How Are Unemployment Benefits Treated in Bankruptcy?

Unemployment Benefits and Bankruptcy

Bankruptcy law treats social welfare benefits differently from other types of income. Some are considered a statutory right, and bankruptcy can’t touch them. Social Security benefits, for example, are mostly exempt from bankruptcy proceedings. What about unemployment benefits? A fairly recent case out of New Jersey, In re McWilliams, 384 B.R. 728 (D.N.J. 2008), sheds some light.

The Facts of the Case

James had a rough patch of years; he received unemployment benefits for several months, found work, and then was laid off again. The New Jersey Department of Labor looked into James’s employment history and found that he had, in fact, been employed for around six months while receiving benefits. The NJDOL conducted a hearing and determined that James had committed fraud. Unemployment benefits are for the unemployed; they’re not an extra source of income for those who have jobs.

Shortly thereafter, James filed for chapter 7 bankruptcy, which was later converted to chapter 13 bankruptcy. The NJDOL filed a claim against James for about $7,000 for the benefits he had fraudulently received, plus interest. After filing for bankruptcy, James filed for unemployment again. For the second time, the NJDOL found him eligible to receive benefits. However, instead of paying him, they withheld payments of about $5,000, the principal amount of the debt. When his debt to the NJDOL was repaid, they started to actually pay him unemployment benefits. In re McWilliams, 384 B.R. 728 (D.N.J. 2008)

Did New Jersey’s Refusal to Turn Over Unemployment Benefits Violate the Automatic Stay?

Unhappy with this situation, James filed a motion with the bankruptcy court to compel the NJDOL to turn over those unemployment benefits that they had withheld. He claimed that this attempt to recoup a debt violated the automatic stay. Under bankruptcy law, mutual debts that arose before the debtor filed for bankruptcy may be “set off” against each other without violating the automatic stay. 11 U.S.C.A. § 553. However, a pre-bankruptcy debt to a creditor may not be set off against a post-filing debt to the debtor. James argued that he incurred a debt to the NJDOL before filing for bankruptcy while their debt to him for benefits arose after he filed.

The NJDOL argued that it withheld James’s benefits for the purpose of recoupment. Recoupment, a common law exception to setoff, applies when the setoff rules result in an inequitable solution. Recoupment applies when both debts “arise out of a single integrated transaction such that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations.” McWilliams, 384 B.R. at 730. The court had to determine whether James’s interactions with the NJDOL were multiple transactions or one integrated transaction.

Are Unemployment Benefits a Social Welfare Payment?

In another, the court ruled that social welfare payments were statutory entitlements, not contractual rights.  In other words, they are not a part of a single integrated transaction (such as would be governed by a contract) and recoupment would violate the automatic stay. Social Security is a social welfare payment. Are unemployment benefits a social welfare payment or part of a contract?

Receipt of unemployment benefits establishes a “continuous and ongoing relationship between the state and the recipient, with both benefits and obligations accruing to the latter.” Id. at 731. Workers pay into the Unemployment Insurance fund with the understanding that if they need it, state support will be available. It’s a “societal contract.” Id. According to the court, even if payments aren’t constant “the contractual agreement between a recipient and the state is an ongoing one.” Id. at 732. New Jersey state statutes also specifically allow recoupments of payments obtained through fraud. Id. The state wants to protect the Unemployment Fund for those who are actually eligible to receive benefits, not for those who try to game the system.

So, James’s motion was denied. The NJDOL had the right to withhold his payments and recoup its losses from his earlier fraud. Bankruptcy is not meant to protect you from payment of your fraudulently received benefits. It’s meant as an honest reorganization tool. James learned the hard way, and spent several months in bankruptcy with no job and no benefits.