The “Best Interest of the Creditor” Test
This is an analysis that we must do on every chapter 13 that we plan on filing with the bankruptcy court. The “best interest of the creditor” test is in place to make sure the creditor will be no worse off by the debtor filing for relief under chapter 13 of the code.
Chapter 7 Liquidation
To properly understand how this works, it is important to first review the nature of a chapter 7 filing. A Chapter 7 bankruptcy is a liquidation of the debtor’s property in theory. I say in theory because the overwhelming majority of the chapter 7s filed do not actually undertake in the liquidation of the debtor’s estate. These cases are labeled as no assets cases after an investigation by the interim trustee selected to review the filing. It is not that he debtor has absolute no assets, but what assets the debtor does have are protected from liquidation. A debtor is allotted a certain amount of statutory exemptions that he can utilize to protect a base level of his property. The public policy in the exemptions is to not strip the debtor of everything, but to allow him a reasonable foundation to begin his “fresh start”. Otherwise, a debtor who has been stripped of everything may face an insurmountable task as he embarks on life after bankruptcy.
Should there be a liquidation of the debtor’s estate, than each of his creditors will share in distribution after the costs of administrative are paid. The creditor’s will be classified under the code and will rank in priority to determine proper allocation of the estate funds. The first creditor class that will receive distribution would be any creditors that were secured by the collateral that was liquidated. The second class of creditors to receive payment in a liquidation case would be those that have a priority status. A common example of this class will be taxes owed to the IRS. Finally the remaining creditors who fall in the non-priority unsecured class will share pro-rata the remaining proceeds under the estate’s liquidation.
Best Interest of the Creditor Test
Every Chapter 13 plan that is confirmed by the bankruptcy court must comply with the best interests of the creditor test. What this means is that the creditor must receive under the proposed chapter 13 plan an amount at least equal to that in which they would have received in a chapter 7 liquidation of the debtor’s estate. For example, if the unsecured non-priority creditors would have received a pro-rata distribution equal to 50% of the their total claim, the same class of unsecured creditors would need to be treated with the same by a plan that proposed to pay them the minimum 50% dividend.
Likewise, if a secured creditor would have been paid in full under the liquidation of particular piece of property in the state, than that same creditor must be paid accordingly under the chapter 7 plan. There is an exception, if the debt owed to the secured creditor is under a contract that exceeds the duration of the 5-year chapter 13 plan. In this case, it is sufficient that the plan continues to pay the secured creditor according to the terms in the contract. These payments often are paid “outside the plan” by the debtor directly to the secured creditor. The plan will have a provision that describes this arrangement and will be contingent on the debtor’s compliance in order for confirmation.
Ironically, the best interest of the creditor test is inherently flawed because it truly does not equate to putting the creditor in the same shoes that they would be in under a chapter 7 plan. This is because in a Ch 7 liquidation, the funds are dispersed after a sale and payment is almost always paid in a lump sum. Alternatively, a creditor must accept a repayment plan of the same amount of money in structured plan that lasts anywhere from 36 to 60 months. This payment plan often does not include any additional interest or compensation for the spread out repayment. Thus, based on the simple principle of the time value of money, the “best interest of the creditor” is not truly achieved in a chapter 13 but stands as a clear and measurably benchmark for the Chapter 13 trustee’s to utilize in performing their duties.
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