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“Singular” Cases on Nondischarge and Dischargeability

Liar businessman with crossed fingers at back .

Two recent cases analyzed the misrepresentations of a debtor regarding a single asset and held a written misrepresented value of a single scheduled estate asset would result in nondischargeability under Section 727, and that a verbal misrepresentation of a pre-petition asset to a creditor did not result in an exception to discharge under Section 523.

In Worley v. Robinson,[1]/ the Fourth Circuit affirmed nondischarge where a financially sophisticated debtor’s Schedules substantially undervalued his estate’s only substantial asset.  In Appling v. Lamar, Archer Cofrin LLP,[2]/ the Eleventh Circuit reversed a district decision and held that a false oral statements to a creditor regarding one pre-petition asset would not render the associated debt nondishargeable because they were statements of “financial condition” that must be in writing to support denial of discharge of a debt.

Litigation seeking nondischarge under Section 727 or the dischargeability of a debt under the exceptions of Section 523 is a broad topic. In general terms:

  • Section 727 provides a broad scope of discharge for the debtor, but sets out certain misconduct that will result in nondischarge, which denies the remedy of discharge of any of the debtor’s obligations.  The scope of such misconduct is generally some manner of fraudulent representation or activity in the context of the bankruptcy case, though it can involve pre-petition conduct.  The issue of nondischarge is raised procedurally by an objection to discharge filed by a creditor, the Trustee, or the U.S. Trustee.
  • Section 523, on the other hand, provides for exceptions to the general discharge of the debtor. These exceptions can render a specific obligation nondischargeable. Many of the exceptions are based on legal policies surrounding the character of the indebtedness, like certain taxes, child support obligations, and student loans.  But the commonly litigated exceptions generally involve some manner of pre-petition fraud upon a specific creditor.  The offended creditor typically initiates an adversary proceeding to obtain such an exception to discharge.

The Worley and Appling cases offer illustrations of nondischarge and dischargeability from the most singular perspective where the debtor’s misrepresentation pertains to only one asset.  The very limited facts regarding the assets actually help to identify the very important governing principals and policies of these different Bankruptcy Code treatments of alleged debtor misconduct.

In Worley, the debtor suffered nondischarge where he used a capitalization of income method to value an investment at $2,500, but the Court found it to be worth at least $13,200 under different considerations.  While just those facts may make it seem the Court was slicing it pretty thin against this debtor, other facts leveraged the adverse holding.  The debtor was an MBA with 10 years of brokerage experience who assumedly knew that the valuation method he used would undervalue the basically non-income producing asset, and that the “no asset” appearance of his bankruptcy Schedules would tend to chill further investigation by creditors or the trustee or even lead to abandonment of the property.  The Court found no clear error in the bankruptcy court’s denial of discharge under Section 727(a)(4), for the making a false oath or account.

Appling also involved very simple facts: the debtor lied to his lawyers to obtain pre-petition legal services on credit, first saying that he expected a big tax refund that would enable him to pay his legal bills, then after getting the refund, using it in his business and telling his lawyers he didn’t get the refund.  But again, the simple facts regarding this asset assist the clarity of the legal issues involved.  Section 523(a)(2)(A) and (B) both provide for exceptions from a discharge a debt obtained by misrepresentations.  However, (B) governs any misrepresentation “respecting the debtor’s … financial condition”, and requires that the misrepresentation be in writing.  Misrepresentations regarding other topics are governed by (A), and may be oral statements.  So, the question in Appling turned to whether debtor’s oral statements about this one asset were statements “respecting the debtor’s … financial condition.”  If they were, then Section 523(a)(2)(B) controls, and if the creditor does not have a written statement, the creditor loses.  Here, the existence vel non of a tax refund did relate to financial condition, and lacking any writing by the debtor about it, the debt was dischargeable.[3](We at The Bankruptcy Cave found this confusing – what oral statements do not relate to financial condition, and thus could lead to nondiscahrgeability?  The opinion answers it – “false [oral] representations about job qualifications and lies about the purpose and recipient of a payment,” for example, are the stuff that can lead to nondischargeability.  But if the creditor is complaining about a falsehood regarding financial condition, it should have gotten it in writing, the Eleventh Circuit held.)

Together the Worley and Appling cases show the varied levels of legal scrutiny of debtor intent and creditor reliance, and variable levels of materiality in the landscapes of nondischarge and dischargeability.  (My colleague Mark Duedall from BC Atlanta also wrote recently on this, in the context of a lender’s failure to perform any real diligence on a debtor’s statements, rendering the lender’s reliance unreasonable and foiling another effort to deny a discharge, here.)  It is intuitively useful to first remember that discharge and a “fresh start” are basically the whole point of the Code, and that variance of that result would be relatively rare.  (See a nice collection of Supreme Court statements on this point here.)

In the context of Section 523 dischargeability and misrepresentations, there is, in practical effect, a relatively lower expectation of debtor intent and a higher scrutiny of creditor reliance. For example, the Appling case arguably weighs “fresh start” against a legally sophisticated creditor’s unsecured lending to a financially distressed guy based on his oral statement that he was going to get a tax refund.  Is that really the creditor due diligence or underwriting standard that the Courts are endeavoring to protect in the scheme of Code policy goals?  Is that the creditor we should break “fresh start” for?  Is it too much to ask for unsecured creditors to obtain written statements of the borrower’s financial condition?  Were the oral statements really material to any reliance upon which credit was extended?  The result in Appling would indicate a negative answer to each of those rhetorical questions.

However, in the context of Section 727 nondischarge and misrepresentations, there is, in practical effect, a relatively higher expectation of debtor intent and a lower scrutiny of creditor reliance.  For example, the Worley case arguably weighs the debtor’s “fresh start” against his own financially sophisticated methods of asset valuation without any consideration of whether reasonably diligent creditors or trustees would have, in fact, been fooled.  Section 727 is itself the “fresh start”, and so the expectations of debtor conduct in the proceeding are high.  Does a debtor have to be scrupulously honest in characterizing his financial condition?  Can a Court scrutinize errors in a debtor’s Court statements down to the level of a single asset and the debtor’s subjective experience and expertise?  In the right circumstances, can a single asset be so material as to support nondischarge?  The result in Worley would yield positive answers to all those questions.

While the Worley and Appling cases involve unusual matters in their analysis of single asset factual disputes, the cases do illustrate that disputes involving nondischarge and dischargeability do not tend to provide safe harbors, and rather always involve a facts-and-circumstances analysis and a result that will largely depend on issues of intent, reliance, and materiality.

 

[1]/          Worley v. Robinson (In re Worley), 15-2346 (4th Cir. Feb. 28, 2017).

[2]/          Appling v. Lamar, Archer Cofrin LLP (In re Appling), 16-11911 (11th Cir. Feb. 15, 2017).

[3]/          The Appling Court noted a substantial Circuit split on this issue.

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Tenth Circuit Joins Missouri River to Divide Kansas City Over What Constitutes A Stay Violation

On February 27, 2017, the United States Court of Appeals for the Tenth Circuit joined a minority approach followed by District of Columbia Circuit:  failing to turn over property after demand is not a violation of the automatic stay imposed by 11 U.S.C. § 362.  WD Equipment v. Cowen (In re Cowen), No. 15-1413, — F.3d —-, 2017 WL 745596 (10th Cir. Feb. 27, 2017), opinion here.

In Cowen, one secured creditor (WD Equipment) repossessed a vehicle in need of repairs for which the debtor (Cowen) could not pay.  Id. at *1.  Another secured creditor (Dring, the debtor’s father-in-law who is likely no longer welcome at Thanksgiving) repossessed a separate vehicle through the use of false pretenses, a can of mace, and five goons helpful colleagues:

“Mr. Dring lured Mr. Cowen under false pretenses to his place of business to repossess the Kenworth [truck].  Mr. Dring asked Mr. Cowen, who had brought along his young son, to leave the keys in the ignition, engine running, and to step out of the truck.  As Mr. Cowen exited the vehicle, Mr. Dring jumped in, grabbed the keys, and declared the truck ‘repossessed.’  When Mr. Cowen asked what was going on, Mr. Dring told him to take his son and leave—immediately.  A group of five men gathered around Mr. Dring while he brandished a can of mace above his head and threatened to use it if Mr. Cowen did not leave.  Mr. Cowen pushed his young son behind him to protect him, and the two left the lot on foot.” Id.

(Editor’s Note from the Bankruptcy Cave:  You can’t find these stories anywhere in the judicial system except in Bankruptcy Court; we love it.  Here is also a Bankruptcy Cave rendering of what we think these fine young lads looked like.)

Dangerous zone

 

 

Within days of the repossessions, Cowen filed for chapter 13 bankruptcy protection in the Bankruptcy Court of the District of Colorado and demanded the return of both trucks, but WD Equipment and Dring both refused.  Id.  Cowen then obtained a show cause order from the bankruptcy court, which ordered the Defendants to “immediately turn over” the trucks to Mr. Cowen; “[c]ontinuing failure to turn over the Truck[s],” the bankruptcy court warned, “may result in the imposition of monetary damages against the Creditors for willful violation of the automatic stay.”   Id. at *2.

After the Defendants failed to comply with the bankruptcy court’s show cause order, Cowen instituted an adversary proceeding against Defendants WD Equipment and Dring for willful violation of the automatic stay.  Id.  During the adversary proceeding, the Defendants argued that Cowen’s rights in the trucks had been properly terminated by Defendants before the bankruptcy petition was filed.  But the bankruptcy court did not find the Defendants’ testimony credible, found that Defendants likely manufactured and forged documents regarding transfer of title, and found that because Defendants’ actions contravened Colorado law, Defendants did not effectively terminate Cowen’s ownership interest in the Trucks.  The bankruptcy court ultimately concluded, “[f]ailing to return the Trucks violated § 362(a)(3) of the Bankruptcy Code,” and it imposed actual and punitive damages under 11 U.S.C. § 362(k)(1). Id.

The district court affirmed, noting that the bankruptcy court had applied the majority rule followed by the Second, Seventh, Eighth, and Ninth Circuits: “that the act of passively holding onto an asset constitutes ‘exercising control’ over it, and such action violates section 362(a)(3) of the Bankruptcy Code.” Id. at *4 (citing Thompson v. Gen. Motors Acceptance Corp., 566 F.3d 699, 703 (7th Cir. 2009); Weber v. SEFCU (In re Weber), 719 F.3d 72, 81 (2d Cir. 2013), California Emp’t Dev. Dep’t v. Taxel (In re Del Mission Ltd.), 98 F.3d 1147, 1151 (9th Cir. 1996), Knaus v. Concordia Lumber Co. (In re Knaus), 889 F.2d 773, 775 (8th Cir. 1989), Unified People’s Fed. Credit Union v. Yates (In re Yates), 332 B.R. 1, 4 (10th Cir. BAP 2005).

The Tenth Circuit reasoned that the majority approach relied too much on legislative history and “practical considerations.”  Id.  In choosing to follow the minority approach followed by the D.C. Circuit (see United States v. Inslaw, 932 F.2d 1467, 1474 (D.C. Cir. 1991)), the Tenth  Circuit stated as follows:

Here again is § 362(a)(3), in relevant part: a bankruptcy petition “operates as a stay … of … any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” Breaking down the sentence, “any act” is the prepositive modifier of both infinitive phrases.  In other words, § 362(a)(3) prohibits “any act to obtain possession of property” or “any act to exercise control over property.”  “Act”, in turn, commonly means to “take action” or “do something.” New Oxford American Dictionary 15 (3d ed. 2010) (primary definition of “act”).  This section, then, stays entities from doing something to obtain possession of or to exercise control over the estate’s property. It does not cover “the act of passively holding onto an asset,” Thompson, 566 F.3d at 703, nor does it impose an affirmative obligation to turnover property to the estate.  “The automatic stay, as its name suggests, serves as a restraint only on acts to gain possession or control over property of the estate.”  Inslaw, 932 F.2d at 1474.  Stay means stay, not go.

Id. The Tenth Circuit concluded: “[a]nd so, adhering to the text of the statute, as we must, we adopt the minority rule: only affirmative acts to gain possession of, or to exercise control over, property of the estate violate § 362(a)(3).  Id. at *5.

Despite the reversal, the Defendants were not absolved of liability.  While simply refusing to turn over the trucks did not constitute affirmative acts of the Defendants, the Tenth Circuit stated that the Defendants’ manufacturing of paperwork, forging of documents, potentially perjured testimony, and coaching of witnesses, “would qualify as post-petition acts to exercise control over the debtor’s property in violation of the automatic stay.”  Id. at *6.

Potential Ramifications

Cowen could prove useful to banks and credit card companies who are faced with allegations that account freezes violate the automatic stay.   Cowen will also necessitate that lawyers practicing on the borders of the D.C. or Tenth Circuits (such as in Kansas City, which is divided between the Eighth and Tenth Circuits) be mindful of the location of repossessions and turnover demands and denials.

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No Trustee Left Behind – Another Bankruptcy Court Requires Colleges to Return Tuition to the Bankruptcy Estate

b09036864402bfedc690a2f80d6de804Another bankruptcy trustee catches another hapless college unaware.  In Roach v. Skidmore College (In re Dunston), Bankr. S.D. Ga. (Jan 31, 2017), a trustee appears to win the next battle of “bankruptcy estates v. child’s college,” ruling that an insolvent parent who paid the college tuition of an adult child made a fraudulent transfer to the college.  Thus, the unsuspecting college will likely have to return the tuition to the parent’s bankruptcy estate.

The theory is simple (albeit unsettling to some).  Under Section 548 of the Bankruptcy Code (and applicable state law, as a back-up), if any debtor makes a transfer to a third party while insolvent, and does not receive reasonably equivalent value in return, the debtor’s bankruptcy trustee may reclaim such transfer for the benefit of unsecured creditors (and for the benefit of the trustee’s fees, of course).  In plain English, the recipient got the money, and didn’t provide anything to the insolvent party which made the payment.  That’s unfair to the insolvent payor’s other creditors (who are left with crumbs, or nothing), and thus a “fraudulent transfer” can be reclaimed for all such other creditors.  Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).  But Congress did not include tuition paid for an adult child in the list of exceptions, and so it is not the place of courts to graft a “adult child college tuition” exclusion to the statute.

We had a prior post on this, here.  In that post, we went over a contrary ruling from the District of Massachusetts, DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Bankr. D. Mass. (Aug. 10, 2016).  In that case, the Bankruptcy Court ruled against the Chapter 7 trustee by holding that the future benefits an adult child may get from a college education can provide “reasonably equivalent value” such that the parent’s tuition payment to the college is not voidable.  As the Palladino Court held, “[a] parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent.  This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  (Other coverage of Palladino and opinions like it, including this recent ruling from Georgia, can be found in the outstanding coverage of Katy Stech of the Wall Street Journal  here, here, and here (alas, WSJ subscriptions required)).

Now, in Roach v. Skidmore College (In re Dunston), the Bankruptcy Court for the Southern District of Georgia has ruled to the contrary.  In Dunston, the Court rejected the argument that an indirect economic benefit of having a well-educated and (hopefully) a gainfully employed adult child is “reasonably equivalent value.”  Instead, according to Dunston, paying an adult child’s tuition is simply honoring a “moral obligation,” and not any legal duty or actual, monetary obligation of the parent.  The college – in this case, the august institution Skidmore College, near beautiful Saratoga Springs and home to some seriously rockin’ a cappella – provided no value to the debtor parent.  Thus, the Dunston court allowed the fraudulent transfer action to go forward – and its will eventually be successful, in The Bankruptcy Cave’s view.

Our previous post on this issue criticized what we believed was a results-oriented decision in Palladino.  To be sure, few like the idea of our educational institutions having to fully refund tuition payments which they accepted innocently, without knowing of the parent’s insolvency.  But despite these misgivings, Palladino was incorrect under a plain reading of the statute – any time an insolvent debtor gives money to a third party, and receives nothing in return, that money should come back to the bankruptcy estate to benefit all other innocent creditors.  The Dunston decision is right.

This problem cries out for a legislative solution.  Until then, bankruptcy courts will honor the wording of the fraudulent transfer status and require colleges to return the tuition (Dunston) or find “future economic value” to the parent that is, in the view of The Bankruptcy Cave, entirely speculative (Palladino).  While there are many problems with our current bankruptcy statutes, this one really needs a solution.

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A Debtor’s Allegedly False Financial Statement Doesn’t, At All, Excuse a Lack of Lender Diligence

A decision rendered during the sometimes peaceful interlude between Christmas and New Year’s is worth reading, and heeding.  Hurston v. Anzo (In re Hurston), Adv. Proc. No. 15-2026 (Bankr. N.D. Ga. Dec. 27, 2016) is a helpful reminder to anyone representing lenders or creditors which are hell-bent-for-leather to pursue a non-dischargeability claim against a debtor that submits a false written statement (e.g., a personal financial statement) to obtain credit.  Often, in the fervor of the start of a bankruptcy case, the creditor (and its lawyer) will make great hay from the fact that a debtor may have lied in a pre-petition credit application, or forbearance agreement, or other written medium.  However, the facts of Hurston show that a creditor (and its lawyer) should pause, take a breath, and critically evaluate whether the creditor actually relied on the pre-petition writing from the debtor, and whether that creditor’s reliance was also, in fact, reasonable.  If not, then the creditor deserves a serious challenge from its own counsel on the wisdom of pursuing a expensive, and likely unsuccessful, non-dischargeability claim.

We don’t need to go in detail on the debtor’s alleged falsehoods – that is not the point of Hurston.  Instead, Judge Sacca of the Bankruptcy Court for the Northern District of Georgia covered in great detail how the creditor didn’t not rely on the allegedly false statements, and even if it did, its reliance was not reasonable.  The key takeaways from the opinion – and helpful advice for any lawyer that is thinking about taking on a “false statement” non-dischargeability action under 11 U.S.C. sec. 523(a)(2)(B) – are what the creditor in Hurston did and didn’t do.

First, where the creditor does not perform any material diligence on the false statement (here, a personal financial statement), then the creditor will have a difficult or impossible time showing that it “reasonably relied” on the allegedly false financial statement.  The creditor should ask for bank statements, tax returns, information from accountants, or other, third party evidence to back up information form a debtor.  If the creditor didn’t perform any follow up diligence, you should advise the creditor (right at the outset) that its claim may fail.

Second, this is especially true where the creditor and debtor do not have a prior relationship.  A prior relationship might (we emphasize, might) provide indicia of reliability of the debtor and its financial wherewithal to overcome a lack of diligence.  But if there is no prior relationship, the creditor should be ready to show that it did more diligence.

Third, where a financial statement (or other writing on which the non-dischargeability claim is based) contains “red flags,” including matters a reasonable creditor would question or that the specific creditor should know to question, the creditor must show that it followed up on those “red flags.”

Fourth, a debtor with an alleged strong financial reputation, or that appears to be wealthy based on appearance and community activity, does not excuse the creditor’s obligation to perform diligence on any written statement or financial statement.  In short, an argument based on “the debtor was a pillar of the community” will not go to show reasonable reliance by the creditor on an otherwise questionable financial statement or other writing.

Fifth, the creditor should be able to show it had established criteria to evaluate the credit being extended – and that those criteria were used and evaluated as a critical part of making any decision to extend credit.  A lack of rules and procedures to evaluate financial statements or other written submissions, or a failure to follow those procedures, will be very harmful to the creditor’s claim.

When you read 11 U.S.C. sec. 523(a)(2)(B), and in particular its requirement that the creditor “reasonably relied” on any alleged false statement, the Hurston decision is not surprising.  But Hurston remains a very helpful reminder for any creditor’s lawyer to critically examine the creditor’s case at the start of the matter.  The lawyer must cross-examine the creditor to get past the allegations of the debtor’s falsehoods (which the creditor will trumpet as much as you let it), and spend a great deal more time on whether the creditor did any diligence on the allegedly false written statements.  This can be an awkward conversation with your client – and perhaps perceived as blaming the victim – but it will be far more awkward to later explain to your client why the non-dischargeability action did not succeed.

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Helpful Cases for Mortgage Servicers Attempting to Comply with Mortgage Servicing Regulations After a Bankruptcy Discharge

Mortgage lenders and servicers face several regulations in servicing residential mortgages. There are requirements under the Truth in Lending Act (“TILA”), Real Estate Settlement Procedures Act (“RESPA”), the Equal Credit Opportunity Act (“ECOA”), the Fair Debt Collection Practices Act (“FDCPA”), state law, and new regulations implemented by the Consumer Financial Protection Bureau (“CFPB”).  Failure to comply with these regulations and laws may give rise to litigation, as well as statutory penalties.  In many cases, the mortgage borrower files for bankruptcy.  When the mortgage borrower states an intention to surrender the mortgaged property in bankruptcy, non-bankruptcy statutes and regulations often conflict with or at minimum create great uncertainty about the mortgage servicer’s obligations to communicate with these borrowers after discharge.  Neither the Supreme Court nor many of the Circuits have provided clarity for mortgage servicers on whether, how, and to what extent they may communicate with a discharged debtor who still owns the mortgaged property.  Accordingly, for the time being, mortgage servicers must attempt to comply with every applicable statute and regulation while not running afoul of any applicable bankruptcy discharge rules.  The following is a compilation of cases dealing with this dichotomy.

  • “[N]ot every communication from a creditor following the conclusion of a Chapter 7 case violates the discharge injunction.” In re Henriquez, 536 B.R. 341, 345 (Bankr. N.D. Ga. 2015).
  • Correspondence does not violate Section 524 unless it includes a clear demand for payment, accompanied by coercion in the form of a threatened action or some other consequence for nonpayment to induce the debtor to pay. In re Gill, 529 B.R. 31, 40 (Bankr. W.D.N.Y. 2015).

A.  Cases Discussing Foreclosure Notices Required by State Law.

  • Foreclosure notices have been held not to violate the discharge injunction because they are required under both the mortgage and state law. Gill, 529 B.R. at 41; In re Ladebush, No. AP 13-1154-JMD, 2016 WL 675580, at *7 (Bankr. D.N.H. Feb. 18, 2016).
  • The Eighth Circuit has held that foreclosure notices from a secured creditor to a debtor that contain a declaration that they were provided “for information purposes” about the status of the property are not an attempt to collect against the debtor personally, as a matter of law. In re Pennington-Thurman, 499 B.R. 329, 332 (B.A.P. 8th Cir. 2013), aff’d, 559 F. App’x 600 (8th Cir. 2014).
  • Several courts have held that a secured creditor’s communication that acknowledges a bankruptcy discharge has been entered and states the notice is not an attempt to collect personally against the debtor does not violate Section 524. Id.; Pearson v. Bank of Am., No. 3:12-CV-00013, 2012 WL 2804826, at *5-6 (W.D. Va. July 10, 2012); Anderson v. Bank of Am., No. 6:12-CV-00017, 2012 WL 4458474, at *3-4 (W.D. Va. July 11, 2012); In re Mele, 486 B.R. 546 (Bankr. N.D.Ga. 2013); Jones, No. 08–05439, 2009 WL 5842122, at *3 (Bankr. S.D.Ind. Nov. 25, 2009); In re Schatz, 452 B.R. 544, 550 (Bankr. M.D. Pa. 2011).

B.  Cases Discussing Escrow Account Review Statements Required by RESPA and State Law.

 

RESPA and some state law require mortgage servicers to provide escrow account review statements at least annually. 24 C.F.R. 3500.17; see e.g., Fla. Stat § 501.137(2)).

  • Escrow account review statements have been held not to violate the discharge order. Pearson, 2012 WL 2804826, at *5-6; In re Whitmarsh, 383 B.R. 735, 736-37 (Bankr. D. Neb. 2008).
  • One court noted that although the Bankruptcy Code prohibits a mortgagee from exerting pressure on the mortgagor to repay an advance or escrow deficiency, it does not prohibit a mortgagee from providing information or notice to a mortgagor of escrow deficiencies. Chase Manhattan Mortg. Corp. v. Padgett, 268 B.R. 309, 314 (S.D. Fla. 2001).

C.  Cases Discussing Foreclosure Alternative Letters Required by RESPA and Allowed by the Bankruptcy Code.

 

Federal regulations require loan servicers to provide post-discharge communications about loss mitigation options and periodic mortgage statements. Regulation X, which implements RESPA, requires loan servicers to fulfill the “early intervention” obligations of 12 C.F.R. 1024.39 – but to suspend compliance during a borrower’s bankruptcy. Effective January 10, 2014, the CFPB amended Regulation X to require loan servicers to resume compliance upon the first delinquency after a bankruptcy discharge. Comment, 12 C.F.R. 1024.39(d)(1)-2 Cmt.; 12 C.F.R. 1026.41(e)(5)-2 Cmt. In implementing this regulation, the CFPB acknowledged the Bankruptcy Code may prevent attempts to collect a debt personally, but concluded the Bankruptcy Code did not prevent servicers from sending consumers information about the mortgage.

  • Several courts have found that letters offering alternatives to foreclosure have been held not to violate the discharge injunction.   Whitmarsh, 383 B.R. at 736-37; Henriquez, 536 B.R. at 344-45.
  • Letters responding to borrowers’ requests for loss mitigation information have also been held not to violate the discharge injunction. Mele, 486 B.R. at 557.
  • In the situation where the debtor indicates an intention to surrender the property but continues to live in the property, courts have found that information provided to debtors about making voluntary payments post-discharge to avoid foreclosure is allowed under 11 U.S.C. § 524(j). Jones, 2009 WL 5842122, at *3.
  • Regulation X’s “early intervention” requirements also include providing the borrower, at least once every 180 days, with contact information for personnel assigned to assist them and examples of potential loss mitigation options. Similarly, an ECOA statement of the estimated property value must be provided to the property owner without regard to bankruptcy. 12 C.F.R. 1002.14(a)(1); see ECOA Valuation Rule: Compliance Guide, Oct. 3, 2013, at 10 (“The rule covers applications for … loss-mitigation transactions, … covered by Regulation B”).
  • These courts have held that customer relationship letters and property value estimates do not violate Section 524. Henriquez, 536 B.R. at 344-45; Best v. Nationstar Mortgage, LLC, 540 B.R. 1, 10 (B.A.P. 1st Cir. 2015); Leahy-Fernandez v. Bayview Loan Servicing, LLC, — F.Supp.3d –, 2016 WL 409633, at * 8 (M.D. Fla. Feb. 3, 2016)(Covington, J.).

D.  Property Insurance Lapse Notices Required by RESPA.

 

RESPA requires servicers to issue at least two notices to property owners before obtaining lender-placed insurance. 12 U.S.C. § 2605(l). RESPA then requires a notice to be sent upon each renewal of a lender-placed policy. 12 CFR 1024.37(e). The CFPB has concluded that a bankruptcy discharge does not relieve mortgagees from this requirement, and its final lender-placed insurance rule provides no notice exceptions for bankruptcy, default, or foreclosure. See Mortgage Servicing Rules Under the Real Estate Settlement Procedures Act (Regulation X), 78 Fed. Reg. 10696-01, at 10,767 (Feb. 14, 2013).

  • These cases held insurance notice communications did not violate the discharge injunction. Leahy-Fernandez, 2016 WL 409633, at * 8; Myers v. Bank of Am., No. 8:14-MP-00007-MGW, ECF 24-1 at 28:18-31:4 (Bankr. M.D. Fla. Nov. 18, 2014).

Since the mortgage crisis began in 2008, Congress has passed additional regulations to help property owners retain their homes. More clarity for mortgage servicers is needed on how these regulations are enforced after the debtor receives a bankruptcy discharge. In the meantime, we hope this compilation of situations and applicable caselaw is of use to you.

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Will Inherited IRAs Be Used As A Tool for Protecting An Inheritance from Creditors?

A recent decision out of a New Jersey Bankruptcy Court highlights a loophole in the Bankruptcy Code which may allow Chapter 7 debtors to keep significant assets out of the hands of trustees and creditors.

In In re Norris,[1] the Bankruptcy Court considered whether an inherited individual retirement account is property of the bankruptcy estate.  Prior to the Debtor filing her bankruptcy case, her stepmother passed away, leaving an inherited IRA naming the Debtor as the beneficiary.  In her amended schedules, the Debtor listed the inherited IRA, claiming it as fully exempt under 11 U.S.C. § 522(d)(12), but also claiming the inherited IRA was not property of the estate.[2]  The Chapter 7 Trustee objected to the exemption and requested the inherited IRA be deemed property of the bankruptcy estate.

The Bankruptcy Court ruled in favor of the Debtor, holding that the inherited IRA was exempt. In reaching its decision, the Bankruptcy Court focused on the threshold question of whether the funds could be deemed property of the estate.  While generally, a debtor’s estate is comprised of all legal and equitable interests of the debtor as of the commencement of the case, there are a few exceptions.[3]  Section 541(c)(2), otherwise known as the spendthrift trust exception, provides that “a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”  The Court cited an applicable New Jersey statute which provides that any property held in a qualifying trust and any distributions from that qualifying trust are exempt from all claims of creditors and are excluded from the estate in bankruptcy.[4]  The statute specifically lists trusts created or qualified and maintained under Section 408 of the Internal Revenue Code, which includes IRAs.

Following the Third Circuit’s analysis in In re Yuhas, 104 F.3d 612 (3d Cir. 1997), the Bankruptcy Court applied a five part test to determine whether an IRA is excluded from the bankruptcy estate under Section 541(c)(2) of the Code:

 

  1. The IRA must constitute a “trust” within the meaning of Section 541(c)(2);
  2. The funds must represent debtor’s “beneficial interest” in that trust;
  3. The IRA must be qualified under Section 408 of the Internal Revenue Code[5];
  4. The provision of N.J.S.A. stating that property held is exempt from all claims of creditors must be a restriction on the transfer of the IRA funds; and
  5. The restriction must be enforceable under nonbankruptcy law.

With four of these elements easily satisfied, the ultimate question for the Bankruptcy Court was whether the change from an IRA to an inherited IRA also changes the asset’s “qualifying status” under the applicable New Jersey statute. While there are distinctions between IRAs and inherited IRAs regarding disposition of funds and tax treatment, the Bankruptcy Court nevertheless found that the six requirements of a qualified trust set forth in 28 U.S.C. § 408(a)(1)-(6) were satisfied by the IRA agreement with Mutual of America.

 

In reaching its decision that the inherited IRA was not property of the estate, the Bankruptcy Court ultimately declined to consider the Debtor’s argument that the inherited IRA was exempt.  In this way, the Court deemed the Supreme Court’s decision in Clark v. Rameker,[6] inapplicable on the grounds that the Supreme Court considered only whether an inherited IRA could be considered “retirement funds” for the purpose of the retirement exemption in Section 522(b)(3)(c).

 

Nonetheless, the Bankruptcy Court did acknowledge that key distinctions between IRAs and inherited IRAs raise significant concerns noted by the Supreme Court in Clark v. Rameker – the debtor beneficiary of an inherited IRA may withdraw the entirety of the funds at any time and for any purpose, and in fact, must withdraw the entirety of the funds within five years or take a minimum annual distribution every year.  With no restrictions on distributions from the inherited IRA, the door is left open for future abuse: potentially significant assets can be excluded from a bankruptcy estate, while the debtor is free to use those inherited funds whenever and however he or she sees fit.

 

[1]           In re Norris, Case No. 15-26458, Docket No. 31 (Bankr. D.N.J. Memorandum Opinion dated May 20, 2016).

[2]           Id. at p. 2 (citing In re Yuhas, 104 F.3d 612 (3d Cir. 1997); In re Andolino, 525 B.R. 588 (Bankr. D.N.J. 2015)).

[3]           11 U.S.C. § 541(a).

[4]           In re Norris, Memorandum Opinion at 4-5 (citing N.J.S.A. 25:2-1(b)).

[5]           26 U.S.C. § 408(a).

[6]           134 S. Ct. 2242, 2247 (2014).

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What Do You Mean the Trust Is Not Asset Protected?

In a recent bankruptcy case, Richard Lewiston unsuccessfully attempted to shelter his assets in the Lois and Richard Lewiston Living Trust (the “Trust”) from inclusion in his bankruptcy estate based on the Trust’s spendthrift provision. Here, the bankruptcy court looked to Michigan state law in applying the provisions of the Bankruptcy Code and concluded the Trust property was part of Lewiston’s bankruptcy estate.

Facts about the Trust:

  • Richard and his wife created the Trust in 1986.
  • Richard and Lois were the only beneficiaries of the Trust for as long as either of them were alive.
  • Richard and Lois served as the Trustees, and either Richard or Lois were designated to act as the Managing Trustee with the power to manage the Trust assets.
  • The Trust contained a Spendthrift Provision protecting all beneficiaries from claims by creditors.
  • The Trust also contained a provision allowing it to be “amended, modified or revoked, in whole or in part, but only by the joint action and consent of Richard and Lois.”
  • In 2008, they amended the Trust to provide that the Trust would become irrevocable once one of them died.

In 2012, when Richard filed bankruptcy, he disclosed the Trust for “notice purposes only” and claimed that it was excluded from his bankruptcy estate under Section 541 of the Bankruptcy Code, which provides an exclusion for trust property subject to a transfer restriction “enforceable under applicable nonbankruptcy law.”

The bankruptcy trustee took exception to this claimed exclusion and filed a complaint in the bankruptcy case against both Richard and Lois, taking the following positions:

  • The spendthrift provision of the Trust is not enforceable under Michigan law as to Richard;
  • Self-settled spendthrift trusts are against Michigan’s public policy; and
  • The Trust property was includible in Richard’s bankruptcy estate.

In essence, the Court found Richard had complete control over the Trust property. Richard’s testimony established the following bad facts:

  • He consistently deposited distributions from Trust assets into his personal bank account; and
  • He dealt with Trust property without disclosing the Trust, notwithstanding the Trust provision that the actions of both Lois and Richard were required to remove property from the Trust.

Nevertheless, Richard claimed that the spendthrift provision was enforceable because the Trust could not be revoked without Lois’s consent, making it irrevocable as to him. Lois filed a response claiming that she had contributed her own property over time to the Trust in the total amount of about $1.5 million, but didn’t submit her signed declaration to that effect until the day before the hearing.

The Court was tasked with determining whether there was a restriction on the transfer of Richard’s beneficial interest in the Trust that was enforceable under Michigan nonbankruptcy law. Under controlling common law, a self-settled spendthrift trust that attempts to place the settlor’s own assets beyond the reach of his/her creditors while retaining the beneficial interest in such assets violates Michigan public policy.

Richard, however, claimed that the Trust was irrevocable because he could not revoke the Trust without Lois’ consent, and that the Michigan Trust Code (MTC), enacted in 2010, overruled this common law so that Michigan now permits irrevocable self-settled spendthrift trusts. Specifically, Richard relied on a section of the MTC which states that during the life of a settlor, while a revocable trust is subject to the claims of the settlor’s creditors even if the trust contains a spendthrift provision, if a trust is irrevocable, the settlor’s creditors can only reach the “maximum amount that can be distributed to or for the settlor’s benefit.” Further, if the trust has more than one settlor, the creditors are limited to “settlor’s interest in the portion of the trust attributable to that settlor’s contributions.”

The Court noted that the MTC did not expressly authorize self-settled spendthrift trusts or specifically state whether it “abrogates or continues to recognize the public policy exception against self-settled trusts under Fornell, Johannes and Hertsberg, all of which predate the MTC.” The Court held that the MTC could not be said to abrogate Michigan common law as to Michigan’s public policy against self-settled spendthrift trusts, and this common law prohibition against self-settled trusts retains its vitality. Accordingly, Michigan law did not validate the Trust’s spendthrift provision as to Richard, and the Trust was not an excluded asset under the Bankruptcy Code.

Lastly, the Court rejected Lois’s argument, that Fornell did not apply at least to the funds she contributed to the Trust because she was also a settlor of the Trust. Lois had not submitted her signed declaration concerning the assets she had deposited into the Trust until just one day before the scheduled hearing, which the Court said was not timely and should therefore be ignored as not properly before the Court. The Court also stated that Lois had cited no authority to support her argument that her contributions to the Trust, which did not name her as settlor in the trust instrument, would make her a settlor of the Trust as to those contributions or limit the access of Richard’s creditors to those contributions. All of the assets of the Trust were therefore included in Richard’s bankruptcy estate.

*Thanks to Alex Fersa for drafting assistance.

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Putative Class Actions in Bankruptcy for Violations of the Discharge Injunction and Bankruptcy Code Section 524(j)

Red Foreclosure Home For Sale Real Estate Sign on White

There has been a relatively recent uptick in plaintiffs’ counsel filing putative class actions in multiple state and federal courts for alleged violations of a debtor’s bankruptcy discharge injunction based upon the debtor’s receipt of post-discharge mortgage-related communications. These claims assert putative class action challenges to post-discharge communications alleged to be attempts at personal collection of the discharged mortgage debt.

Bankruptcy Code Section 524(j) expressly allows a secured creditor with a security interest in the debtor’s principal residence to communicate with the debtor in the ordinary course of business provided the creditor is seeking periodic payments associated with a valid security interest in lieu of pursuing in rem relief to enforce the lien. This section is under-developed in case law, but is receiving some attention because, effective January 10, 2014, 12 C.F.R. 1024.39 and 1026.41 allows mortgagees/servicers to provide debtors with periodic statements regarding the status of the mortgage loan and loss mitigation options post-discharge.

While a discharge extinguishes the debtor’s personal liability on his or her creditor’s claims, a discharge does not extinguish a creditor’s right to enforce its in rem rights against surrendered property. Johnson v. Home State Bank, 501 U.S. 78, 84-85 (1991). A bankruptcy discharge does not affect a secured creditor’s lien in collateral; the lien survives and is enforceable after the bankruptcy proceeding in accordance with state law. Dewsnup v. Timm, 502 U.S. 410, 417 (1992). Further, while the Code provides a discharge of personal liability for debt, it does not discharge the debtor’s post-petition burdens of owning property such as insurance and taxes. In re Arsenault, 456 B.R. 627, 631 (Bankr. S.D. Ga. 2011). Thus, until foreclosure or other transfer of title, the debtor still owns the property, and the secured creditor is entitled to, and sometimes obligated under non-bankruptcy law, to communicate with the property’s owner about the status of the property post-discharge. One such communication a secured creditor is expressly entitled to make under the Bankruptcy Code is to seek periodic payments in lieu of pursuing in rem relief to enforce the lien. 11 U.S.C. § 524(j).

Congress specifically authorized a mortgagee/servicer “seek[] or obtain[] periodic payments associated with a valid security interest” so that debtors might have the option of staying in their homes. Section 524 specifically provides that a debtor may voluntarily pay a debt in spite of the discharge in order to discourage the mortgagee from foreclosing on the property. 11 U.S.C. §§ 524(f) and 524(l ). Information provided to debtors about this option does not violate § 524. In re Jones, No. 08-05439-AJM-7, 2009 WL 5842122, at *3 (Bankr. S.D. Ind. Nov. 25, 2009).

Nonetheless, plaintiffs are attempting to create an independent class action based upon a single debtor’s claim for an alleged violation of his § 524 discharge order. Section 524 does not provide for a private right of action for a discharge injunction violation, much less a class action. Pertuso v. Ford Motor Credit Co., 233 F.3d at 421 (analyzing the legislative history of § 524, contrasting § 524 with Congress’s choice in § 362(h) to create private causes of action for violations of bankruptcy stays, and concluding § 524 does not impliedly create a private right of action)); Walls v. Wells Fargo Bank, N.A., 276 F.3d 502, 509 (9th Cir. 2002) (tracking and adopting Pertuso’s analysis); and Cox v. Zale Del., Inc., 239 F.3d 910, 917 (7th Cir. 2001) (agreeing with the result in Pertuso and concluding that a contempt action in the bankruptcy court that issued the discharge is the only relief available to remedy alleged § 524 violations); In re Joubert, 411 F.3d 452, 456 (3d Cir. 2005) (adopting the reasoning of Pertuso, Walls, and Cox in the context of § 506(b) post-petition assessment of fees); see also, Bessette v. Avco Fin. Servs., Inc., 230 F.3d 439, 444-45 (1st Cir.2000) (refusing to address whether § 524 implies a right of action, because, in the First Circuit’s view, a bankruptcy court’s contempt power under § 105(a) offers sufficient remedies).

In the lead case, Pertuso, a group of discharged Chapter 7 debtors brought a purported class action in district court against a common secured creditor, alleging the creditor violated the discharge injunction. Pertuso, 233 F.3d at 420. The issue before the court was whether § 524 impliedly creates a private right of action. After examining the factors to be considered in determining whether a private right of action exists for breach of a federal statute and the legislative history of § 524, the Sixth Circuit determined that, unlike the private cause of action created by Congress for violations of the automatic stay in § 362, Congress did not impliedly create a private right of action in § 524 for violations of the discharge injunction. Id. at 421–422. The Eleventh Circuit has similarly held the power to sanction contempt of the discharge injunction is jurisdictional and exclusive to the issuing court. Alderwoods Grp., Inc. v. Garcia, 682 F.3d 958, 970 (11th Cir. 2012) (the court that issued the injunctive order alone possesses the power to enforce compliance with and punish contempt of that order). Given § 524 does not accord a plaintiff with a private right of action for a violation of the discharge injunction, it would be improper for the court to recognize one based on state consumer protection laws.

The First Circuit is in a distinct minority allowing this procedure. Bessette v. Avco Fin. Servs., Inc., 230 F.3d 439, 444-45 (1st Cir. 2000). The Third, Sixth, Seventh, and Ninth Circuits do not allow it.   The Eleventh Circuit provides the seminal case which limits redress of alleged discharge injunction violations to civil contempt proceedings. In re Hardy, 97 F.3d 1384, 1390 (11th Cir. 1996). Hardy held that § 524 does not authorize an independent claim for damages, and a plaintiff’s remedy for a § 524 violation was under the contempt powers conferred by § 105. Hardy, 97 F.3d at 1389. Civil contempt is a sanction to enforce compliance with an order of the court or to compensate for losses or damages sustained by reason of noncompliance. McComb v. Jacksonville Paper Co., 336 U.S. 187, 191 (1949). It is not an independent cause of action because it is entirely dependent upon the defendant’s knowledge of a pre-existing order in the original case. Hardy, 97 F.3d at 1390; Blalock v. United States, 844 F.2d 1546, 1550-51 (11th Cir. 1988) (per curiam). To sustain a class action, there must first be a cognizable cause of action. Contempt of court is not an independent cause of action, and § 105 does not provide one.

Bankruptcy Rule 9020 states contempt proceedings are contested matters governed by Rule 9014. Fed. R. Bankr. P. 9020. Bankruptcy Rule 9014 specifically excludes from contested matters several rules applicable only in adversary proceedings. Rule 7023 for class actions is excluded and does not apply to contested matters. Fed. R. Bankr. P. 9014. Further, the bankruptcy judge has discretion under Rule 9014 not to apply Rule 7023 in any contested matter. Reid v. White Motor Corp. (In re White Motor Corp.), 886 F.2d 1462, 1463-64 (6th Cir. 1989). Bankruptcy courts routinely exercise that discretion not to invoke Rule 7023 in contested matters. Only occasionally will bankruptcy courts apply Rule 7023 in a contested objection to a proof of claim filed by a pre-petition, putative class-action plaintiff. Reid, 886 F.2d at 1464. Outside the claims objection process, there is no need to apply Rule 7023 to contested matters because contested matters are not sufficiently complicated to warrant the application of adversary rules. In the Matter of Baldwin-United Corp., D.H., 52 B.R. 146, 150 (Bankr. S.D. Ohio 1985). Further, contempt proceedings are fact-specific inquiries which routinely fail to meet the stringent requirements for class certification. In re Montano, 488 B.R. 695, 712, reconsideration denied, 493 B.R. 852 (Bankr. D.N.M. 2013) (Proposed debtor class members, in order to establish discharge injunction violation, would have to present individualized proof of coercive effect which credit union’s conduct had on them, which prevented named class representatives from showing significant questions of law or fact common to class. Citing Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541 (2011)).

Thus, a clear majority of courts have held that § 524 does not create a private right of action, making a class action a rare remedy for post-discharge mortgage communications. The development of case law under Section 524(j) should add further clarity.

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Debtors Cannot Void Junior Liens on Underwater Property in Chapter 7

On June 1, 2015, the Supreme Court released its opinion in Bank of America, N.A. v. Caulkett, No. 13-1421, 575 U.S. ____ (2015), in which it held that a Chapter 7 debtor may not void a junior mortgage under Section 506(d) of the Bankruptcy Code merely because the debt owed on a senior mortgage exceeds the present value of the property and the creditor’s claim is secured by a lien and allowed under Section 502. For now, this opinion cuts off a Chapter 7 debtor’s ability to “strip off” an underwater junior lien.

In Caulkett, the debtor had two mortgage liens on his home; Bank of America held the junior lien. The amount owed on the senior mortgage exceeded the value of the home, rendering Bank of America’s junior mortgage fully “underwater,” or with no current economic value. Generally, where the value of a creditor’s interest in its collateral is zero, a creditor’s claim cannot be a “secured claim,” and the lien securing the junior mortgage can be voided in a Chapter 7 case.

The authority for this voiding procedure lies in Section 506 of the Bankruptcy Code. Under Section 506(a), “[a]n allowed claim of a creditor secured by a lien on property . . . is a secured claim to the extent of the value of such creditor’s interest in . . . such property,” and “an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” 11 U.S.C. § 506(a)(1). Under Section 506(d), “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” 11 U.S.C. § 506(d). Based on this understanding of Section 506, the Caulkett debtor argued that Bank of America’s junior lien should be void.

But in a 1992 opinion, Dewsnup v. Timm, 502 U.S. 410 (1992), the Supreme Court adopted a different construction of the term “secured claim” that focused on two things: (1) the validity of the creditor’s perfected security interest in its collateral; i.e., Does the lender have a valid lien? and (2) whether the creditor’s claim was “allowed” under Section 502, which governs the allowance of claims in bankruptcy cases; i.e., did the lender file a proper claim in the bankruptcy case, and did anyone object? Notably, the Dewsnup construction of “secured claim” did not take into consideration the collateral’s value.

The Supreme Court in Caulkett explained that it was bound by the Dewsnup construction. Accordingly, the debtor could not void Bank of America’s junior mortgage because the mortgage was (1) secured by valid a lien and (2) supported by an allowed claim to which no party had objected.

In a footnote, which Justices Kennedy, Breyer, and Sotomayor declined to join, the Court acknowledged that “[f]rom its inception, Dewsnup . . . has been the target of criticism.” This is because it appears to be at odds with the plain language of Section 506. In addition, Dewsnup has generally not been applied to Chapter 13 cases, where the stripping off of underwater liens is common, and debtors can rely on other similar sections of the Bankruptcy Code.

On the other hand, preserving a junior lien is especially important during times of depressed real estate prices. Once a creditor’s lien has been stripped, upon the sale of the property—even where the value of the property has later appreciated—the junior mortgage creditor gets nothing, and the benefit goes to the debtor. Under Caulkett, the lender is not harmed by a temporary drop in real estate prices, as it may retain its lien even if the property appears to be completely underwater. Chapter 7 debtors like the one in Caulkett may argue that, under Dewsnup and now Caulkett, they are unduly burdened by a lender’s lien, and that the “fresh start” they hoped a bankruptcy case would afford them is diminished.

But the Court emphasized that it wasn’t asked to overrule Dewsnup, and the Court concluded that, under Dewsnup, a Chapter 7 debtor may not void a junior mortgage lien under Section 506(d) merely because the debt owed on a senior mortgage lien exceeds the value of the collateral. With the Court appearing to have left open the possibility of revisiting its Dewsnup decision, it is likely that this contentious issue will remain in play.

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