Cite as: Keith M. Lundin, Lundin On Chapter 13, § 89.1, at ¶ ____, LundinOnChapter13.com (last visited __________).
For reasons rooted in history and in the desire of debtors to avoid the payment of trustee’s fees, Chapter 13 plans occasionally propose that the debtor will act as a disbursing agent to make payments directly to creditors.1 Once upon a time, this practice was called paying claims “outside” the plan.2 More accurately, all payments to creditors, whether by the Chapter 13 trustee or directly from the debtor, are payments “through” or “pursuant” or “under” or “inside” the Chapter 13 plan.
One often overlooked defect in a plan provision for direct payment of a creditor by the debtor is a classification of claims. A difference in the method of payment—payment by the Chapter 13 trustee versus payment directly by the debtor—is a separate classification that must be measured against the unfair-discrimination standard in § 1322(b)(1). Though the separate classification of some fully secured claims for direct payment by the debtor has been permitted,3 most courts refuse the separate classification of unsecured claims for payment directly by the debtor.4 In an extreme example, one bankruptcy court denied separate classification of criminal fines for direct payment by the debtor notwithstanding that a state court ordered the debtor to pay the fines directly to the court or risk incarceration.5
Separate classification of unsecured claims for direct payment has been permitted when there are other factors favoring the fairness of the classification. For example, direct payment is sometimes approved when the claims are entitled to priority under § 507 and to full payment under § 1322(a)(2).6 Direct payment of child support has been allowed.7 Several courts have held that it is not unfair discrimination to make direct payments on a long-term student loan under § 1322(b)(5)8 notwithstanding that the result is unequal payment of the student loan and other unsecured claims.9
Some of the cases refusing separate classification of unsecured debt for direct payment reveal surreptitious attempts by debtors to accomplish questionable payments to a creditor. For example, one debtor separately classified an unsecured claim that was secured by property belonging to the debtor’s mother and proposed to pay 100 percent of the direct claim and only 25 percent to other unsecured claims.10 In another case, it was unfair discrimination for the debtor to make “side payments” directly to an unsecured claim holder that enabled that creditor to receive more than the allowed amount of its claim when other unsecured claim holders received only the allowed amounts of their claims.11 Separate classification for direct payment provides no insulation from other tests at confirmation: a proposal to separately classify direct payment of a loan from the debtor’s 401(k) plan is still subject to and fails the disposable income test in § 1325(b)(1).12
Separate classification for direct payment is sometimes an effort to pay in full a partially secured claim while other unsecured claim holders receive less than 100 percent.13 The unsecured portion of the partially secured claim receives full payment through the almost invisible process of direct payments that continue after the secured portion of the claim is retired. Direct payment of a partially secured claim can have the additional unfair effect of paying postpetition interest on the unsecured portion of the favored claim. On unusual facts—when the mathematical effect of direct payment of a partially secured claim was to increase the percentage payment of other unsecured claims through the plan—one court found fair discrimination in the direct payment of a partially secured car lender.14
The Supreme Court’s decision in Nobelman v. American Savings Bank15 encourages Chapter 13 plans that separately classify partially secured mortgages for direct payment by the debtor. In Nobelman, the Supreme Court held that § 1322(b)(2) prohibits claim splitting when the debt is secured only by real property that is the debtor’s principal residence.16 After Nobelman, most Chapter 13 debtors deal with an undersecured home mortgage by curing default and maintaining payments under § 1322(b)(3) or § 1322(b)(5).17 This treatment eventually has the effect of paying the unsecured component of the debt in full, with postpetition interest, consistent with the original contract. In every such situation, if other unsecured claims are not being paid in full with interest, the partially secured claim is separately classified for more favorable treatment. This discrimination is compounded when the debtor also proposes to pay the undersecured mortgage holder directly to avoid trustee’s fees and late charges that might result from the timing of payments by the trustee.18
That § 1322(b)(2) prohibits modification of the rights of an undersecured mortgage holder is strong support for the separate classification of a partially secured mortgage holder for more favorable treatment than other unsecured claims.19 However, nothing in Nobelman speaks to the fairness of direct payment of a partially secured claim holder. Nobelman can be fully respected through a Chapter 13 plan without direct payment by the debtor. Direct payment of the partially secured home mortgage threatens the stability and feasibility of payments to other creditors by the Chapter 13 trustee.20
In other rare situations, bankruptcy courts have permitted the separate classification for direct payment of unsecured claims. When a debtor is in need of unsecured credit after confirmation to carry out the plan—for example, a traveling salesperson who uses credit cards—direct payment has been held to be fair discrimination.21 When the debtor omitted an unsecured claim holder in the original schedules, an amendment to pay the omitted claim directly by the debtor was held to be fair discrimination.22
In a district in which payroll deduction orders are not routinely entered,23 permitting direct payment is a temptation for the debtor to give first call to the claim holder that is paid directly and to remit to the trustee only when there are funds remaining. At worst, direct payment of an unsecured claim can become a subterfuge for the payment of postpetition preferences to claim holders who are near and dear to the debtor. The Chapter 13 debtor has a substantial burden to prove the fairness of any separate classification for direct payment of unsecured claims.
1 See §§ 59.1 [ Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise ] § 53.10 Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise, 64.4 [ Compensation on Direct Payments by Debtor ] § 54.6 Compensation on Direct Payments by Debtor, 103.2 [ Direct Payment of Secured Claims by Debtor ] § 74.8 Direct Payment of Secured Claims by Debtor before BAPCPA and 147.1 [ Direct Payment of Mortgage or Payment by Trustee ] § 85.6 Direct Payment of Mortgage or Payment by Trustee.
2 The phrase “outside the plan” described the pre-1978 Code practice of making no plan provision for a dissenting secured claim to avoid the defeat of confirmation under § 652 of the former Act, 11 U.S.C. § 1052 (repealed). Secured claim holders lost veto power over confirmation of Chapter 13 plans on October 1, 1979. See also §§ 59.1 [ Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise ] § 53.10 Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise and 147.1 [ Direct Payment of Mortgage or Payment by Trustee ] § 85.6 Direct Payment of Mortgage or Payment by Trustee.
3 See §§ 59.1 [ Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise ] § 53.10 Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise, 103.2 [ Direct Payment of Secured Claims by Debtor ] § 74.8 Direct Payment of Secured Claims by Debtor before BAPCPA and 147.1 [ Direct Payment of Mortgage or Payment by Trustee ] § 85.6 Direct Payment of Mortgage or Payment by Trustee. See, e.g., In re Eason, 181 B.R. 127, 135 (Bankr. N.D. Ala. 1995) (“Because secured creditors have particular properties with different values and interest rates, each may be classified separately.” That the plan appears to pay a first mortgage according to its terms directly by the debtor while modifying the terms of a second mortgage for payment through the Chapter 13 trustee does not “intrinsically weigh in favor of any creditor or discriminate against another.”).
4 In re Gregg, 179 B.R. 828, 830 (Bankr. E.D. Tex. 1995) (“Several courts have held that treatment of some unsecured claims outside a plan while treating others under a plan amounts to discriminatory classification, and that, therefore, unsecured claims may not be so treated, where such treatment is not justified under the ‘fairness’ test.”). Accord In re Gaskin, 79 B.R. 388 (Bankr. C.D. Ill. 1987); In re Eby, 38 B.R. 318 (Bankr. D. Or. 1984); In re Gunn, 37 B.R. 432 (Bankr. D. Or. 1984); In re Case, 11 B.R. 843 (Bankr. D. Utah 1981); In re Dziedzic, 9 B.R. 424 (Bankr. S.D. Tex. 1981); American Family Ins. Group v. Barker, 7 B.R. 707 (Bankr. W.D. Mo. 1980); In re Weeden, 7 B.R. 106 (Bankr. D.R.I. 1980); In re Tatum, 1 B.R. 445 (Bankr. S.D. Ohio 1979); In re Blevins, 1 B.R. 442 (Bankr. S.D. Ohio 1979).
5 In re Veasley, 204 B.R. 24, 25–26 (Bankr. E.D. Ark. 1996) (That municipal court ordered debtor to pay municipal fines directly to the court or risk incarceration is not a ground for separate classification. Confirmed plan provided for full payment of six municipal fines. After confirmation, debtor moved to modify the plan to pay the fines “outside” because “the Judge of the Sherwood Municipal Court has ordered Debtor . . . to pay these fines directly or he will order that she be incarcerated.” Chapter 13 trustee objected. “The mere fact that a particular creditor desires to be treated differently is not grounds to ignore the mandates of federal law. Moreover the fact that the creditor demanding disparate treatment is a court does not alter this rule. . . . [T]his does not justify separate classification. . . . No creditor or other court has the power or authority to direct the debtor to act in contravention of the law or make particular provisions in a plan of reorganization.”).
6 See § 151.1 [ Priority Claims ] § 87.4 Priority Claims. See, e.g., In re Gordon, 217 B.R. 973 (Bankr. S.D. Ga. 1997) (Over objection of IRS, debtor permitted to pay IRS directly consistent with prepetition agreement for $110 a month toward claim of $36,405 that was in part a priority claim and in part a secured claim.).
7 See § 152.2 [ Alimony, Maintenance and Support ] § 88.4 Alimony, Maintenance and Support.
9 See § 153.1 [ Student Loans ] § 88.6 Student Loans. See, e.g., In re Chandler, 210 B.R. 898, 904 (Bankr. D.N.H. 1997) (In dicta, debtors should propose direct payment “outside” the plan of long-term unsecured student loans because “it may be beneficial to other unsecured creditors to have the debtors make such current payments on long-term unsecured debt directly to the creditor, as permitted by section 1326(c) of the Bankruptcy Code, rather than through the Chapter 13 Trustee, in order to avoid a further reduction of the pool of monies available for other unsecured creditors because of the Chapter 13 trustee’s ten percent fee.”); In re Cox, 186 B.R. 744 (Bankr. N.D. Fla. 1995) (Plan can separately classify a student loan for payment directly by the debtor consistent with § 1322(b)(5) notwithstanding that the effect is to pay 42.3% of the student loan over the life of a plan that only pays 18% to other unsecured claim holders.); In re Benner, 156 B.R. 631 (Bankr. D. Minn. 1993) (Not unfair discrimination for debtors to pay long-term student loan “outside” plan and to cure default on such loan within the plan notwithstanding that the result will be 57% payment of the student loan during the plan period and only 5% payment of other nonpriority unsecured claims. Proposed “long-term” treatment of the student loan outside the plan meets the four-part test in Mickelson v. Leser (In re Leser), 939 F.2d 669 (8th Cir. 1991).); In re Dodds, 140 B.R. 542 (Bankr. D. Mont. 1992) (Confirms payment in full of nondischargeable student loan “outside” the plan with contract interest according to contract terms over a period of 54 months while other unsecured claims receive approximately 79% over 36 months through the plan.).
10 In re Green, 70 B.R. 164 (Bankr. W.D. Ark. 1986).
11 Hope v. Brown & Williamson Fed. Credit Union (In re Vaughn), 110 B.R. 94 (Bankr. M.D. Ga. 1990).
12 In re Helms, 262 B.R. 136, 140–42 (Bankr. M.D. Fla. 2001) (On trustee’s disposable-income-test objection to confirmation, court rejects debtor’s argument that direct payment of a 401(k) loan is fair discrimination. “The through a plan/outside a plan distinction is legally inoperative. The distinction seems to arise from a misreading of § 1325(b)(1). . . . If § 1325(b)(1) is properly read as requiring that all disposable income be applied to plan payments, then the through a plan/outside a plan distinction disappears, because plan payments will always be made through a plan. . . . Debtors . . . contend that they should be allowed to apply this disposable income to an unnecessary expense rather than to plan payments because the First Amended Plan has been lengthened in order to make up for the funds dedicated to 401(k) loan repayment and because the First Amended Plan provides for a relatively high pro rata distribution to unsecured creditors. . . . Debtors argue that they should be allowed to separately classify and discriminate in favor of the 401(k) loan because they have done so in good faith. . . . However, the Code does not make this demonstration of good faith relevant to the disposable income inquiry. . . . Section 1325(b) clearly states that, unless a plan provides for a one hundred percent payout, all disposable income must be applied to plan payments. . . . There is no ‘good faith’ corollary to this definition.”).
13 See § 74.7 Classification of Secured Claims, § 74.8 Direct Payment of Secured Claims by Debtor before BAPCPA, § 74.9 Direct Payment of Secured Debt after BAPCPA, § 74.10 Partially Secured Claims, § 87.1 Power to Classify Unsecured Claims: Tests for Unfair Discrimination and § 88.9 Long-Term Debts. See, e.g., First Bank & Trust v. Gross (In re Reid), 179 B.R. 504 (E.D. Tex. 1995) (Direct payment by the debtor of one partially secured creditor, coupled with a reaffirmation agreement and payment of other partially secured creditor through the Chapter 13 trustee, violates the equal treatment requirement in § 1322(a)(3).).
14 In re Delauder, 189 B.R. 639, 645–47 (Bankr. E.D. Va. 1995) (Direct payment of undersecured car lender separately classifies by silently providing payment in full with interest of the unsecured portion of the claim. “First, Hyundai will receive a greater percentage payment on account of its unsecured claim than do other unsecured creditors. Second, both the secured and unsecured portions of Hyundai’s claim will be paid directly by the debtor, while other unsecured creditors must wait for disbursement by the trustee.” Car loan was a long-term debt on which the last installment was due after the last payment under the plan. Applying the five-factor test in In re Husted, 142 B.R. 72 (Bankr. W.D.N.Y. 1992), there is no evidence that the debtor could not pay the car lender through the plan. Debtor did not propose direct payment solely to avoid trustee’s fees. If the long-term debt were paid through the Chapter 13 trustee, the percentage distribution to all unsecured claim holders would actually fall from 25% to approximately 18% because the unsecured portion of the car lender’s claim is small and accelerating long-term car loan for payment in full during the life of the plan would reduce the money available to unsecured claim holders. In other words, the discrimination in favor of the car lender actually worked to the advantage of other unsecured claim holders. “[A]lthough this court would not, as a routine matter, permit an undersecured automobile loan to be paid directly by a debtor outside the plan, such treatment is not improper in this case. Here, the last payment on the automobile loan is due after the last payment under the plan, the direct payment does not reduce the dividend to unsecured creditors and does not appear to be motivated primarily by a desire to avoid the trustee’s commission, and the plan otherwise complies with all the requirements for confirmation. For these reasons, the court cannot find that the plan unfairly discriminates against general unsecured creditors.”).
15 508 U.S. 324, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993).
16 See § 118.1 [ Most Home Mortgages Cannot Be Modified: § 1322(b)(2) and Nobelman ] § 79.1 Most Home Mortgages Cannot Be Modified: § 1322(b)(2) and Nobelman.
17 See § 129.1 [ Overview: General Rules for Saving Debtor’s Home ] § 81.1 Overview: General Rules for Saving Debtor’s Home.
18 See §§ 64.4 [ Compensation on Direct Payments by Debtor ] § 54.6 Compensation on Direct Payments by Debtor, 138.1 [ Late Charges, Attorneys' Fees, Costs and Other Charges ] § 83.6 Late Charges, Attorneys' Fees, Costs and Other Charges and 147.1 [ Direct Payment of Mortgage or Payment by Trustee ] § 85.6 Direct Payment of Mortgage or Payment by Trustee.
19 See § 155.2 [ Long-Term Debts ] § 88.9 Long-Term Debts.
20 See §§ 59.1 [ Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise ] § 53.10 Make Payments to Creditors Unless Plan or Confirmation Order Provides Otherwise, 103.2 [ Direct Payment of Secured Claims by Debtor ] § 74.8 Direct Payment of Secured Claims by Debtor before BAPCPA and 147.1 [ Direct Payment of Mortgage or Payment by Trustee ] § 85.6 Direct Payment of Mortgage or Payment by Trustee.
21 In re Perskin, 9 B.R. 626 (Bankr. N.D. Tex. 1981).
22 In re Hartdegen, 67 B.R. 230 (Bankr. N.D. Ala. 1986).
23 See § 248.1 [ Order to Debtor’s Employer ] § 125.1 Order to Debtor’s Employer.