Bankruptcy Reform Act of 2005: A New Landscape
Roxane DeLaurell and Robert Rouse
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.
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.
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.
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.
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.
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
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 (www.uscourts.gov/bnkrpctystats/bankruptcystats.htm)
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.
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
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.
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.
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.
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.
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.
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
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.
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.
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
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.
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.
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.
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.
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.
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
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.”
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
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.
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.
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.
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
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
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.
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.
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.
broad conclusions with implications for business may be
drawn from a summary review of the Act.
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.
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.
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.
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.
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.
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,