California bankruptcy court rules that five debtors infringed upon creditors' rights to object

By Tara Mapes | Oct 18, 2016

SAN FRANCISCO -- Five California debtors made modifications to their Chapter 13 bankruptcy model plans that violate the bankruptcy code, according to a bankruptcy court in California.

Judges M. Elaine Hammond and Stephen L. Johnson of the U.S. Bankruptcy Court for the Northern District of California concluded that the debtors were failing to notify the trustee and court of modifications to the plan, which infringed on the creditors’ rights to object.

"Debtor's attempt to construct a plan that authorizes modifications without notice to parties in interest eliminates creditor's rights to object to the modification and flouts [the law]," the judges wrote. "Debtors cavalierly state that creditors are not entitled to any notice of an early termination if the plan paid them nothing. Why would a creditor care, they argue, if the creditor received $0 in 30 months or $0 in 60 months? This line of argument is both illogical and contrary to the exacting provisions of the bankruptcy code.”

The court contended that the additional provisions added by the debtors seek to perpetuate the practice of terminating plans early. The court said it stands to reason that creditors would be interested to know why a debtor who proposed a plan of 60 months, with no payments to unsecured creditors, was able to pay that plan off in only 30 months and receive a discharge.

The modifications made by debtors to the model plan permitted them to pay off their plans at any time and obtain a discharge without going through the modification process or to have their plans reviewed by the court to determine if they had the means to pay off other unsecured claims, the court noted. The debtors did so by including  "modifications" to the model plan without providing notice through a motion to the court, according to court documents.

"Because the plan is confirmed based upon the facts at that time, it is common that the plan does not make an explicit provision for increased income," Candace Carlyon, an attorney with Morris, Polich and Purdy, and a certified business bankruptcy specialist, told the Northern California Record. "Generally, the creditors or the trustee will have the burden of coming in and seeking to modify the plan based on that change in circumstance. But to foreclose the possibility is to take advantage of the system. Kudos to the judges for catching this and acting.”

The decision read, “the apparently long-standing practice in the San Jose division that permits confirmation of Chapter 13 plans without a defined term that allows no possibility of distribution on allowed claims of general unsecured creditors, and that permits debtors to obtain a discharge prior to the end of the estimated term without further court order. All in all, these provisions are intended to authorize debtors to pay off their plans and obtain a discharge at any time after confirmation without having to go through the plan modification process and without having to pay allowed unsecured claims in full.”

The judges wrote that the modifications to the model plan are inconsistent with the plans throughout the state and bankruptcy code in application. The judges wrote in their decision, “Because of the way the practice has developed in this division, we determine that each and every plan shall have a stated length and any substantive variation from that length will require a motion to modify. Although not cited by debtors, several well-reasoned decisions have concluded that a Chapter 13 plan must run to its stated length.”

Filing a Chapter 13 bankruptcy

The process for filing a Chapter 13 is that a debtor agrees to submit some or all of his or her future earnings or other future income to a standing Chapter 13 trustee. The trustee accumulates this money and uses it to pay creditors' claims. The plan serves as a tool for a debtor to alter certain obligations such as a secured creditor or to cure a default on his mortgage, according to court documents.

The length of a Chapter 13 plan can vary based on income after repayment of certain expenses and total obligated repayment terms under the plan. While plans typically last between three and five years, many factors play a role in creating a "potential" plan length.

The five debtors argued that because there was no objection by the trustee or creditors in these cases that no minimum plan length is required. However, the court found the lack of an objection does not negate the intention of the law, which is that debtors repay obligations based on ability and excess funds be used to pay obligations. Additionally, the court found the debtors didn’t provide notice of modifications to the trustee or creditors to permit a fair review and determination of whether they had an objection.

“The issue with the debtors’ approach is that the debtors were taking advantage of the rules by not filing a notice to modify,” Carlyon said. “If there is an objection, the plan must pay net income over five years. There is not an order to determine which creditors are paid, rather the plan will provide an amount that goes to each class of creditors, the trustee, the debtors counsel, secured claims and if there is anything left over, that amount is distributed pro rata to unsecured creditors.”

The debtors argued that it’s not the court's place to review plans, which received no objections. The court wrote, “They apparently believe the plans should be summarily confirmed given the absence of an objection. To comply, the bankruptcy court would be required to abdicate its duty to ensure that Chapter 13 plans comply with the law, a duty that must be discharged even where there is no objection to confirmation.”

Background on the model plan

Pursuant to local bankruptcy rules, the court may approve and require the use of practice forms, or model plans. These forms may be adopted on a district-wide or division-wide basis.

The judges of the Northern District decided to draft a model Chapter 13 plan for the entire district in 2012 to establish uniformity in filings with a practical, efficient and effective plan. San Jose did not adopt the plan at that time, but the decision says in late 2015, the judges in the San Jose division announced that they would adopt it. This likely contributed to additional scrutiny by the court for plans submitted that did not align with the model.

At the confirmation hearings, the court expressed its concerns about the nature of the additional provisions in these cases and made some preliminary comments about the plans' confirmability. Because of the convolution of the issues, the absence of a trustee objection and the need for certain factual findings, each case was scheduled for an evidentiary hearing.

The court’s identification of the nonconformance led to the hearing and this decision. 

“Specifically, the debtors have added language to the model plans that prohibit the trustee from distributing excess funds. Under the San Jose form plan, any additional funds received above the stated percent or amounts were returned to debtors unless the trustee obtained an order modifying the plan authorizing distribution of the funds. The debtors wanted to perpetuate this practice,” Carlyon said.

The debtors contended that requiring a model plan’s use is a local rule that is inconsistent with acts of Congress and should be invalidated. The court responded, “The model plan is neither unlawful nor a violation of any party's rights because it faithfully follows applicable law, unlike the proposed additional provisions.”

"The problem is the inattention. A creditor might not pay attention and depending on the workload of the court, the trustees may not, either,"  Carlyon said.

She said that on a practical level, she agrees that the court can be overwhelmed by filings, but in the case of Espinoza out of Tucson, Arizona, the judge ruled that the court committed an error in permitting non-dischargeable debts to be included in a plan that was binding. The judge said it was the court and trustee’s independent duty to not confirm plans that do not comply with bankruptcy rules. Essentially, the decision means regardless of the workload of the court, that does not negate the trustee or court’s obligation to review each plan and ensure it complies.  

“The court ruled it was the trustee’s job to do that. Judges should be applauded in this case, this is exactly what congress intended when it introduced the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 to ensure debtors who can pay creditors, do pay them. It is hard, but they did the right thing,” Carlyon said.

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U.S. Bankruptcy Court for the Northern District of California U.S. District Court for the Northern District of California, San Jose Division

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