Timing Is Everything...or Is It Cortez Challenges the Snapshot Approach to Analyzing Abuse Pursuant to 707(b)

Journal Issue

Oct 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 8, p. 1, October 2006

Bankruptcy Code

707

Topic Tags

Consumer Bankruptcy

Discharge/Dischargeability

Journal HTML Content

"You can never plan the future by the past." 
-Edmund Burke
</blockquote>
It
has been said that life is all about timing. This is especially true when examining
someone's financial status. Someone could be solvent today and insolvent tomorrow
(or vice versa). Timing is also crucial when analyzing a prospective debtor's
chapter 7 bankruptcy options. When a debtor is consulting with counsel regarding
financial options and bankruptcy eligibility, the present status of the debtor's
assets, liabilities and income are carefully examined. The debtor's information
is then usually processed to determine if nonbankruptcy options are feasible
as an alternative to bankruptcy options. The bankruptcy analysis entails determining
a debtor's eligibility to discharge debts, as well as an ability to exempt assets.
In addition, a debtor's current monthly income and expenses are examined to
ensure that it would not be "abuse" to grant the debtor a chapter
7 discharge pursuant to 11 U.S.C. §707(b). If the chapter 7 debtor appears
to have the ability to repay his or her debts based on current income and expenses,
grounds for dismissal pursuant §707(b) may exist. This analysis is crucial
since the enactment of the 2005 Bankruptcy Abuse Prevention and Consumer Protection
Act (BAPCPA), as the newly created "means test" enumerated in §707(b)(2)
requires a more precise examination of the debtor's income for the six-month
time period "ending on the last day of the calendar month immediately proceeding
the date of the commencement of the case."
The Snapshot Approach to Analyzing §707(b)

Bankruptcy courts traditionally employed the "snapshot" approach
when examining a chapter 7 debtor's eligibility pre-BAPCPA. Under the snapshot
approach, the debtor is required to disclose the accuracy of his or her debts,
assets, income and expenses as of the day of the filing of the petition. In
essence, this gives the court and creditors a financial snapshot of the debtor's
status as of the petition date. Pursuant to this approach, most post-petition
changes in the debtor's finances such as incurring new debt, purchasing assets
and incurring a fluctuation (either up or down) in monthly expenses and/or income
are irrelevant for purposes of determining eligibility to obtain a chapter 7
discharge. Traditionally, these post-petition changes are irrelevant due to
the fact that they are outside of the snapshot that was created on the day the
petition was filed. Although there are some exceptions to this principle,1 generally
post-petition financial changes have little effect on chapter 7 eligibility.
Despite this long-standing snapshot principle, a recent decision from the U.S.
Court of Appeals for the Fifth Circuit has altered the traditional view.
Looking into the Future with Cortez 
In U.S. Trustee v. Cortez, 457 F.3d 448 (5th Cir. July 20, 2006), the
Fifth Circuit affirmed the decision of the U.S. District Court for the Northern
District of Texas to reverse a bankruptcy court decision to exclude a post-petition
increase in a debtor's income when evaluating abuse pursuant §707(b). The
case was then remanded back to the bankruptcy court for further proceedings.
Procedurally, Cortez involved a husband and wife who filed a joint chapter
7 bankruptcy on April 8, 2004. Debtors' petition showed a secured claim for
the mortgage on their house, and unsecured debt in the amount of $85,719 (the
majority of which consisted of credit card debt). In addition, as of the date
of filing, on Schedule I the debtors listed their net monthly income as $4,417,
with Schedule J listing the monthly household expense payments as $5,320. Due
to Mr. Cortez's unemployment at the time of the bankruptcy filing, all of the
income was attributed solely to Mrs. Cortez's employment as a registered nurse.
Prior to Mr. Cortez's unemployment, the debtors reported a combined annual income
of $145,600 in 2003. The bottom of Schedule I requires the debtors to report
"any increase or decrease of more that 10 percent in any of the above categories
anticipated to occur within the year following the filing of this document.
In response, debtors reported that Mr. Cortez "believes he will be employed
this month, but he has not started working yet." In fact, four days after
filing for bankruptcy, Mr. Cortez did receive a job offer as a human resource
director for a large company. There is no evidence that Mr. Cortez had been
extended this job offer pre-petition. Mr. Cortez accepted the position and began
working on April 24, 2004. The position reportedly paid $95,000 (or $5,896 per
month), a $5,000 signing bonus after 60 days of employment, as well as making
Mr. Cortez eligible to use a company car. After becoming employed, Mrs. Cortez
voluntarily reduced her hours, and thus her net monthly income fell to $750.
These post-petition income changes resulted in the debtors' new income exceeding
their monthly expenses as listed in the petition by $1,328 per month.
Upon request of the U.S. Trustee, the debtors provided documentation evidencing
Mr. Cortez's post-petition employment position, and testified accurately regarding
the same at the §341 meeting of creditors. Shortly after the §341
meeting, the trustee filed a motion to dismiss pursuant to §707(b), asserting
abuse. Because this was a 2004 bankruptcy filing, the court applied §707(b)
prior to being amended by BAPCPA. The pre-BAPCPA provision of §707(b) stated
as follows:
<blockquote>

(1) After notice and a hearing, the court, on its own motion or on a motion
by the U.S. Trustee, but not at the request or suggestion of any party in
interest, may dismiss a case filed by an individual debtor under this chapter
whose debts are primarily consumer debts if it finds that the granting of
relief would be a substantial abuse of the provisions of this chapter. There
shall be a presumption in favor of granting the relief requested by the debtor.
In making a determination whether to dismiss a case under this section, the
court may not take into consideration whether a debtor has made, or continues
to make, charitable contributions (that meet the definition of "charitable
contribution" under §548(d)(3)) to any qualified religious or charitable
entity or organization (as that term is defined in §548(d)(4)).2 
</blockquote>
As expected, in response to the trustee's motion to dismiss pursuant to §707(b),
the debtors invoked the snapshot defense—i.e., that the petition
was completely accurate as of the day of the bankruptcy filing, and that it
would be error for the bankruptcy court to consider post-petition events in
deciding whether or not to dismiss the case. On Nov. 5, 2004, the bankruptcy
court agreed with the debtors' argument and denied the trustee's motion. Specifically,
the bankruptcy court held that events that occur after the filing should not
be considered when evaluating abuse under §707(b) "unless the events
were clearly in prospect at the time of filing for bankruptcy." The court
reasoned that analysis for abuse to be performed under §707(b) should occur
at the commencement of the case because the statute utilizes the term "granting
of relief," which the bankruptcy court indicated really meant granting
an "order for relief," which occurs at the commencement of the case
pursuant to §301. Thus, the bankruptcy court reasoned that it was required
to perform the abuse analysis as of the day of filing, and therefore could not
take into account Mr. Cortez's post-petition employment.
On appeal, the district court reversed the bankruptcy court, holding that the
plain language of §707(b) makes it clear that post-petition events are
to be taken into account because the statute specifically instructs courts not
to consider whether a debtor has made, or continues to make, charitable contributions.
According to the district court, this language is forward-looking and only restricts
viewing the future as to charitable contributions, not changes to income.
The issue on appeal for the Fifth Circuit was whether dismissal for abuse pursuant
to §707(b) includes consideration of post-petition events. The Fifth Circuit
first examined the bankruptcy court's conclusion that the undefined term "granting
of relief" was intended to refer to an "order for relief," thus
requiring the court to conduct its abuse analysis based solely on the time the
petition was filed. The Fifth Circuit disagreed, holding that although "granting
of relief" is undefined, contextually it is referring to relief in the
form of a discharge and not the relief afforded upon the initial filing of a
petition. In addition, the Fifth Circuit found that §707(b) "does
not condition dismissal on the filing of the bankruptcy being a 'substantial
abuse' but rather on the granting of relief, which suggests that in determining
whether to dismiss under §707(b), a court may act on the basis of any development
occurring before the discharge is granted."

After determining that pursuant to §707(b) post-petition factors can be
utilized to complete an abuse analysis, the Fifth Circuit then went on to examine
other circuits' treatment of §707(b). According to the Fifth Circuit, several
other circuits have ruled that a debtor's ability to repay his or her debts
out of future earnings is abuse, and specifically courts can consider whether
the debtor has sufficient disposable income to fund a chapter 13 plan. To bolster
their position, the Fifth Circuit noted that to assist courts with bankruptcy
eligibility, Congress enacted §521 in 1984, which requires a debtor to
file a schedule of current income and expenditures with his or her bankruptcy
schedules. In a chapter 13 case, debtors are required to amend their schedules
to include subsequent income, even if it is unknown and unanticipated at the
time of filing. In fact, the Fifth Circuit points out that examining post-petition
income in chapter 13 cases is commonplace based on §1329, which allows
the trustee to seek a subsequent modification of the plan based on an increase
in the debtor's income so that ultimately more money is paid to the creditors.
In affirming the district court's ruling, the Fifth Circuit abandoned the snapshot
approach as it applies to a chapter 7 debtor's income, and held that although
post-petition earnings are not property of the estate under §541(a)(6),
future earnings should be taken into account for purposes of determining abuse
pursuant to §707.
The Impact of Cortez Post-BAPCPA 
Although BAPCPA did make some changes to §707(b)(1) and added the complex
means-test requirement pursuant to §707(b)(2), Cortez is still a
relevant and important decision. In fact, if adopted by other circuits, Cortez
could invoke a major change in the way chapter 7 bankruptcies are analyzed,
planned and administered. Cortez has discredited the snapshot theory
as it applies to examining a debtor's income.

Duties of the Trustee Post-Cortez 
The Cortez holding now appears to require that bankruptcy trustees in
the Fifth Circuit be burdened with additional investigative duties. For example,
the trustees must investigate and look for post-petition improvements in income
in order to determine if abuse exists up until the point at which the chapter
7 discharge is issued. In addition, if a post-petition improvement in income
is discovered prior to discharge in which a debtor now fails the means test,
the trustee appears obligated to file a motion to dismiss for abuse pursuant
to §707. Thus, debtors who were eligible for chapter 7 relief pursuant
to the means test on the day the petition was filed may suddenly find themselves
ineligible for chapter 7 relief if they experience a post-petition/pre-discharge
change in income. If discovered, the trustee would then be required to file
a motion to dismiss. Additional questions remain pertaining to the scope of
the trustee's post-Cortez investigation duties. For example, does the
trustee's abuse inquiry require that the trustee ask about an upward change
in the debtor's post-petition income at the 341 hearing? Does Cortez
extend beyond that, and require that the trustee do a last check immediately
prior to the discharge issuing? If a post-petition debtor is actively seeking
employment, can the trustee extend the time to object to a debtor's dischargability
solely to buy more time so that the trustee can continue to check on possible
future changes in income?
Post-Cortez Planning for Debtors and Debtors' Counsel

If Cortez is widely accepted, it will also have serious repercussions
for debtors and debtors' counsel. The holding seems to encourage debtors to
maintain their post-petition financial status quo. For example, if an unemployed
debtor is eligible and files for chapter 7 relief, it would appear that the
debtor is better off to remain unemployed until the discharge issues. As discussed
previously, the concern is that if the debtor improves his post-petition income
by becoming employed, he may in fact improve himself out of eligibility based
on the means test. In addition, do grounds for dismissal exist if an employable
debtor voluntarily remains unemployed/underemployed simply in order to maintain
chapter 7 eligibility? It would appear that in addition to a debtor's counsel
carefully examining a debtor's current income, a hypothetical analysis may need
to be performed for the debtor regarding potential future income.
Cortez is not just a concern for unemployed debtors; the holding also has repercussions
for certain employed debtors. For example, debtors who receive a post-petition
pay raise, commission or bonus may all be susceptible to abuse dismissal motions.
Should an employed debtor now conduct post-filing financial planning, such as
deferring income increases until the discharge, and what is counsel's role in
recommending this evasive move?
Living in a Post-Cortez World 
Cortez appears to be statutorily well-reasoned, despite the fact that
the outcome is contrary to most practitioners' concepts of chapter 7 timing
and planning. If widely adopted, discarding the snapshot theory of income will
likely increase the costs and time for debtors, debtors' counsel, the trustees
and the bankruptcy court. As future income always has some degree of uncertainty,
for the time being debtors in the Fifth Circuit will file chapter 7 bankruptcies
without knowing their discharge eligibility until the final order is issued
by the bankruptcy court. Until such time, debtors will have to rely on the adage
"timing is everything," and hope their timing will allow everything
to turn out as anticipated.
<blockquote>
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</blockquote>

<hr>
<h3>Footnotes</h3>
 1 For example, 11 USC §541(a)(5) requires that debtors must disclose
information beyond the snapshot if they become the recipient of a gift, inheritance,
divorce property settlement, or life insurance proceeds within 180 days following
the date of the filing of the petition. 
2 Although it should be noted that BAPCPA did make textual modifications to
§707(b), it is the author's belief that the changes are not substantial,
nor would it have changed this analysis and outcome even if this were a post-BAPCPA
case.

Journal Authors

Justin H. Dion

Journal Date

Sunday, October 1, 2006 - 12:00

Bankruptcy Rule

2006

none