§ 106.5     Separate Classification of Nondischargeable Claims and Good Faith
Cite as:    Keith M. Lundin, Lundin On Chapter 13, § 106.5, at ¶ ____, LundinOnChapter13.com (last visited __________).
[1]

Faced with good-faith objections to confirmation of plans that compromise claims that are or might be nondischargeable in a Chapter 7 case, many Chapter 13 debtors have responded by separately classifying the nondischargeable claim for more favorable treatment.1 Separate classification must satisfy the unfair-discrimination test in § 1322(b)(1).2 Good-faith analysis under § 1325(a)(3) and unfair-discrimination analysis under § 1322(b)(1) collide head on in this context. The collision is not pretty because good faith toward the victim of prepetition misconduct may be unfair discrimination from the perspective of other creditors.

[2]

If compromise of a nondischargeable claim is bad faith for purposes of § 1325(a)(3), can the debtor favorably classify the nondischargeable claim and solve the good-faith problem? Or is it out of the frying pan and into the fire for the debtor: if it is better faith to favorably classify the nondischargeable claim, is it then unfair discrimination to pay the nondischargeable claim more than other unsecured claims?

[3]

The tests for good faith under § 1325(a)(3) and for unfair discrimination in § 1322(b)(1) do not measure the same things. Good faith is generally treated as a test of the debtor’s honesty, motives and intent.3 Unfair discrimination measures the effect of the plan on creditors.4 The debtor’s prepetition misconduct may demand extra compensation to the creditor the debtor hurt; but that worthy sentiment almost inevitably burdens, perhaps unfairly, other (innocent) creditors with the wages of the debtor’s sins. Debtors have to search for the balance point between good faith and fair discrimination. Neither the reported good-faith cases5 nor the reported unfair-discrimination cases6 are much help.

[4]

The best strategy for debtors may be to propose a plan that favorably classifies the nondischargeable claim. If the court denies confirmation on the ground that the separate classification is unfair discrimination, the debtor can modify the plan to put all unsecured claim holders in a single class, compromising the nondischargeable claim with other unsecured claims at whatever percentage the debtor is able to pay. Objecting creditors are then put to the task of explaining that it is unfair discrimination to separately classify the nondischargeable claim and bad faith not to do so.

[5]

A few courts have dealt with the good faith of plans that compromise claims that would be nondischargeable in a Chapter 7 case by requiring the debtor to pay the claims in full through the plan.7

[6]

Requiring full payment of nondischargeable claims as the price of proving good faith turns on its head the unfair-discrimination test in § 1322(b)(1) in every Chapter 13 case in which the debtor is unable to pay all unsecured claims in full. If good faith requires full payment of the nondischargeable claim, then is it automatically fair discrimination to classify the nondischargeable claim for payment in full when other unsecured claim holders will receive less than 100 percent payment? Or does the good-faith test simply refuse confirmation to all plans that include nondischargeable claims when the debtor is financially unable to pay all unsecured claims in full? General unsecured claim holders would be rightfully indignant to learn that the protection from unfair discrimination in § 1322(b)(1) is trumped by a good-faith rule that requires them to subsidize the full payment of claims that resulted from the debtor’s prepetition misconduct.

[7]

If Congress intended all favorable classifications of nondischargeable claims to be fair discriminations, it is reasonable that Congress would have revealed this preferred status somewhere in § 1322(b)(1), perhaps in the same manner Congress blessed “different” treatment for co-signed debts in § 1322(b)(1).8 Applying both the unfair-discrimination test and the good-faith test, one court found it was unfair and bad faith to separately classify nondischargeable traffic fines for payment in full in 49 months with no payment to general unsecured claim holders when the debtor could extend the plan 11 months and provide a dividend to all unsecured creditors.9

[8]

One unreported bankruptcy court decision rejected both good-faith and unfair discrimination challenges to a plan that separately classified the victims of criminal misconduct for more favorable treatment. In In re Etheridge,10 the debtor wrote lots of worthless checks. Some but not all of the hot paper found its way to the D.A., and criminal actions resulted. The checks that were prosecuted ended up subject to a pretrial diversion contract. When the debtor filed Chapter 13, the plan separately classified the checks in pretrial diversion for 100 percent payment, while other worthless checks were general unsecured debt to be paid 70 percent. The bankruptcy court found this arrangement consistent with good faith and fair discrimination:

Particularly persuasive is the debtor’s degree of effort in repaying at least 70% of unsecured claims over an extended period of at least 54 months. . . . The classification is based on the consequences of the debtor’s failure to comply with the pretrial diversion contract. . . . Conviction would likely result in the loss of her employment, and loss of the debtor’s employment would dramatically reduce the chances that any of the debtor’s creditors would be repaid.11
[9]

Especially after the 1990 amendments to the Bankruptcy Code, debtors have tested the good-faith and unfair-discrimination boundaries of plans that manage claims that are nondischargeable in the Chapter 13 case itself. In 1990, Congress enlarged the exceptions to discharge in Chapter 13 cases to include educational loans described in § 523(a)(8),12 claims under § 523(a)(9) for personal injury and death incurred as a result of unlawful operation of a motor vehicle while intoxicated13 and claims under § 1328(a) for restitution and fines included in a sentence upon the debtor’s conviction of a crime.14 Debtors have added incentives to favorably classify these claims: the claim holders demand special treatment and argue bad faith if they don’t get it; the more the debtor pays through the plan, the less remains a personal liability after discharge. Because educational loans typically accrue interest, favorable classification also avoids the accumulation of nondischargeable interest during the plan.15

[10]

The legislative history to the 1990 amendments may be some help in divining what treatments of these nondischargeable claims will survive good-faith analysis under § 1325(a)(3). The debts that became nondischargeable in 1990 were added to the discharge provisions of Chapter 13 by amendment to § 1328. With respect to restitution, Congress considered but rejected amending § 1322(a) to require debtors to pay restitution in full to accomplish confirmation of a plan.16 The legislative history accompanying the restitution and drunken driving exceptions to discharge confirms that Congress contemplated that Chapter 13 debtors would pay less than 100 percent of these new nondischargeable claims during the plan:

As in the case of intoxicated driving offenses, a criminal restitution victim will participate fully as a creditor in a Chapter 13 plan. Following completion of the plan, any remaining portion of the restitution obligation will remain owed to the victim until fully paid.17
[11]

This legislative history supports the argument that Congress did not intend to require Chapter 13 debtors to treat these new nondischargeable claims more favorably than other unsecured claims. Courts should resist any invitation to find a requirement of special treatment in the good-faith test.

[12]

Claims for alimony, maintenance and support described in § 523(a)(5) have always been nondischargeable in Chapter 13 cases.18 In 1994, Congress further refined the management of alimony and support in Chapter 13 cases by granting most such debts a seventh priority under § 507(a)(7).19 Because most alimony and support debts are now priority claims entitled to full payment under § 1322(a)(2),20 separate classification for full payment is routine in Chapter 13 plans without good-faith or unfair-discrimination problems.21


 

1  See discussion of separate classification of nondischargeable claims beginning at § 88.1  In General.

 

2  See § 149.1 [ Power to Classify Unsecured Claims: Tests for Unfair Discrimination ] § 87.1  Power to Classify Unsecured Claims: Tests for Unfair Discrimination.

 

3  See § 177.1 [ In General ] § 103.1  In General.

 

4  See § 149.1 [ Power to Classify Unsecured Claims: Tests for Unfair Discrimination ] § 87.1  Power to Classify Unsecured Claims: Tests for Unfair Discrimination.

 

5  See discussion beginning at § 106.1  In General.

 

6  See discussion beginning at § 88.1  In General.

 

7  See, e.g., In re McCall, 199 B.R. 173, 175 (Bankr. E.D. Ark. 1996) (Court finds bad faith when debtors converted from Chapter 7 to Chapter 13 one month after bankruptcy court determined a large credit card debt to be nondischargeable and plan seemed to “redeem” property for the debtors without paying unsecured claim holders in full. “The Court deems it appropriate to permit the debtors to either amend their plan to propose to pay all of their unsecured debt by extending the term of the plan and increasing payments or reconvert the case to a case under Chapter 7.”); In re Baez, 106 B.R. 16 (Bankr. D.P.R. 1989); In re Rose, 101 B.R. 934 (Bankr. S.D. Ohio 1989); In re Harkai, 68 B.R. 990 (Bankr. E.D. Mich. 1987); Credit Union of Johnson County v. Stauffer, 54 B.R. 559 (Bankr. W.D. Mo. 1985). See also In re Day, 208 B.R. 358, 374–75 (Bankr. E.D. Pa. 1997) (In Chapter 13 cases filed by public housing tenants within six years of discharge in prior Chapter 7 cases, confirmation is denied because debtors cannot satisfy good-faith requirement without proposing to pay rent obligations in full. “The plans proposed by the present Debtors are no more than disguised Chapter 7 liquidations intended solely to avoid payment of rent to the CHA falling due after the Debtors legitimately received discharges of prior rent obligations in their previous Chapter 7 cases. . . . Debtors may not have the benefit of two effective Chapter 7 liquidations within a six-year period . . . . [A]s a condition for allowing them to proceed to discharge rent obligations owed to the CHA again in these Chapter 13 cases, filed within the six-year period following their prior Chapter 7 discharge, we will require the Debtors to propose and perform according to Chapter 13 plans which will pay to the CHA all of the rent obligations falling due subsequent to their Chapter 7 discharges.”).

 

8  See § 150.1 [ Co-signed Debts ] § 87.3  Co-signed Debts.

 

9  In re Games, 213 B.R. 773, 778–80 (Bankr. E.D. Wash. 1997) (Applying four-part test for separate classification of unsecured claims, court rejects debtors’ proposal to extend plan only 49 months to permit 100% payment of nondischargeable criminal traffic fines but 0% to other unsecured claim holders. “[T]he burden on a Chapter 13 debtor in establishing good faith is especially heavy, when ‘superdischarge’ or discharge of an otherwise nondischargeable debt is sought. . . . [T]he Debtor proposes a 49 month plan which is sufficient to pay the fines and child support, but offers nothing to unsecured creditors who comprise the bulk of the general unsecured claims. . . . The Debtors must be in the plan 49 months as a minimum to accomplish their purposes and to obtain the benefits of the super discharge. An additional eleven months in the plan would provide an additional $3,080.00 for distribution to the unsecured creditors. This is a sufficient amount as not to cause an administrative burden for the trustee. A refusal by the Debtors to go beyond the bare minimum effort is evidence of their intent to take advantage of the substantial benefits of Chapter 13 super discharge but avoid any detriment. . . . It does not appear from the record that it would cause any undue burden on the Debtors if they extended the term of their plan to the full five years . . . . [T]he Debtors seek the extraordinary benefit of the Chapter 13 super discharge—discharge of civil traffic infractions, reinstatement of driving privileges and repayment of nondischargeable and priority debt over an extended period of time—with no extraordinary sacrifice, all to the detriment of the general unsecureds. . . . The court finds the Debtors’ refusal to provide any benefit to the general unsecured creditors evidences a lack of good faith.”).

 

10  No. 02-32347-DHW, 2003 WL 22037715 (Bankr. M.D. Ala. Mar. 28, 2003) (unpublished).

 

11  2003 WL 22037715, at *3–*5.

 

12  See §§ 153.1 [ Student Loans ] § 88.6  Student Loans, 186.1 [ Student Loans ] § 106.4  Student Loans and 346.1 [ Student Loans ] § 158.2  Student Loans.

 

13  See §§ 155.1 [ Driving While Intoxicated ] § 88.8  Driving, Boating or Flying while Intoxicated and 347.1 [ Driving While Intoxicated ] § 158.3  Driving while Intoxicated.

 

14  See §§ 154.1 [ Restitution, Fines and Other Criminal Problems ] § 88.7  Restitution, Fines and Other Criminal Problems and 348.1 [ Criminal Restitution and Criminal Fines ] § 158.4  Criminal Restitution and Criminal Fines.

 

15  See §§ 153.1 [ Student Loans ] § 88.6  Student Loans and 346.1 [ Student Loans ] § 158.2  Student Loans.

 

16  See §§ 154.1 [ Restitution, Fines and Other Criminal Problems ] § 88.7  Restitution, Fines and Other Criminal Problems and 348.1 [ Criminal Restitution and Criminal Fines ] § 158.4  Criminal Restitution and Criminal Fines.

 

17  H.R. Rep. No. 101-681, at 165 (1990).

 

18  See § 345.1 [ Alimony, Maintenance or Support ] § 158.1  Alimony, Maintenance or Support.

 

19  See 11 U.S.C. § 507(a)(7), as amended by Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 304, 108 Stat. 4106 (1994), discussed in §§ 99.1 [ What Claims Are Priority Claims? ] § 73.2  What Claims Are Priority Claims?, 152.2 [ Alimony, Maintenance and Support ] § 88.4  Alimony, Maintenance and Support, 301.1 [ Alimony, Maintenance and Support in Cases Filed after October 22, 1994 ] § 136.20  Alimony, Maintenance and Support in Cases Filed after October 22, 1994 and 345.1 [ Alimony, Maintenance or Support ] § 158.1  Alimony, Maintenance or Support.

 

20  See §§ 98.1 [ Plan Must Provide Full Payment ] § 73.1  Plan Must Provide Full Payment and 301.1 [ Alimony, Maintenance and Support in Cases Filed after October 22, 1994 ] § 136.20  Alimony, Maintenance and Support in Cases Filed after October 22, 1994.

 

21  See §§ 151.1 [ Priority Claims ] § 87.4  Priority Claims and 152.2 [ Alimony, Maintenance and Support ] § 88.4  Alimony, Maintenance and Support.