Bankruptcy has always favored business debtors over consumer debtors. Bankruptcy Code Section 707(b) specifically reflects this: it allows consumer debt cases to be dismissed if abusive but not business debt cases. ‘Abuse’ usually means a debtor with sufficient income to pay necessary household expenses and still pay money to creditors. But historically, bankruptcy in America has allowed people who pursue business to start over; forgiving failure is essential to encouraging success.
A recent case in Michigan threatens this policy. There, a bankruptcy judge could not get past the gratuitous opulent lifestyle of a pair of upper class debtors and allow them to walk away from a Florida land deal gone bad. In re Rahim & Abdulhussain; Bankr. Eastern District of Michigan, Southern Division Chap. 7 bk #10-57577; Hon. Steven Rhodes; decision Dec. 16, 2010 (on appeal.)
The details of the Debtors’ lifestyle are admittedly hair-raising, when compared to the debtors we see every day in bankruptcy court. The debtors jointly operate a medical practice. Their monthly income is $39,400, not including personal expenses paid directly by the business, such as the cost of two Mercedes and a BMW. They live in one of the wealthiest suburbs of Detroit – Bloomfield Hills – and still send their kids to private school. They support other members of their extended family. They maintain a vacation home in Florida, and own a third house, which is apparently rented out at a loss.
They have $6.6 million in unsecured debts, mostly from failed real estate investments in Florida. Two of these creditors, Pacifica Loan Four LLC ($3.8 million) and David Bartley ($329,000) filed motions in bankruptcy court asking for the case to be dismissed. Note that neither the trustee nor the United States Trustee joined in this motion (an attorney for the trustee testified that was probably a $200,000 asset case; not a lot of trustees would want to walk away from that payday.) Because Sect. 707(b) was not available in this case, as business debt greatly exceeded the consumer debt, the creditors moved under Sect. 707(a), saying the case should be dismissed “for cause.”
“For cause” is quite an elastic concept. 707(a) lists as possible causes the failure to pay the filing fee or file schedules withing 15 days, or unreasonable delay prejudicial to creditors. Case law shows that “for cause” can also include a case filed in bad faith. In most cases I am aware of, bad faith usually refers to defrauding a single creditor and then filing a case basically to escape that fraud. But there is at least one case, the Sixth Circuit Court of Appeals had stated that Sect. 707(a) bad faith could include the same elements as Sect. 707(b) abuse: the ability of a debtor to repay was one of the major factors in In re Zink;
931 F2d 1124 (6th Cir. 1991.) But in Zink, the court found the debtor had arranged his bankruptcy filing to single out one creditor for discharge, a debt arising out of a “malicious breach of a noncompetition agreement” (Zink at 1129). The Zink court explained that a 707(a) dismissal for bad faith is “generally utilized only in those egregious cases that entail concealed or misrepresented assets and/or sources of income, and excessive and continued expenditures, lavish lifestyle, and intention to avoid a large single debt based on conduct akin to fraud, misconduct, or gross negligence.” Zink at 1129; emphasis added).
But in the Rahim case, the court did not cite any egregious behavior in respect to the creditors bring the motion (or any other creditors.) Nor did the court find the debtors misrepresented assets (the debtors’ scheduling of income in a confusing and misleading fashion was subject to criticism.) Rahim concentrated exclusively on the lavish lifestyle of the debtors, and their failure to ‘tighten their belts’ was the sole basis for finding the bankruptcy petition was filed in bad faith.
It is hard to justify debtors as wealthy as these getting a bankruptcy discharge while more modest middle class debtors have their income and expense examined in excruciating detail in Sect. 707(b) abuse inquiries. Especially in Detroit, one of the most distressed metro areas in the country, debtors whose Beemer is their down-market third car will garner little sympathy. Never the less, Congress intended to encourage honest, ambitious entrepreneurship by allowing a failed business person to go bankrupt and, in exchange for surrendering all non-exempt assets to a trustee, obtain a fresh-start discharge.
Rahim states that the intent of Congress in this regard cannot be so easily divined. “If Congress fully intended to allow chapter 7 relief to a debtor with primarily business debt regardless of income, expenses, ability to pay or lack of need, surely it would have so stated explicitly in the bankruptcy code.”
Rahim, pg 9.
Frankly, I think Congressional intent is explicit. When originally enacted in 1978, the Bankruptcy Code did not have the ‘abuse’ provisions of Section 707(b); that sub-section was added in 1984 and only applied to consumer debt cases. To rephrase, Congress added the ability-to-pay provision as an amendment to the original “for cause” section, and only in consumer cases. If the original “for cause” language already included the authorization to dismiss cases due to ability to pay, there would have been no need to amend the section.
If there was any question as to Congressional intent in adding Sect. 707(b) in 1984, was it not reemphasized in 2005 with BAPCPA? Revising Section 707(b), by adding the ‘means test’, broadening ‘substantial abuse’ to simple ‘abuse’, and allowing creditors (not just the US Trustee) to file abuse motions in above-median-income cases was the cornerstone of that legislation and the ‘means test’ in particular dominated congressional debate. Yet the limitation of Sect. 707(b) to consumer cases was left intact, and the current means test form 23 is entirely inapplicable if the majority of the debtor’s claims are business-related.
In my analysis, Rahim goes way beyond Zink by finding ability to repay, by itself and with no finding of ‘fraud, misconduct, or gross negligence’ against a creditor, bad faith in a business debt case.
Other circuit courts have gone the other way in this area. The Third Circuit, in
Perlin v. Hitachi Capital, 497 F.3d 364 (2007), specifically warned that such a 707(a) “dismissal would essentially be based upon a debtor’s mere ability to repay, which is expressly prohibited by the legislative history.”Perlin at 374. The Eighth Circuit, in In re Huckfeldt, 39 F3d 829 (1994) agreed with a lower court opinion in another case that “bad faith under § 707(a) be limited to extreme misconduct falling outside the purview of more specific Code provisions, such as using bankruptcy as a ‘scorched earth’ tactic against a diligent creditor, or using bankruptcy as a refuge from another court’s jurisdiction.” Huckfeldt at 832, citing In re Khan, 172 B.R. 613, 624-26 (Bankr. D. Minn. 1986.) The Ninth Circuit doesn’t even accept that bad faith is grounds for a Sect. 707(a) dismissal at all (In re Padilla, 222 F3d 1184 (2000)).
In any case, the bankruptcy court may not be the last word on this case; according to the court docket, the Rahim case has been appealed to District Court.
I woul like to express my appreciation to attorney Christopher K. Werner at Boylan, Brown for bringing this case to my attention.