment to pay off the plan in full. This payment was made 22 months before the plan was set to be completed. Instead of filing a motion to modify the plan under 11 U.S.C. ~ 1329(a) (which would have allowed creditors to object and request a higher distribution) a motion for entry of discharge was filed. The debtors sought to “slip away into the night” in an attempt to obtain an early discharge and bypass the review that would occur if they sought to modify the plan to allow for an early payoff and discharge. The motion was opposed by the Chapter 13 Trustee.

The Court in Fridley analogized the interplay between ~ 1328 (the debtor’s attempt to obtain an early discharge) and ~ 1329 (the creditor’s attempt to force increased payments through a plan modification) as a race between the debtor and the trustee/creditors. If the debtor wins the race and is able to pay off his plan in full before a modification can be requested, he will obtain his discharge, no more automatic stay will be in effect, and his obligations will cease under his plan. On the other hand, if the creditor/trustee wins the race by forcing a modification, the debtor must comply with modification requirements and may be required to pay any excess income towards unsecured allowed claims for the life of the plan in order to obtain discharge. [2] The court examined the debtor’s attempted “shortcut” in the race for early discharge by circumvention of the notice requirements and held that a debtor’s request for early discharge must be examined under the more rigorous requirements of ~1329 plan modifications unless a debtor is proposing to pay all unsecured claims in full. The Court noted that in the race for early discharge “[t]he debtor would get to run a shorter route if prepayment amounted to a ticket to bypass the matrix of the noticed plan modification process which all other competitors must run.” [3]

The court further reasoned that a plan was not “completed” within the meaning of 11 U.S.C. 1328(a) [4] and the debtor was not entitled to his discharge unless and until a modification was proposed under 11 U.S.C. ~ 1329(a) as there is an implied requirement that the plan remain in effect for the “applicable commitment period”. A similar situation arises in the context of early payoff due to refinance or sale of real property in which unsecured creditors are not paid in full out of escrow. The court noted its previous position in In re Sunahara [5] , stating that the “applicable commitment period” of 11 U.S.C. ~ 1325(b)(1) is “temporal in nature” and “necessitates compliance with the procedure imposed by Rule 3015(g).” [6] The court reasoned that allowing the debtor to bypass an 11 U.S.C. ~ 1329(a) noticed motion in order to pay off his plan in full would essentially amount to a “handicap” to the creditor in the race for early discharge. The debtor should not be allowed to bypass a noticed motion and cruise to an early discharge unbeknownst to the creditors.

Creditors should note that increased disposable income will not automatically mandate increased payments under a plan. Although, the 9th circuit has adopted a “good faith” requirement, the court noted that the requirements of ~ 1325(b) that “all of the debtor’s projected disposable income” be applied to make payment to unsecured creditors under the plan, does not apply for purposes of analyzing plan modifications. [7] However, the good faith requirement of 11 U.S.C. ~ 1325(a)(3) (specifically incorporated through 1329(b)(1) [8] and outlined in In Re Goeb [9] ), provides the creditor a basis to demand increased payments in this situation based on “equity”, taking into account the “totality of circumstances” and is tool that can be utilized by creditors in their race to avoid early discharge. A debtor cannot merely confirm a plan in compliance with ~ 1325(b) and then file a subsequent modification to bypass the disposable income test. [10]

In addition, changes to the bankruptcy code through BAPCPA provide additional reasoning to limit early completion of a plan absent a properly noticed plan modification under 11 U.S.C. ~ 1329(a) and Bankruptcy Rule of Procedure 3015(g). Recognizing the possibility of a windfall in this situation, 11 U.S.C. ~ 521(f) and (g) were added to require post-petition tax returns upon request as well as a requirement for an annual statement that includes the amount and sources of the debtor’s income. The court noted that “[t]he obvious purpose of this self-reporting obligation is to provide information needed by a trustee or holder of an allowed unsecured claim in order to decide whether to propose hostile ~ 1329 plan modifications.” [11] The increased access to Debtor’s financial information provides an opportunity for the creditor to revisit the issue of “disposable income” at a later date and to look at the debtor’s “good faith” in seeking to discharge the debt. Through the changes in BAPCPA, the creditor now has a monitoring tool to assure utilization of the debtor’s income to its full potential.

The moral of the story is that a Chapter 13 is no longer a haven for debtors to simply discharge unsecured debt. Not only did BAPCPA reduce the effects of the “super discharge” in a chapter 13 by limiting the debt that could be discharged [12] , it also provided additional tools to be utilized by the creditors and the trustee to allow an ongoing analysis of a debtor’s post-petition financial status. While it is not always in the creditor’s best interest to expend additional funds and resources to monitor a debtor’s income throughout a plan, it is a legitimate means for a creditor to capture increased income by proposing “hostile” plan modifications. A mere cursory analysis of the documents that the debtor is required to provide under ~ 521(f) and (g) may be the difference in a creditor “winning the race” and mitigating its losses as opposed to having its debt discharged in its entirety despite legitimate means being available for payment. Creditors can take comfort in knowing that they should now have an opportunity to oppose modifications proposing early discharge, but this does not diminish the need to timely respond to motions to modify or to monitor the debtor for fluctuations in income.

With the recent downturn in real property values that have rendered many secured creditors partially or even wholly unsecured, an analysis in changes in the debtor’s post-petition financial status should be a consideration for secured or partially unsecured creditors, as well as unsecured creditors. Chapter 13 is unique in that it gives the trustees and the creditors the power to capture a material increase in income during the life of the plan. The Fridley case illustrates the trend since BAPCPA to try to force more accountability of Chapter 13 debtors. Obvious scenarios such as a debtor who wins the lottery after confirmation or a debtor who subsequently obtains an inheritance [13] would be cause for bankruptcy judges to raise the level of payment commitment a debtor might have to creditors, however, the door has also been opened for a closer examination of the debtor’s ability to pay due to less obvious windfalls, and the creditor should utilize this tool in its race to avoid early discharge.

[1] Three parties can request a modification under 11 U.S.C. ~ 1329(a): the debtor, the Chapter 13 Trustee, or the unsecured creditors. If a modification is needed, the party must file a motion under ~ 1329(a) and pursuant to Bankruptcy Rule 3015(g). This allows the debtor, the trustee, and all other creditors at least 20 days to object to any such modification. If no objection is made, the modification is granted (See 11 U.S.C ~ 1329 and Bankruptcy Rule of Procedure 3015(g)).

[2] The court also noted that a debtor could also merely choose to dismiss the action and face personal liability on the debt. See Fridley at 8.

[3] Fridely at 8.

[4] 11 U.S.C. ~ 1328(a) provides in part for the debtor to receive his discharge “as soon as practicable after completion by the debtor of all payments under the plan”. The court analyzed the “completion” requirement in determining that completion was not merely making the required payments under the plan and that the requirement was also temporal in nature.

[5] Sunahara v. Burchard (In re Sunahara), 326 B.R. 768, 781-82 (9th Cir. BAP 2005)

[6] Fridley at 9 quoting Sunahara at 781-82.

[7] See Sunahara, 326 B.R. at 781.

[8] > This section specifically incorporates section 1322(a), 1322(b), 1323(c) and 1325(a) to ~ 1329(a) proposed plan modifications.

[9] Goeb v. Heid (In re Goeb), 675 F.2d 1386, 1390-91 (9th Cir. 1982)

[10] Fridley at 11.

[11] Fridley at 13.

[12] See 11 U.S.C. 1328(a)(2).

[13] See In re Wetzel, 381 B.R. 247 (Bankr. E.D. WI 2008).