Bankruptcy Personal Injury Claims after Morasch and Conforti

Many personal injury actions include a significant claim for income loss, future loss of earning capacity or loss of competitive advantage.1  It is not uncommon for personal injury claimants to succumb to bankruptcy after suffering significant injuries that interfere with their ability to earn income.   Because bankruptcy has immediate and significant effects on the bankrupt’s property and income, it is important for personal injury lawyers to understand how a client’s bankruptcy will affect the claims they advance in a tort action.

Prior to the two recent cases referred to in the title to this paper, most personal injury lawyers and trustees in bankruptcy proceeded on the understanding that a plaintiff’s claim for income loss vests in the trustee when the plaintiff files an assignment in bankruptcy. The “old” case law held that a plaintiff’s claims for income loss and other pecuniary losses (such as loss of earning capacity and loss of competitive advantage) were “property” as defined in section 67 of the Bankruptcy & Insolvency Act (BIA).

Under the old case law, the cause of action for a bankrupt plaintiff’s income loss claim would vest in the trustee in bankruptcy pursuant to section 67 of the BIA.  From a practical perspective, a plaintiff could not pursue their income loss claims once they filed for bankruptcy because that “property” vested in the trustee.

Shrewd defence lawyers usually took the position that the plaintiff could no longer pursue the income loss claims because those claims vested in the trustee upon the bankruptcy. Trustees also took this position in order to extract some money from the bankrupt’s personal injury action upon settlement.  Often the trustee and the bankrupt plaintiff would enter into an agreement whereby the plaintiff would pay a portion of the damages for past and future income loss to the trustee upon settlement of the personal injury action.  The agreement typically involved an assignment of the income loss claims back to the bankrupt so they could pursue the claims in the personal injury action. Negotiating such an agreement with the trustee often led to protracted and sometimes difficult negotiations which distracted plaintiff’s counsel from the real task at hand.

Two relatively recent decisions will change the way personal injury lawyers handle these cases and hopefully the decisions will also change the way trustees in bankruptcy approach these cases.  Before we examine the Morasch and Conforti decisions, the applicable provisions of the BIA are discussed below.

SCHEME OF THE BANKRUPTCY & INSOLVENCY ACT REGARDING INCOME

Under section 67(1) of the BIA, the “property of the bankrupt divisible among creditors” includes:

(c) all property wherever situated of the bankrupt at the date of the bankruptcy or that may be acquired by or devolve on the bankrupt before their discharge…”

This section explicitly excludes property that the bankrupt holds in trust for another person, property that is exempt under provincial law, RRSP funds, and certain government benefits.

The section has been judicially construed to also exclude damages for pain and suffering, which are considered to be ‘personal’ to the bankrupt.

Section 68 of the BIA establishes a scheme to determine which portion of the bankrupt’s total income is divisible among creditors. The Supreme Court of Canada has decided that s. 68 is a complete code dealing with the bankrupt’s income. If an asset or entitlement falls within the s. 68 definition of total income, that asset or entitlement will be wholly excluded from s. 67. In other words, s. 68 is a carve-out from s. 67. Total income is defined by s. 68(2)(a) as follows:

“Total income” (a) includes, despite paragraphs 67(1)(b) and (b.3), a bankrupt’s revenues of whatever nature or from whatever source that are earned or received by the bankrupt between the date of the bankruptcy and the date of the bankrupt’s discharge, including those received as damages for wrongful dismissal, received as a pay equity settlement or received under an Act of Parliament, or of the legislature of a province, that relates to workers’ compensation; …

To simplify this language somewhat for the purposes of this paper, the definition can be parsed as follows:

“Total income” includes:

• a bankrupt’s revenues of whatever nature or from whatever source;
• that are earned or received by the bankrupt between the date of the bankruptcy and the date of their discharge;
• including revenues received as wrongful dismissal damages, as a pay equity settlement or under a worker’s compensation scheme.

The definitions in ss. 67 and 68, when taken together, mean that a recovery under any component of a personal injury settlement can fall within one of the following three categories:

Category 1:  Divisible property under s. 67 that accrues to the trustee entirely and does not fall within s. 68.  This category consists, for our purposes of the following:

(i) Revenue that was received before bankruptcy and has not been spent, which constitutes cash on hand at the date of bankruptcy.

(ii) Non-revenue assets, i.e. “capital” assets, that are either held by the bankrupt on the date of bankruptcy or that devolve on the bankrupt before his or her discharge.  Note that a cause of action is itself an asset.

Such assets accrue 100% to the trustee.

Category 2:  Property that does not fall within ss. 67 or 68, and is therefore retained entirely by the bankrupt. For our purposes this category includes damages for pain and suffering, and revenue that is earned and received after the bankrupt’s discharge.

Category 3: Divisible property under s. 67 that is “carved out” by s. 68 because it falls within the definition of “total income”.  This category consists precisely of the following:

Revenue that is earned or received by the bankrupt between the date of bankruptcy and the date of the bankrupt’s discharge, i.e. revenue earned or received by the bankrupt during their bankruptcy.

This category is treated under the needs-based scheme of s. 68 which is designed to ensure that creditors benefit from the bankrupt’s income during bankruptcy except to the extent necessary for the welfare of the bankrupt and their family.  This is done by means of the “Superintendent’s Standards”, established by way of a Directive of the Superintendent of Bankruptcy.  The applicable directive is No. 11R2, which is updated each year in accordance with that year’s poverty line.  Essentially it requires the bankrupt to pay to the trustee 50% of the amount by which his or her after-tax income exceeds the poverty line, often on a monthly basis until the bankrupt is discharged.

If the bankrupt and the trustee cannot agree on the determination of the monthly amount payable to the trustee, the issue must go to mediation before the Official Receiver (“O.R.”, the designation used for the local representative of the Superintendent of Bankruptcy).  Failing resolution, the matter may be brought before the bankruptcy court. The bankruptcy judge need not follow Directive 11R2, but may make any order that considers both the Standards and the personal and family situation of the bankrupt.

In respect of non-periodic income, such as in the form of damages awards or settlements, the treatment of the settlement funds is complex and will be discussed below.  With this background, we can address the treatment of various components of a tort award or settlement discussed further below.

THE CONFORTI & MORASCH DECISIONS

There are two Conforti2 decisions and I will refer to them as Conforti #1 and Conforti #2 as per their chronological order.  In Conforti #1, the trustee in bankruptcy sought directions as to the entitlement to certain proceeds of settlement of personal injury litigation in the amount of $275,000.  The issue before the court was whether a receipt of settlement funds in respect of a motor vehicle accident on account of “loss of future competitive advantage” is “property” of the bankrupt to be dealt with under section 67 of the BIA or is included in “total income” for purposes of section 68(2)(a) of the BIA and therefore to be dealt with under s. 68 of the BIA.

In following the Supreme Court’s decision in Wallace v. United Grain Growers Ltd.3, Justice Wilton-Siegel took a purposive approach in deciding whether a particular receipt of money is income for purposes of s. 68 of the BIA.   The purposive approach provides that the court should look to the essential nature of the settlement or award to determine whether it is income or not despite the characterization of the funds provided by the parties in the minutes of settlement.

In Conforti’s underlying personal injury action, the minutes of settlement referred to a “future loss of competitive advantage”.  As a result of his injuries, Conforti could no longer earn income at the level he previously could earn.  It was clear that this payment was on account of the loss of Conforti’s future income.

Employing the purposive approach, Justice Wilton-Siegel found that the essential nature of the award is compensation for lost income.  The fact that the award is a capital sum does not change the character of the payment, which is to replace or compensate for lost income. Similarly, the fact that Conforti continued to earn some income is not inconsistent with the award being, essentially, replacement income for the difference between what he could have earned and what he is earning now and likely to earn in the future.

In the end, Justice Wilton-Siegel concluded that the award is “akin to income”.  It replaces the income in the future that Conforti will never make.  It therefore falls within the definition of “total income” in s. 68(2)(a) and is subject to the regime in s. 68 of the BIA.  He also found that an award for loss of competitive advantage is conceptually indistinguishable from an award for a loss of future earnings or loss of earning capacity in a bankruptcy context and therefore all three types of awards should be treated as income under s. 68 of the BIA.

Justice Wilton-Siegel’s sound reasons were followed a few months later in Morasch v. Gauvreau.4  The Morasch decision was rendered within the context of a personal injury action after the plaintiff had filed for bankruptcy.  The defendant took the position that the income loss claim was property under the BIA and therefore that claim had vested in the trustee and no longer belonged to the plaintiff.  The bankrupt plaintiff therefore brought a motion to determine whether she could advance her income loss claim in the personal injury action. The issue before the judge was whether the future loss of income claim in the motor vehicle action should be characterized as property under s. 67 of the BIA or whether it should be characterized as income under s. 68(2)(a) of the BIA.

Madam Justice P.C. Hennessy followed Conforti #1 in concluding that the claim for future income loss shall be considered as part of the “total income” under s. 68(2) of the BIA.  In other words, the income loss claim did not vest in the trustee when the plaintiff filed for bankruptcy.  She also ordered the bankrupt/plaintiff to serve her decision on the trustee and the trustee may seek directions if deemed necessary.

I have spoken with defence counsel in Morasch and he advised me that his client did not appeal the decision.  The plaintiffs’ bar therefore has both the Conforti and Morasch decisions to rely upon in these types of cases where defence counsel take the position that the bankrupt plaintiff can no longer pursue the income loss claim because it vested in the trustee.

SPECIFIC COMPONENTS OF A PERSONAL INJURY ACTION IN LIGHT OF CONFORTI & MORASCH

Knowing whether a bankrupt client’s income loss claims constitute property or income under the BIA is important, however the inquiry does not end there.  What about the other heads of damages?  These heads are discussed briefly below, as well as accident benefit claims.   However, regardless of which type of claim is being considered, it is worth noting that the date of the tort does not matter.  In other words, the legal principles apply equally whether the tort occurs before the bankruptcy or during the bankruptcy.  In both cases the issues discussed in this paper must be addressed, as both ss. 67 and 68 include assets, i.e. causes of action that accrue during the time that the tort claimant is bankrupt.

Only if the tort occurs after the date of the bankrupt’s discharge will the damages claims entirely escape these issues.  Nonetheless, the discharge order should be reviewed if there is one, as most discharges are granted automatically after the expiry of either 9 or 21 months.  However in a rare case some disposition or assignment of the tort proceeds may have been ordered as a condition of discharge.

1. Pre-Bankruptcy Lost Income

Until recent Supreme Court of Canada decisions in the past twenty years, a distinction was drawn between pre-bankruptcy and post-bankruptcy income. It was generally accepted that all lost income accruing up to the date of bankruptcy vested automatically and exclusively in the trustee under Category 1, under the theory that s. 68 income of the bankrupt only included income earned while the debtor was actually bankrupt, and excluded pre-bankruptcy income which therefore fell under s. 67 to the trustee entirely. This position has been reversed in the last 15 years, and it is now clear that it is the nature of the claim — income — and not when it was earned or recovered that determines its characterization as income. The Ontario Court of Appeal convincingly adopted this approach in Landry, Re:5 Pre-bankruptcy lost income falls under s. 68 and does not accrue 100% to the trustee.

A portion of a tort award or settlement for past income loss or an award of past income replacement benefits in an AB dispute may well fall under this category of pre-bankruptcy lost income.  Imagine a scenario where the client suffers injuries in a motor vehicle accident on January 5, 2013 and he is unable to work.  He then subsequently files for bankruptcy a year later in January 2014 and is discharged nine months later in September 2014.  His tort action does not settle until the summer of 2016.  His past income loss claim in tort covers a period of 3.5 years.  Some of that time frame includes pre-bankruptcy lost income.

Under the above scenario, there are two treatments possible for a lump sum award for pre-bankruptcy income under s. 68 of the BIA. The first approach is for the court to make an order “at large”, based on all the circumstances, that allocates a certain portion of the lump sum settlement to the bankruptcy estate. This ‘rough justice’ approach has been used without the prorating discussed below, and without reference to the Superintendent’s Standards.  Examples of this approach can be seen in Marion v. Keith G. Collins Ltd6. where the court ordered that 2/3 of a $40,000 severance award be paid to the estate; and Goulet (Syndic de) c. C.N.7, where the estate was awarded 75% of a $54,000 severance package in connection with a termination of employment that occurred while the debtor was an undischarged bankrupt.  In that case, the debtor had settled his claim during the bankruptcy but artfully deferred receipt until after his discharge. This approach now appears to be outmoded, if only because it runs afoul of the language of s. 68(10), which requires the court to fix the amount “in accordance with the applicable standards, and having regard to the personal and family situation of the bankrupt …” [Emphasis added].

The second treatment of lump sum pre-bankruptcy lost income is to prorate this amount over the duration of the bankruptcy, as follows:

1. Divide the net amount (after deducting the pro rata portion of legal

fees applicable to the past lost income claim) of the past lost income claim, by the number of months of the debtor’s bankruptcy;

2. Add each monthly amount to the bankrupt’s actual income during that

period; and

3. Apply the Superintendent’s Standards in respect of this monthly total,

after deducting notional income tax.

If the bankrupt’s actual income exceeds the poverty line, this will result in the trustee receiving 50% of the pre-bankruptcy lost income amount. If, however, the bankrupt’s actual income during the bankruptcy falls below the poverty line, then the trustee only receives 50% of the amount available after the bankrupt’s income is topped up to the poverty line. This treatment more properly follows the scheme of s. 68, and takes account of the debtor’s need, during the bankruptcy, to retain a sufficient income to at least meet the poverty line.

This treatment was adopted, more or less, in Conforti #28.  It has also been applied in Coates, Re9, where the lost income award was prorated over the period of the bankruptcy; and in Berridge, Re10, where the trustee was held to be entitled to its surplus income entitlement in respect of all amounts referable to the MVA past income loss claim, prorated over the period of the bankruptcy.

2. In-Bankruptcy Lost Income

In-bankruptcy lost income is that portion of the income loss award that is applicable to the period in which the plaintiff is bankrupt.  It clearly falls within s. 68.  This amount is prorated over the number of months of the debtor’s bankruptcy, and is treated precisely as if it had been earned by the debtor in each such month. In this regard, it is treated exactly the same as pre-bankruptcy lost income.

3. Future Income Loss/Loss of Competitive Advantage/Loss of Earning Capacity 

There are two questions that arise in respect of future entitlements.  The first question is whether lost earning capacity, or loss of competitive advantage, is a capital asset that falls within Category #1 above.  If so, it is an asset accruing entirely to the trustee that does not constitute income under s. 68.

As mentioned above, recent cases in this area of the law (including the Conforti and Morasch decisions) stand for the proposition that tort awards for future income loss are not capital assets.   Therefore claims for future income loss are not treated as property under s. 67 the BIA and the claims do not vest in the trustee upon the claimant’s bankruptcy.  Rather, the award or settlement for future income losses are treated as income and ought to be dealt with under the needs analysis scheme in s. 68 of the BIA.

In Conforti #1, Justice Wilton-Siegel concluded that lost future earning capacity is a replacement for future earned income that maintains its character as income and thus falls within s. 68.  Hence the trustee does not automatically receive 100%, or indeed any part at all, of such a recovery.  The trustee’s maximum entitlement is 50% under the Superintendent’s Standards, and will be less than 50% if the needs of the debtor and his or her family must be met to any extent out of those monies.

Conforti #1 is a well-reasoned decision that is likely to be followed in subsequent Ontario and Canadian case law.  The decision has been followed already by Hennessy J. in the subsequent Ontario Morasch decision who agreed that an award for loss of competitive advantage is to be treated as lost income under the BIA, and only accrues to the trustee, if at all, under the s. 68 needs analysis.

The second question involves s. 68 and the Superintendent’s Standards, namely how to address the fact that the award or settlement for future income loss may be referable to a period long after the debtor is discharged from bankruptcy. This situation arose and the question was answered in Conforti #2, where Justice Spence agreed that the future lost income should be allocated to the time period for which it was awarded.  In Conforti #2, the lost future income covered a period of 17 years until the debtor’s retirement, only 4 of which corresponded to the debtor’s bankruptcy.  Spence J. allocated 4/17 of the net (after legal expenses) future lost income recovery to that period.  He then prorated this amount over the number of months in bankruptcy, and added each monthly amount to the debtor’s actual earned income in that period to calculate the surplus income under the Superintendent’s standards.

4. Health Care & Housekeeping/Home Maintenance Claims

Awards received for health care costs or housekeeping/home maintenance expenses should normally be excluded from income, as they are intended to subsidize costs actually incurred in the care and housekeeping that will be done by another due to limitations resulting from physical impairment, or the pain and suffering that will be endured by the debtor if they have to, or choose to, perform the housekeeping personally.

Both of these pecuniary claims fall within the broad definition of “expenses associated with a medical condition” under s. 5(3)(d) of the Standards, and are properly excluded from the definition of net income under the Standards.  It is of some concern however that in Conforti #2, Justice Spence did not address the exclusion issue at all, and simply directed that these amounts ($7,000 for future care, $15,000 for future housekeeping) are to be added to income without deduction.  He did not permit this issue to be argued, unfortunately.11 The decision is currently under appeal in that respect.

5. Statutory Accident Benefits

Statutory accident benefits may include lost income payments (IRBs), which are treated as above, through prorating.  Lump sum settlements for medical/rehabilitation benefits ought to be excluded from income because they fall within a deduction from the Superintendent’s Standards, namely s. 5(3)(d), “expenses associated with a medical condition”.

The same ought to apply to settlements associated with housekeeping benefits and attendant care benefits.  Such awards are intended to subsidize costs actually incurred for housekeeping or attendant care, as a result of limitations resulting from physical or psychological impairment.  This area of the law is still evolving however and as can be seen by Conforti #2, the correct approach in dealing with awards for health care and housekeeping expenses is not as straightforward as it seems.

6. Pain, Suffering & Loss of Enjoyment of Life

The case law is settled with respect to non-pecuniary damages.  That is, damages for pain and suffering are personal to the bankrupt and they are not considered income for purposes of s. 68.  Damages for pain and suffering are therefore exempt from bankruptcy proceedings under s. 68.

ARTIFICIAL ALLOCATION OF THE TORT AWARD

In most settlements, the heads of damages are not clearly broken down into its constituent components, thereby making it difficult to determine which amounts pertain to pain and suffering, past or future lost income, health care expenses, etc.  In such cases, the court may allocate the damages as best it can. The court may accomplish this task by comparison to the individual amounts claimed in the pleadings for the various heads of damages,12 or by reviewing the evidence of the settlement negotiations.

In one recent case, the Bankruptcy Registrar apportioned the settlement 50-50 between lost earning capacity on one hand and pain and suffering on the other.13  In some instances the debtor and his MVA counsel will strategically seek to apportion the tort settlement so as to artificially minimize that portion of the settlement that corresponds to lost income. The case law is clear that the trustee is not bound by such allocation.  The bankruptcy court,14 or a jury,15 can pierce an artificial allocation of the tort damages as between lost income and other components.

The bankrupt debtor has a statutory obligation to advise the trustee of all changes to their income and financial affairs while bankrupt.16  Thus the debtor is required to advise the trustee of the MVA claim and any consequent litigation.  If settlement or judgment is reached while the debtor is bankrupt, the debtor must inform the trustee.  At that point negotiations will ensue as to what portion of the award or settlement must be paid to the trustee as surplus income.  Technically however, unless and until the trustee obtains a s. 68 order from the bankruptcy court, the trustee has no legal authority to prohibit the tort lawyer from paying the settlement funds out to the debtor.  Conflict is to be expected in this situation, as trustees are at present becoming aware of the evolving case law in this area.

If the debtor discloses the MVA claim to the trustee, and is discharged before the claim is resolved, the case law is unclear as to the trustee’s rights.  Landry17 indicates that a s. 68 order may be made after the debtor’s discharge if the claim was concealed from the trustee. But if the claim was disclosed, arguably the trustee’s remedy is either to obtain a s. 68 order before discharge, or to oppose the discharge in the hope or expectation of obtaining a similar order as a condition of discharge.

Prudence requires the personal injury lawyer to be alive to the issues raised in this paper.  It would also be beneficial to the bankrupt plaintiff if counsel took the time to provide a “realistic breakdown” of the tort settlement into the various heads of damages (or benefits if it’s an AB dispute) and incorporate the breakdown into Minutes of Settlement or into the final Release.  Breaking the settlement down this way will take the guess work out of doing it months or even years later when the issue becomes important for the client in their bankruptcy proceedings.  A proper breakdown of the settlement into its various heads should also prevent a bankruptcy court from adopting a somewhat arbitrary allocation of damages between pain and suffering and lost income as was done in at least one case.

Although the bankruptcy court or trustee is not bound by the breakdown, such a breakdown as agreed to by all parties in the tort action should nonetheless be given considerable weight by a bankruptcy court should the need arise to determine how much of the settlement is considered income for purposes of the BIA.

The issues covered in this paper arise when personal injury law intersects with bankruptcy law.  Given that the Bankruptcy and Insolvency Act makes the Insurance Act seem like a very easy read, counsel are well advised to refer their personal injury client to the appropriate bankruptcy counsel should the need arise post-settlement.18