Following its own precedent and declining the government’s invitation to create a circuit split, the Ninth Circuit held that the doctrine of recoupment “is not permissible where, as here, [the Social Security Administration] seeks to recoup overpayments it made absent any fault by a no-asset bankrupt beneficiary.”

In an era when the equitable powers of bankruptcy courts are eroding year by year, the Ninth Circuit announced that equity is alive and well to bar application of the doctrine of recoupment when the government’s mistake led to overpayments.

Simply put, recoupment is a creature of equity that requires consideration of equitable factors.

The Receipt of Retroactive Disability Payments

Injured at work in 2007, the debtor was permanently disabled and began receiving workers’ compensation of almost $5,000 a month. Without counsel, the debtor applied for Social Security disability benefits in 2017 that were denied. Hiring counsel, the debtor appealed and was found entitled to disability benefits by an administrative law judge in 2019.

The government sent the debtor a questionnaire where he accurately reported receiving workers’ compensation benefits. Having failed to record the workers’ compensation benefits, the government awarded the debtor $2,000 a month in disability benefits beginning in 2019 plus more than $73,000 in retroactive payments.

Several months after the award, the debtor filed a chapter 7 petition. The debtor quickly received a discharge in his “no asset” case where creditors were not required to file claims. Whether or not a creditor filed a claim, claims were discharged because it was a no-asset case. See Section 727(b).

The Social Security Administration did not receive notice of the bankruptcy since the debtor had not listed the government as a creditor. The debtor did not list the Social Security Administration because there had been no claim of overpayment by the government.

The Recoupment of Overpayments

Two years after bankruptcy, the government sent the debtor a notice saying that he was not entitled to the $73,000 in retroactive benefits because he had been receiving workers’ compensation. Exercising its rights under the Social Security Act, the government began withholding payments to recover the overpayment.

The debtor’s lawyer notified the government about the bankruptcy and said that the debt had been discharged. Counsel explained that debts in a no-asset case are discharged without notice to creditors.

Several months later, the debtor reopened his bankruptcy case and moved to hold the government in contempt for violating the discharge injunction. The bankruptcy court ruled in favor of the government, and so did the Bankruptcy Appellate Panel in a nonprecedential opinion on appeal.

Sitting by designation, District Judge Richard D. Bennett explained in his March 20 opinion for the Ninth Circuit how the BAP decided that recoupment allowed for recovery of the overpayments.

Judge Bennett said that the “BAP effectively ended its inquiry” after determining that “recoupment was permissible because the overpayment and ongoing entitlement to benefits were logically related: they arose from the same disability period, disability, trust fund, and statutory scheme.” In other words, the BAP believed that “the logical relationship test precluded consideration of the equities, such as [the debtor’s] lack of fault in [the] overpayment.”

The debtor appealed to the Ninth Circuit. Judge Bennett stated the question as being “whether the [government] may recoup [disability] benefits it overpaid, through its own error, from a beneficiary who has already received a no-asset discharge in bankruptcy.”

The Government’s Fault Bars Recoupment

Judge Bennett explained how the Social Security Act allows recovery of overpayments through, among other things, reductions in future benefits or reducing tax refunds. The government took the position that the recovery was permissible through recoupment, an equitable remedy that permits recovery of discharged debts.

Explaining the differences between recoupment and setoff, Judge Bennett said that setoff applies between “different” transactions. Unlike setoff, “recoupment enables a creditor to recover discharged debt that would otherwise be” discharged in bankruptcy. Therefore, he said that recoupment “carries extraordinary power to undermine the fundamental purpose of the Bankruptcy Code by enabling creditors to evade the discharge injunction and collect discharged debts.”

The government contended on appeal “that the logical relationship test permits consideration of only the factual and legal connections between the countervailing obligations.” However, Judge Bennett explained that “recoupment is governed by the logical relationship test, which asks whether the countervailing obligations at issue arose from the same transaction or occurrence such that recoupment is equitable.”

Most notably citing Newbery Corp. v. Fireman’s Fund Ins. Co., 95 F.3d 1392 (9th Cir. 1996), Judge Bennett said, “Our prior decisions make clear that our logical relationship test demands consideration of both equitability and the purpose of the Bankruptcy Code.” He said that the Ninth Circuit was publishing a precedential opinion to “clarify that the logical relationship test demands consideration of the fundamental purpose of the Bankruptcy Code and of the equities in each case.”

Citing Ninth Circuit precedent, Judge Bennett said that “the factual and legal relationships between countervailing obligations alone cannot justify recoupment unless they establish that recoupment is equitable on the facts of the case.” Indeed, he said, “We have never held that the logical relationship test precludes consideration of the equities.” He cited the First, Second, Third and Eighth Circuits as requiring consideration of the equities before applying recoupment.

On the facts of the case, Judge Bennett said that “the application of recoupment to [the debtor’s] case was inequitable and incongruous with the fundamental purposes of both the Bankruptcy Code and the Social Security Act.” Why? Because “recoupment undermined the fundamental purpose of the Bankruptcy Code and deprived an innocent beneficiary of his income in violation of the fundamental purpose of the Social Security Act.”

In terms of equitable factors, Judge Bennett noted that the debtor was not told about the overpayment until two years after discharge. Of perhaps greater significance, he said there was “no evidence that [the debtor] engaged in conduct that would make it inequitable for him to retain the benefit of the overpayment. Both parties agree that the overpayment occurred at least in part due to [the government’s] own processing error.”

The government argued that the debtor had failed to pursue administrative remedies. The failure to take an administrative appeal “does not constitute inequitable behavior,” Judge Bennett said. He added, “There is no requirement that a debtor utilize administrative remedies before reopening a bankruptcy proceeding based on a creditor’s alleged violation of the discharge injunction.”

Judge Bennett reversed and remanded for the BAP to remand to the bankruptcy court “for further proceedings consistent with this opinion.”

Acknowledgments

The debtor was represented by Marc S. Stern of Seattle.

The National Consumer Bankruptcy Rights Center and National Association for Consumer Bankruptcy submitted an amicus brief on behalf of the debtor and participated in oral argument. The amicus brief was authored by Thomas Moers Mayer of Kramer Levin Naftalis & Frankel LLP, New York City.

In a footnote, the opinion by Judge Bennett acknowledged participation by the amicus.