A decision by Bankruptcy Judge Christopher M. Klein of Sacramento, Calif., is required reading for anyone drafting a plan for an individual or small business reorganizing under subchapter V of chapter 11, especially when the payment to creditors depends on whatever the debtor’s “disposable income” turns out to be.

The October 15 opinion by Judge Klein shows the importance of carefully defining the term “disposable income” and ensuring that the debtor complies with his or her reporting requirements. As Judge Klein points out, the burden of proof mostly rests on the debtor to establish the right to a discharge. Just saying there was no disposable income won’t suffice.

The Small Hotel

The debtor owned a small motel. He confirmed a seven-year chapter 11 plan in 2011 and paid the secured portion of the first mortgage every month, with a balloon due at the end of the term of the plan. The second mortgage and the unsecured portion of the first mortgage were treated as unsecured creditors. Together, they represented more than 80% of unsecured claims.

The plan provided that the debtor would pay his “disposable income” to unsecured creditors under Section 1129(a)(15)(B). The debtor was the disbursing agent under the plan and was obligated to give his creditors a report on disposable income three times a year. There was no disposable income in the first two years. After two years, he stopped making reports.

At the end of seven years, the debtor did not make the balloon payment on the first mortgage. He claimed there had been no disposable income and therefore nothing owing to unsecured creditors. The first mortgagee filed a motion to dismiss the chapter 11 case or convert to chapter 7.

What Is Disposable Income?

Judge Klein first addressed the questions arising from the lack of definition given by the plan to “disposable income.” He said it was “certain” that “a ‘disposable income’ plan payment based on Section 1129(a)(15)(B) means actual disposable income, even though the plan confirmation standard . . . focuses on projected disposable income.” [Emphasis in original.]

Although “disposable income” means “income from all sources,” Judge Klein noted that the plan and disclosure statement only mentioned income from the motel business. He nonetheless found as a fact that disposable income meant income from all sources. He said the references to motel revenue were “understood not as a limitation on source of payment, but as a representation regarding the then-existing business plan.”

The distinction was important, because it turned out that the debtor had other income, although the amount was disputed.

There were other definitional problems. Were loss carryforwards permitted? Would depreciation be included in deciding whether there was disposable income?

Interpreting the plan as a contract governed by California law, Judge Klein construed the plan “most strongly” against the debtor regarding loss carryforwards and depreciation.

Reporting Responsibilities and the Burden of Proof

Next, Judge Klein dealt with the debtor’s reporting responsibilities arising from his service as disbursing agent. Whether the debtor had contractual or fiduciary duties to report, he said, “it adds up to a duty to account” for his actual disposable income.

The burden of proof was tricky. Ordinarily, the lender would have the burden of showing that the failure to report was a default under the plan. On the other hand, the debtor in an individual chapter 11 case has the burden of showing the completion of plan payments as a condition to receiving a discharge under Section 1141(d)(5)(A). In terms of discharge, it was therefore the debtor’s burden of showing there never had been any disposable income.

In other words, Judge Klein said, showing a material default on the plan and establishing the right to a discharge “are reciprocal and inextricably intertwined issues.”

Analyzing the evidence, Judge Klein said he “did not believe” the debtor’s testimony. He ruled that the failure to report was a default. He also found disposable income in some years, in part stemming from “undisclosed sources of income” outside of the motel.

For instance, the debtor made an $11,000 down payment on a $71,000 automobile 10 days after the end of the seven-year term of the plan. The facts, Judge Klein said, warranted an inference that the $11,000 was attributable to income during the 84-month term of the plan.

Finding that conversion was in the best interest of creditors, Judge Klein converted the case to chapter 7. He noted that conversion to chapter 7 “in principle” might salvage the debtor’s chapter 7 discharge. He said that the chapter 7 trustee would have the option of operating the hotel to foster a going-concern sale.