The 9th U.S. Circuit Court of Appeals has ruled that the strict language of the 2005 bankruptcy reform law allows higher-income debtors to limit the amount of money and time for repayment of debts, though lower-income debtors do not share the same benefit.

Also, the 9th Circuit held that bankruptcy judges must stick to the terms of the 2005 bankruptcy reform law even though it treats higher-income debtors better than lower-income debtors when it comes to calculating income available to pay creditors in Chapter 13 reorganizations.

“We may not make changes to the plain language of the Bankruptcy Code based on policy concerns because that is the job of Congress,” wrote Judge Eugene E. Siler, a visiting judge of the 6th Circuit sitting by special designation.

The decision provides a potential windfall for what the law defines as “above-median income debtors” because repayment plans can be created to pay creditors smaller amounts over shorter periods of time. Debtors in the “below-median income” classification must still make “reasonable” repayments for up to five years, the standard set by the statute.

First impression

The ruling, In re Kagenveama, 527 F.3d 990 (2008), makes the 9th Circuit the first in the country to come down on the side of following the literal letter of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 on the means test to calculate “projected disposable income.” The ruling allows the repayments to be for periods shorter than five years, meaning that if a debtor received a windfall after the shortened repayment period, the creditor would have no recourse to collect.

In the 2005 reforms, Congress removed the discretion from bankruptcy judges in setting “reasonable” repayment plans for higher-income debtors and set up its own schedules based on the most recent six months of disposable income.

This creates an incentive for a higher- income debtor “to fiddle with his expenses and income just before he presents his creditor plan for confirmation,” wrote Judge Carlos Bea in dissent. “So long as he can push up his expenses and delay receipt of income so as to show no ‘disposable income’ at the time of plan confirmation, he can propose such a short period of time that he can save any postponed income from the creditors’ clutches.”

“This case is a giant for the 9th Circuit,” said M. Jonathan Hayes, an adjunct professor at the University of West Los Angeles School of Law, who helped file an amicus on behalf of the National Association of Consumer Bankruptcy Attorneys in support of the debtor, Laura F. Kagenveama.

“I know a whole bunch of lawyers in [Southern California] filing cases proposing [repayment] plans using the means test and a six-month plan of nominal payment, even if the person can clearly pay more,” said Hayes of Woodland Hills, Calif.

Bankruptcy courts around the country have been torn about whether to apply the rule as written by Congress or to declare “potential disposable income” a starting point to calculate what a high-income debtor can actually afford to repay.

“A mess on their hands”

A 9th Circuit Bankruptcy Appellate Panel, in November, came down on the opposite side of the circuit’s Kagenveama decision, in Pak v. eCast Settlement Corp., 378 B.R. 257 (2007).

In Pak, the Bankruptcy Appellate Panel held that the historic definition of “disposable income” is merely a “starting point” to determine “projected disposable income” that a debtor can devote to payment under the 2005 law.

“[Kagenveama] is a huge message to Congress that they’ve got a mess on their hands and they can’t leave it to the courts to fix it,” said Judge Keith Lundin, a bankruptcy judge for Tennessee’s Middle District and author of Chapter 13 Bankruptcy (3d ed). Bankruptcy trustees around the country warned Congress in 2005 this would be a problem, but they ignored it, Lundin said.

Hayes predicted “major divisions among the circuits” over this issue. “This Supreme Court will have to take it at some point,” he said.

The current dispute began when Chapter 13 trustee Edward Maney of Arizona challenged a repayment plan by Kagenveama when her bankruptcy petition showed she had an income of $74,000 a year and $1,500 per month in disposable income to dedicate to paying creditors. But as an above-median-income debtor, she was required to recalculate her living expenses under Section 1324(b)(3), leaving her with zero in disposable income.

She volunteered to repay $1,000 per month for three years, rather than the typical five-year commitment period. The trustee appealed, and the 9th Circuit agreed she could limit her repayment to three years at the lower amount, even though her income projections realistically showed a greater ability to pay.

Justice Department spokesman Charles Miller declined to comment on the whether the case would be appealed.

Kagenveama’s attorney, Andrew S. Nemeth of Phillips & Associates in Phoenix, could not be reached for comment.