The Good Faith Requirement in Chapter 13

When it comes to bankruptcy, it’s important to take act in good faith and take up an honest approach to your specific case.

A recent example of how good faith comes into play is when pensioners and other creditors challenged the City of Detroit’s eligibility to file a Chapter 9 bankruptcy case and reorganize its finances.

The central objection was Detroit’s obligation under the Bankruptcy Code to negotiate with its creditors in “good faith” before filing its bankruptcy case.

The creditors lost this objections when the bankruptcy judge pointed out that the Bankruptcy Code also gives the municipal debtor an “out” if the debtor “is unable to negotiate with creditors because such a negotiation is impracticable.” The court said that with over 100,000 creditors, pre-bankruptcy negotiations with creditors was “impossible.”

Is negotiating a requirement?

Individual bankruptcy debtors are not required to negotiate with their creditors before filing bankruptcy, but debtors are expected to act honestly throughout the bankruptcy case. In fact, the federal bankruptcy process is built on a foundation of honesty.

The U.S. Supreme Court has stated many times that bankruptcy is meant to help the “honest but unfortunate debtor” achieve a fresh start at a new financial life:

• “. . . purpose of the act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor . . . a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” Local Loan Co. v Hunt, 292 US 234 (1934)
• “We have been careful to explain that the Act limits the opportunity for a completely unencumbered new beginning to the ‘honest but unfortunate debtor.’” Grogan v Garner, 498 US 279 (1991)
• “The principal purpose of the Bankruptcy Code is to grant a ‘fresh start’ to the ‘honest but unfortunate debtor.’” Marrama v Citizens Bank of Massachusetts, 549 U.S. 365 (2007)

Good faith and the Chapter 13 repayment plan

Section 1325 directs the bankruptcy court to confirm a debtor’s plan so long as certain conditions are met.

One of these conditions is found in section 1325(a)(3) (“the plan has been proposed in good faith and not by any means forbidden by law”). “Good faith” is not defined by the Bankruptcy Code, so courts across the country have established various tests to determine when a debtor has acted in “good faith.”

Example of good faith

Some bankruptcy courts interpret the “good faith” requirement as an extension of the debtor’s ability to pay creditors. For these courts, “good faith” centers mainly on the disposable income test – is the debtor paying all he can?

Other courts look at the “totality of the circumstances” and avoid a rigid calculus to find good faith from the debtor’s actions. For these courts, “honesty of intention,” complete and accurate disclosure of information, and best efforts of the debtor are the guiding principles in good faith evaluations. Cf. In re Farmer, 186 B.R. 781 (Bankr. D.R.I. 1995).

Bankruptcy courts expect debtors to be open, honest, to cooperate with the bankruptcy trustee, and to deal fairly with creditors.

Evidence of fraud, dishonesty, or concealed assets are all hallmarks that the debtor is not acting in “good faith.”

What would make the courts not trust me?

Debtors often incur good faith objections when there are errors in calculating “current monthly income” for the bankruptcy means test.

Current monthly income, or CMI, is the debtor’s average income over the past six months and the debtor must also disclose any current or anticipated changes to income.

The bankruptcy court may then consider these changes when calculating the debtor’s CMI. See Lanning v. Hamilton, 130 S. Ct. 2464 (2010). The debtor’s CMI is the starting point for many issues in bankruptcy, including disposable income used to pay unsecured creditors.

If the debtor fails to accurately report his CMI, all of the trustee’s calculations will be wrong, and can prompt a lack of good faith objection.

Another place debtors often run into good faith objections is when listing expenses on the means test or Schedule J (current monthly expenses). Some debtors attempt to “pad” expenses in an effort to reduce the amount available to pay unsecured creditors.

Chapter 13 trustees commonly see through this ploy and will object to these plans as not in good faith. Expenses must be reasonably necessary for the support of the debtor or the debtor’s family. This good faith requirement can also extend to payment of luxury items, such as a boat, or even overpriced property, like an expensive car or house. If the debtor is paying for a car that is more expensive than the bankruptcy judge drives, there may be a good faith objection on the horizon!

The take home

The main point of this article is to keep everything above board and as honest as possible. In the end you’ll thank yourself and the proceedings will go smoothly. I know the temptation to keep as much money and assets as you can is strong, but if the court finds your not acting in good faith, you can expect more to go wrong for you if it’s discovered your not being honest.