Alabama Bankruptcy Lawyer Blog

Having never done much domestic relations work, I don't have much contact with dischargeability issues from a debtor's perspective. We all remember from a seminar that BAPCPA created an animal known as the "domestic support obligation" ("DSO"), and generally made liabilities in divorce situations, or DSO's, more difficult to avoid. This week, however, I had an inquiry that required a little research into the post-BAPCPA treatment of DSO's in Chapter 13 cases. At the risk if displaying my ignorance, there appears to be a difference in Chapter 13 and 7 with respect to DSO's.

In Chapter 13, the plan is subject to confirmation if it complies with the requirements of Section 1325. Among those requirements is the payment of any claim entitled to priority treatment under Section 507. Pursuant to 507(a)(1)(A), a DSO is entitled to priority treatment. Accordingly, if the plan is confirmed, and the debtor owes something from a divorce settlement or decree that does not qualify as a DSO (example, an obligation to pay attorneys fees), the plan does not have to pay it in full. Only those obligations within the definition of a DSO are entitled to priority.

Of course, the Chapter 7 discharge excludes DSO's from discharge under Section 523(a)(5). But in a bit of a catch-all provision, 523(a)(15) also excepts from the Chapter 7 discharge certain obligations owed to a spouse, former spouse or child of the debtor, that are not within the DSO definition. The language is broad, and basically covers any obligation to pay pursuant to a separation or divorce agreement that is incorporated into a state court decree. A common example that comes to mind is attorney's fees and the obligation of one spouse to pay and hold harmless on marital debts. In Chapter 7, the exception from discharge is accordingly broader. In Chapter 13, you don't have to pay the 523(a)(15) obligations to get a discharge.

Moral of the story? If you want an obligation to be non-dischargeable, you better make sure it qualifies as a DSO. In general terms, this means it must be in the nature of alimony, support or maintenance. Otherwise, he (or she) files Chapter 13 and only has to pay the claims that qualify for priority because they are DSO's. Anything else is a general unsecured claim. When in doubt, and if you are negotiating a settlement agreement, buy a little time with a bankruptcy attorney. If not, and the judge is writing the decree, just give some thought to how your evidence is presented. It's not enough for the judge to call it alimony, support or maintenance. Your evidence should point in that direction.

This very brief post involves a decision that created quite a stir when released, and again when affirmed. United Rentals has petitioned the Supreme Court for a writ of certiorari to review a decision out of the 4th Circuit affirming a preference finding in a case where both bonds and statutory liens apparently assured payment. It will be interesting to see if the Roberts' court agrees to review the case, and if so, whether its "pro-business" leanings are apparent.

The facts: Partition is a subcontractor on two jobs and had rented equipment from United. Partitions ends up in Chapter 7. Within 90 days of bankruptcy, Partition had paid United $75,800. The trustee sought avoidance as a preference.

United argued that since the jobs were bonded, the trustee could not prove it received more than it would have received in liquidation. United also argued new value, since it had released its rights to bond recovery and assertion of a statutory mechanics' or materialmans' lien under North Carolina law.

The bankruptcy court, District Court and the 4th Circuit all concurred: the payments were avoidable as preferences under Section 547. I'm going to keep a close eye on this one. As a Chapter 7 Trustee in a depressed (or "recessed") economy, I'm seeing some contractors in bankruptcy, although frankly, most of my debtor contractors aren't paying anyone within 90 days of filing. United Rentals is, however, an important case, and the Supreme Court's ruling on the petition will I'm sure be anxiously awaited.

My A/C is out, it is 96 degrees outside (SE Alabama) and 89 degrees in the house, the World Cup is over (kind of dull, wasn't it), and what better to do than check email alerts for interesting bankruptcy decisions. This one is noteworthy for both trustees and debtors alike, and indirectly, unsecured creditors.

During the administration of their case, the debtors paid taxes owed to the IRS. Debtors thereafter filed proofs of claim as priority claims for the amounts paid to the IRS. The trustee apparently interposed no objection, and submitted his final application to the court proposing to pay the priority claims filed by the debtors, leaving nothing for distribution to other creditors.

There were, according to Judge Speer, Northern District of Ohio, "two glaring problems with the debtors' position." The case is In re Sarnovsky, 09-30037, July 6, 2010, Northern District of Ohio.

First, priority status under Section 507(a)(8) is expressly afforded only to claims filed by a "governmental unit." Noting that a debtor is defined as a person in Section 101(13), the court held that by implication an individual debtor cannot be a "governmental unit."

Second, by definition a "creditor" is an entity with a claim against the debtor. Since the law does not recognize the right of an entity to enforce a claim against itself, it stands to reason that a Chapter 7 debtor cannot also be a creditor in the same case. The end result is a windfall for the other creditors in the case. The IRS is paid with non-estate funds of the debtors, and is out of the way. The debtors payment is essentially gratuitous (although I doubt debtors have a warm, fuzzy feeling as a result of their generosity), and creditors who would otherwise have received no dividend now receive one.

One might ask: could the priority claim held by the IRS have been assigned to the debtors? I've been down this road informally, and have been told by the IRS and by state agencies that claims either cannot or will not be transferred or assigned. Either pay it off, or don't.

For a bit of clever lawyering, and use of an equitable subrogation argument where a buyer at foreclosure paid taxes to extinguish an IRS right of redemption, see ,Bevan v. Socal Communication Sites, LLC, 327 F.3d 944 (9th Cir. 2003). Buyer bought the property at foreclosure, paid off the taxes owed to IRS, then requested a notice of transfer of claim pursuant to Federal Rule of Bankruptcy Procedure3001(e) (which the clerk honored), and then sought to amend the claim up to the amount of taxes it paid. At the end of the day, the Bankruptcy and District Courts bought into it, but the Ninth Circuit reversed. While not "on point" with the subject of this post, it is close, and one pretty neat piece of legal work.

Debtors write checks, then file Chapter 7 with the balance shown on Schedule B, but before outstanding checks have cleared their account. Is the balance in the bank on the date of filing an asset of the Bankruptcy Estate? Clearly it is, but that is not the problem. By the time the Trustee looks into it, the checks have cleared, and the question becomes: Does the trustee seek recovery, and from whom does the trustee recover the money---the debtor(s), or, the recipient of the funds evidenced by the check?

First a practical comment. Most debtors in Chapter 7 aren't going to have much of a bank balance, or they wouldn't be in Chapter 7. So from a pragmatic point of view, in the vast majority of cases the money at issue is not enough to warrant a turnover action. But, I need something to talk about in this post, so play along with me and assume the debtor had a large bank balance just before filing, wrote out several large checks, and one or more had not cleared. Rather than my pursuing payments as a preference, for which the recipient may have defenses, I would rather just say those were estate funds, now give them back, or lose your discharge (in the event of the debtors) or get sued for turnover (in the case of the recipient). So let's look at some law.

Here's the opening paragraph of In re Pyatt, 486 F.3d 423 (8th Cir. 2007):

"Gary Wayne Pyatt filed a voluntary petition for chapter 7 bankruptcy relief. His petition did not list several checks which had been written prior to his filing but not yet honored. The trustee moved to compel Pyatt to turn over to the estate the value of these checks which amounted to $1938.76. The bankruptcy court granted the motion, and Pyatt appealed to the bankruptcy appellate panel1 which reversed. Pyatt v. Brown (In re Pyatt), 348 B.R. 783 (8th Cir. BAP 2006). The trustee appeals, and we affirm."

So the 8th Circuit did not allow the Trustee to recover the funds from the debtor. The court's reasoning was that by the time the Trustee sought turnover, the debtor no longer had control of or possession of the funds. The checks had long since cleared. The debtor therefore had nothing at that time to turnover. Trustee argued that the critical date was the petition date--that if debtor controlled it then, that was sufficient. The court disagreed, however, and did not allow recovery from the debtor. Trustee would have to recover the funds from the recipient.

Now to the point of all this. In a recent decision out of Florida Middle, In re Brubaker,2010 WL 1260131 (Bkrtcy.M.D.Fla), Judge Paskay saw it differently. The court first found that the balance in the bank accounts on the petition date were property of the Bankruptcy Estate. The money did not leave the account when the checks were written or delivered, but when they were paid or honored by debtors' bank. Fine. What happens next?

The court, though sympathetic to pro se debtors who exhibited no indicia of bad faith, held that the debtors were required to turn over the non-exempt portion of the bank account, in the amount that existed on the petition date, and without any reduction for checks that cleared after the bankruptcy was filed.

Harsh result? I don't think so. The debtors controlled the checkbook and controlled the timing of writing and delivering checks as well as the timing of the filing of their bankruptcy. While they may not have been acting in bad faith, they were nevertheless driving the train, and should bear the burden of any derailments.

You're in the business of selling equipment, and want to cash in by financing, but don't want the hassle of preparing security agreements, filing financing statements, and heaven forbid, repossessing and disposing of collateral in a commercially reasonable manner. So you and your lawyer come up with the idea of leasing instead. Since title never passes, you just go get your equipment if they don't pay.

Right? Well, maybe not!

The age old issue is simply this: if it is a true lease, then fine. Title does not pass, and in case of bankruptcy, the equipment is not part of the bankruptcy estate. If, however, the lease is a disguised conditional sales agreement, then as trustee my next question is "show me your financing statement." Most of the time, there is no financing statement, the property enters the bankruptcy estate, and the "lessor" is now an unsecured creditor.
Here are examples of what I look for as trustee when examining leases, along with a little law for good measure. Note that no one factor is necessarily conclusive, and the courts will look at the totality of the circumstances to determine the intent of the parties.

1. Nominal value purchase option: at the end of the lease term, the "lessee" has the option of purchasing the leased property for nominal value. This is one big red flag. The value at the end of the term should bear some reasonable relationship to the actual value of the property at term's end.

2. Lessee bears risk of loss or damage: if under the lease, the lessee bears all risk of loss, then by inference lessor has essentially conveyed its interest in the property and passed it to lessee, who bears all risk of loss. Or, there is an option to renew the lease for nominal consideration for the remaining economic life of the property; same thing as buy it for nominal value.

3. Lessee bears all maintenance responsibility: this is self-explanatory, and the rationale is the same as #2.

4. Lessee pays all insurance and taxes.

5. The lease is personally guaranteed: why, you might ask, does this matter? If the transaction is truly a lease, and title never passes and you can go pick up your goods, why do you need a guaranty? The presence of a personal guaranty may not alone be sufficient, but it sure makes my nose twitch. See, In re Wakefield, 217 B.R. 967,971 (Bkrtcy. M.D. Ga. 1998)

6. Can the lessee walk away: if the lessee can walk away with no obligation to pay for the goods, this is an almost conclusive indication of a "true lease." Frankly, however, I have never seen such a lease.

Now for some law. First, the question of whether a transaction is a lease of secured transaction will always be one of state law. This implicates some choice of law issues, but that is another subject for another day. And in most every case, it won't matter a great deal because the starting point will be the Uniform Commercial Code.

Your statutory law is Ala. Code, Section 7-1-203, entitled "Lease distinguished from security interest," which is substantively identical to former Section 7-1-201(37).

For a very well reasoned review of the factors to be considered, see the opinion of Judge Keith Lundin in In re Puckett,, 60 B.R. 223 (Bkrtcy. M.D. Tenn. 1986). Closer to home, see Judge Cohen's opinion in In re Winston,181 B.R. 589 (Bkrtcy. N.D. Ala. 1995).

For the view of the IRS, see REV. RUL. 55-540, 55-2 C.B. 39, setting out nine plus factors to consider in distinguishing between a conditional sales agreement and a lease.

And here are the factors considered notable by Professor Barkley Clarke in his often cited treatise The Law of Secured Transactions:, which I set out in the event you don't have immediate access to this treatise:

(1) Is the lessee obligated contractually to pay the full purchase price? If so, the transaction smacks of purchase financing. Some cases use this factor as the only necessary evidence of a disguised secured transaction.

(2) Is there a purchase option and, if so is it nominal? In assessing this critical factor under U.C.C. Section 1-201(37), the court should compare the option price with the anticipated fair market value of the property at the time of exercise, as viewed from the inception of the transaction. Alternatively, the courts have compared the option price with total rentals over the lease term or with the original cost of the goods. The bottom line is the economic reality of transaction, that is, would any lessee in its right mind fail to exercise the purchase option?

(3) Is the lease term equivalent to the economic life of the good? IF it is, there [**16] is no meaningful residual value for the lessor, thus suggesting a financing arrangement rather than a true bailment lease.

(4) At the expiration of the initial lease term, can the lessee renew indefinitely or for a period extending through the economic life of the goods? This factor is of course closely related to the prior two.

(5) Does the lessor retain any meaningful residual value in the goods? When the lessor parts with any residual value because of a termination adjustment clause in an open-end lease which allows the lessor to sell the goods at termination or default, collect any deficiency, or turn over any surplus to the lessee, the transaction looks more like a financing arrangement. In effect, the lessee is guaranteeing the residual value of the leased goods.

This should get you started. And again, let me emphasize that no one factor is conclusive. The court will examine the totality of circumstances and determine what the parties to the transaction intended--a true lease, or a conditional sales contract disguised as a lease. If the latter, you better be perfected.

Thanks for reading.