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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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U.S. Supreme Court: Inherited IRA Funds not “Retirement Funds”

On June 12, 2014, the Supreme Court issued a unanimous opinion in Clark v. Rameker, Dkt. No. 13-299, 573 U.S. ___ (2014), holding that funds held in inherited Individual Retirement Accounts are not “retirement funds” within the meaning of 11 U.S.C. § 522(b)(3)(c) and therefore not exempt from the bankruptcy estate. This opinion limits retirement funds that remain out of creditors’ reach when an individual files a bankruptcy case.

In Clark, Heidi Clark inherited a traditional IRA account established by her mother. Clark then filed a Chapter 7 bankruptcy case and claimed the inherited IRA account as exempt from the bankruptcy estate under Section 522(b)(3)(C). The trustee and unsecured creditors objected, arguing that the inherited IRA funds were not “retirement funds” within the meaning of the statute.

The Court distinguished between inherited IRAs and traditional IRAs, noting that holders of inherited IRAs are prohibited from making contributions to those accounts, setting them apart from traditional retirement accounts; that holders of inherited IRAs are required to withdraw money from such accounts, regardless of how many years they may be from retirement; and that holders of inherited IRAs may withdraw the entire balance of the account at any time and for any purpose, without penalty. Observing that the funds in an inherited IRA could be spent on even a “vacation home or a sports car,” the Court expressed concern that allowing an inherited IRA to be exempt from the bankruptcy estate would convert the Bankruptcy Code’s purposes of providing a “fresh start” into a “free pass.”

The Clark opinion resolves a split among Circuits. The Fifth Circuit ruled in In re Chilton, 674 F. 3d 486 (5th Cir. 2012) that inherited IRAs constituted retirement funds within the “plain meaning” of § 522 of the Bankruptcy Code and were thus exempt from the bankruptcy estate, under § 522(d)(12) (the federal exemptions). The Seventh Circuit, in Clark, disagreed, emphasizing that the Bankruptcy Code should not be used to exempt from creditors’ reach funds that were freely accessible for current use by the debtor, without penalty.

Although Clark excludes inherited IRAs from exemption under Section 522(b)(3)(c), some states, including Missouri, provide a separate exemption for inherited IRAs under state law. The Clark decision is not likely to affect bankruptcy cases and practices in these states.

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