Cite as: Keith M. Lundin, Lundin On Chapter 13, § 90.4, at ¶ ____, LundinOnChapter13.com (last visited __________).
The best-interests-of-creditors test requires that unsecured claim holders each receive “not less than the amount that would be paid on such claim” if the estate were liquidated under Chapter 7.1 Clever lawyers representing the holders of claims that would be nondischargeable in a Chapter 7 case have argued that the Chapter 13 debtor must pay such claims in full to satisfy the best-interests-of-creditors test. Every reported decision that has considered this argument has rejected the creditor’s position.2
Similarly, creditors with claims guaranteed by (solvent) nondebtor third parties have argued that they are entitled to full payment through the Chapter 13 plan because, in a Chapter 7 case, they would receive full payment from the guarantor. The courts have uniformly held that the presence of a third-party guarantor who would be required to pay in full outside bankruptcy does not preclude confirmation of a plan that calls for less than full payment of the guaranteed claim.3
The logic of these decisions is sound: the payments under a Chapter 13 plan need only exceed the liquidation value of the debtor’s property; the best-interests-of-creditors test involves no comparison of plan payments and the amount that a creditor might receive upon collection of a guaranteed or nondischargeable debt after a Chapter 7 case.4 The holder of a nondischargeable claim is not paid any more or any less than its pro rata share of distributions in a Chapter 7 case. That the nondischargeable claim holder may have the right to collect the balance of its claim from the debtor or from a third party after discharge does not alter the ordinary calculation of the liquidation value of the estate for § 1325(a)(4) purposes.
But the same cannot be said for the holders of tardily filed claims in a Chapter 7 case. Mentioned above,5 a tardy claim is one of the rare circumstances in which an unsecured creditor has greater rights to distributions in a Chapter 7 case than in a Chapter 13 case. The allowance of tardy claims becomes entangled with the best-interests-of-creditors test at confirmation in a Chapter 13 case.
Prior to the Bankruptcy Reform Act of 1994,6 there was much controversy whether untimely claims were allowable in Chapter 13 cases.7 Certain kinds of tardily filed claims are entitled to distributions in Chapter 7 cases under § 726 of the Code.8 Prior to the 1994 Act, some courts reasoned that late-filed proofs of claim were allowable in Chapter 13 cases because a debtor could not satisfy the best-interests-of-creditors test unless the plan could provide for the payment of tardily filed claims consistent with distribution rights in a Chapter 7 case.9
For example, in In re Nanes,10 the proposed plan paid nothing to untimely filed claims. The only claim holder that filed a proof of claim filed after the bar date in Bankruptcy Rule 3002 and would receive no distribution under the plan. In a Chapter 7 case, because of 11 U.S.C. § 726(a)(3) the untimely filed unsecured claim would be entitled to a distribution. The court held that the best-interests-of-creditors test in § 1325(a)(4) precluded confirmation of the plan because in a (hypothetical) Chapter 7 case, the tardily filed unsecured claim holder would receive more than under the plan:
In a Chapter 7 case the estimated dividend for unsecured creditors would be $2,016.00. Only one creditor has filed a proof of claim in this case . . . and that proof of claim was not timely filed. . . . Consistent with [In re Babbin, 164 B.R. 157 (Bankr. D. Colo. 1994),] if this Court confirms the Debtor’s plan as it is written and proposed, there will be no distribution to the unsecured creditor, even if that claim is ultimately liquidated and otherwise allowable. Thus, the unsecured creditor who has objected to confirmation of the plan would not receive a distribution under the confirmed plan even though the evidence shows that if the debtor’s estate was liquidated in Chapter 7, this creditor’s untimely filed claim would receive a dividend of at least $2,016.00. . . . Section 1325(a)(4) of the Code is explicit. This Court cannot confirm a plan unless the Court can determine that the value, as of the effective date of the plan, of property to be distributed under the plan on account of each “allowed unsecured claim” is not less than the amount that would be paid on such claim in Chapter 7. . . . [I]n a Chapter 7 case, this creditor’s claim . . . would have to be recognized and this creditor would receive a distribution of $2,016.00 by reason of the provisions of 11 U.S.C. § 726(a)(3). Therefore, the existence of this claim, even though it has not been timely filed, must serve to bar confirmation of the plan.11
The Bankruptcy Reform Act of 1994 changed the best-interests-of-creditors-test analysis in Nanes by clarifying that tardy claims are disallowed. The 1994 Act amended § 502(b)(9) to provide that a claim is not allowed to the extent that “proof of such claim is not timely filed.”12 The legislative history indicates this amendment was intended to overrule cases holding that untimely claims were allowable claims.13
One side effect of the 1994 amendment to § 502(b) is that some creditors will be better off in a Chapter 7 case than in a Chapter 13 case, notwithstanding the best-interests-of-creditors test in § 1325(a)(4). For example, in Chapter 13 cases filed after October 22, 1994, a creditor that fails to timely file a proof of claim cannot have an allowed claim.14 However, such a creditor could file a tardy proof of claim and be entitled to distributions in a Chapter 7 case under the circumstances described in § 726(a). Although the best-interests-of-creditors test is generally intended to ensure that creditors in a Chapter 13 case are paid at least the amount they would be paid if the estate were liquidated under Chapter 7, the test breaks down when creditors have claims that are allowable under one chapter and not under the other. Because only “each allowed unsecured claim” in the Chapter 13 case is protected by § 1325(a)(4), any creditor with a claim that is not allowable in the Chapter 13 case forfeits the entitlement to equality of distributions through the best-interests-of-creditors test.
In Chapter 13 cases filed before October 22, 1994, the best-interests-of-creditors test may have required a Chapter 13 debtor to provide for the payment of tardy claims that would be entitled to distributions in a Chapter 7 case under § 726(a). In jurisdictions where late-filing of a proof of claim was not a bar to allowance,15 the phrase “each allowed unsecured claim” in § 1325(a)(4) could include tardily filed claims. Because a tardily filed claim has distribution rights under Chapter 7, any allowable tardily filed unsecured claim in the Chapter 13 case would be entitled to at least equivalent payment.
This possibility should have passed quickly with the enactment of the 1994 amendments to § 502(b)(9). The best-interests-of-creditors test is a confirmation issue, and there should not be any pending cases filed before October 22, 1994, which have not reached confirmation. In all Chapter 13 cases filed after October 22, 1994, the amendments to § 502(b)(9) apply and the best-interests-of-creditors test in § 1325(a)(4) will not help tardily filed claim holders. The cross-reference to § 726 in § 502(b)(9) should not be misinterpreted to provide tardy claims with any special rights at confirmation in Chapter 13 cases.16
1 11 U.S.C. § 1325(a)(4).
2 See Education Assistance Corp. v. Zellner, 827 F.2d 1222 (8th Cir. 1987); Phoenix Inst. of Tech. v. Klein, 57 B.R. 818 (B.A.P. 9th Cir. 1985); In re Gonzales, 297 B.R. 143 (Bankr. D.N.M. 2003); In re Houston, No. 96-40097, 1996 WL 33366595, at *5 (Bankr. S.D. Ga. Sept. 20, 1996) (unpublished); In re Kazzaz, 62 B.R. 308 (Bankr. E.D. Va. 1986); In re Akin, 54 B.R. 700 (Bankr. D. Neb. 1985); In re Hawkins, 33 B.R. 908 (Bankr. S.D.N.Y. 1983); In re McMonagle, 30 B.R. 899 (Bankr. D.S.D. 1983); In re Severs, 28 B.R. 61 (Bankr. S.D. Ohio 1982); Security Ins. Co. v. Vratanina, 22 B.R. 453 (Bankr. N.D. Ill. 1982); In re Graves, 19 B.R. 402 (Bankr. W.D. La. 1982).
3 See Sapos v. Provident Inst. of Sav. (In re Sapos), 132 B.R. 528 (W.D. Pa. 1991) (That mortgage holder in a Chapter 7 case would retake title and file a claim with the Veterans Administration to recover most or all of its losses did not preclude confirmation on best-interests-of-creditors test grounds when the plan proposed to bifurcate the mortgage holder’s claim and to pay the allowed secured portion in full with interest. The confirmed plan did not prevent the mortgage holder from proceeding in a separate action against the Veterans Administration.); In re Ward, 129 B.R. 664 (Bankr. W.D. Okla. 1991) (That mortgage company has a contractual insurance arrangement with HUD that would result in full payment of the mortgage in a Chapter 7 case does not entitle the mortgage holder to anything more than the present value of the mortgaged property in a Chapter 13 case. The mortgage company’s contract right to payments from HUD cannot be said to be amounts that would be “paid” on account of the mortgage holder’s unsecured claim in a hypothetical Chapter 7 case.).
4 See, e.g., In re Gonzales, 297 B.R. 143, 146 n.2 (Bankr. D.N.M. 2003) (“The measure of distribution contemplated is what the dividend on an unsecured claim would be from the proceeds of the estate property. [The creditor’s] interpretation of the statute would measure his chapter 7 distribution by what he was able to (also) collect outside the chapter 7 case from the Debtor.”); In re Houston, No. 96-40097, 1996 WL 33366595, at *5 (Bankr. S.D. Ga. Sept. 20, 1996) (unpublished) (Nondischargeable claims are entitled to no special consideration in the best-interests-of-creditors test. “[A] claim which is dischargeable in Chapter 13, but non-dischargeable in Chapter 7, should not be considered any differently from any other non-priority unsecured claims . . . . A plan which provides for less than full payment of such a claim does not, for that reason, cause the liquidation analysis test to fail.”).
5 See § 160.1 [ In General: Plan Payments vs. Hypothetical Liquidation ] § 90.1 In General: Plan Payments vs. Hypothetical Liquidation.
6 Pub. L. No. 103-394, 108 Stat. 4106 (1994).
7 See § 289.1 [ Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon ] § 135.6 Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon.
8 11 U.S.C. § 726(a) provides in part:
(a) Except as provided in section 510 of this title, property of the estate shall be distributed—
(1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title, proof of which is timely filed under section 501 of this title or tardily filed before the date on which the trustee commences distribution under this section;
(2) second, in payment of any allowed unsecured claim, other than a claim of a kind specified in paragraph (1), (3), or (4) of this subsection, proof of which is—
(A) timely filed under section 501(a) of this title;
(B) timely filed under section 501(b) or 501(c) of this title; or
(C) tardily filed under section 501(a) of this title, if—
(i) the creditor that holds such claim did not have notice or actual knowledge of the case in time for timely filing of a proof of such claim under section 501(a) of this title; and
(ii) proof of such claim is filed in time to permit payment of such claim;
(3) third, in payment of any allowed unsecured claim proof of which is tardily filed under section 501(a) of this title, other than a claim of the kind specified in paragraph (2)(C) of this subsection.
9 See § 289.1 [ Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon ] § 135.6 Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon.
10 168 B.R. 715 (Bankr. D. Colo. 1994).
11 In re Nanes, 168 B.R. at 717. Compare In re Stuart, 31 B.R. 18 (Bankr. D. Conn. 1983) (Section 726(a)(3) might allow a creditor in a Chapter 7 case to late file a claim against a solvent estate and § 726(a)(3) might be relevant at confirmation of a Chapter 13 plan to determine whether each allowed unsecured claim will receive no less than it would if the estate were liquidated; however, an unsecured creditor who fails to file a timely proof of claim in a Chapter 13 case and fails to object to confirmation cannot thereafter assert the best-interests test as grounds for allowance of a late-filed claim.).
12 11 U.S.C. § 502(b)(9), as amended by Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 213, 108 Stat. 4106 (1994). See § 290.1 [ Untimely Filed Claims in Cases Filed after October 22, 1994 ] § 135.7 Untimely Filed Claims in Cases Filed after October 22, 1994.
13 See 140 Cong. Rec. H10,752, H10,768 (section-by-section analysis by Congressman Brooks) (“The amendment to section 502(b) is designed to overrule In re Hausladen, 146 B.R. 557 (Bankr. D. Minn. 1992), and its progeny by disallowing claims that are not timely filed.”).
14 11 U.S.C. § 502(b)(9).
15 See § 289.1 [ Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon ] § 135.6 Untimely Filed Claims in Cases Filed before October 22, 1994: The Hausladen Phenomenon.
16 See § 290.1 [ Untimely Filed Claims in Cases Filed after October 22, 1994 ] § 135.7 Untimely Filed Claims in Cases Filed after October 22, 1994. See, e.g., In re Wright, 300 B.R. 453, 465–66 (Bankr. N.D. Ill. 2003) (Arguably in dicta, “[w]hile some portion of § 726(a) necessarily must be incorporated into § 1325(a)(4), the exception in § 726(a)(2) permitting late-filing chapter 7 creditors to share the same priority as other general unsecured creditors, nevertheless, is not incorporated into chapter 13. . . . While § 726(a) may alleviate due process concerns in chapter 7 cases . . . it does not do so in chapter 13 cases.”); In re Lang, 196 B.R. 528, 530 (Bankr. D. Ariz. 1996) (Addition of timeliness requirement to § 502(b) and its cross-reference to § 726(a) did not create a new exception to the 90-day bar date for the timely filing of proofs of claim in Chapter 13 cases. “[T]he issue is whether § 726(a)(1)–(3) applies to all chapters because it is referenced in § 502(b) or whether the exception contained in § 502(b) is limited to claims which independently fall within the explicit provisions of § 726(a). . . . Rule 3002(c)(6) includes a procedure whereby claims may be filed late and still participate in a distribution if a surplus remains after the allowed (timely) claims have been paid in full. . . . [S]uch a distribution scheme has no place in a Chapter 13 reorganization setting. . . . [T]he exceptions for late-filed claims set forth in § 726, and referenced in § 502, are only applicable to claims filed in a Chapter 7 case.”).