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Non-Final Finality: Does One Interlocutory Issue Resolved in a Bankruptcy Court Order Render All Issues Addressed in the Order Non-Appealable?

appellate court concept with gavel. 3D rendering

As the Supreme Court recently reminded us in Bullard v. Blue Hills Bank, not all orders in bankruptcy cases are immediately appealable as a matter of right.  Only those orders deemed sufficiently “final” may be appealed without leave under 28 U.S.C. § 158(a).  In light of the numerous parties and controversies involved in a typical bankruptcy case, determining whether an order is “final” can be complicated affair.  Thus, finality in bankruptcy is a “flexible standard” applied to discrete disputes that arise within the larger case. See generally 14 Wright, Miller & Cooper, Federal Practice and Procedure § 3926.2 (collecting examples of final and non-final orders).  That flexibility, however, has led to disparate results.

In In re Wolff, B.A.P. No. CO-16-016 (B.A.P. 10th Cir. Jul. 18, 2016), the Tenth Circuit Bankruptcy Appellate Panel (the “BAP”) dismissed an appeal filed by debtors Deris and Cheryl Wolff (the “Debtors”) on the grounds that the appeal was taken from an order that was interlocutory, and thus, non-appealable absent leave.  That order resolved two issues, one of which was interlocutory and the other of which ordinarily would be entitled to immediate appellate review.  The Wolff decision is an interesting example of what can occur when a single bankruptcy-court order resolves a typically final matter in connection with a non-final one.

An Order Determining Property of the Estate Is Interlocutory?

In Wolff, the Debtors filed a voluntary chapter 13 case, but their case was later converted to chapter 7.  The Debtors’ schedules listed two parcels of real property as assets, but the Debtors failed to claim either property as exempt.  The chapter 7 trustee filed two separate motions seeking approval to retain real estate brokers to market the properties.  The Debtors objected to the motion as to the first property and filed a motion for reconsideration of the order granting retention of the broker as to the second property.  In both the objection and the motion to reconsider, the Debtors argued that the properties could not be sold because they were not property of the bankruptcy estate, and that any post-petition appreciation in value belonged to the Debtors rather than the estate.

The bankruptcy court entered an order overruling the objection, denying the motion for reconsideration, and approving the trustee’s retention of a real estate broker to market and sell both properties. The bankruptcy court rejected the Debtors’ arguments that the properties were not part of the estate because 11 U.S.C. § 348(f)(1) provides that when a case is converted from chapter 13 to chapter 7, “property of the estate in the converted case shall consist of property of the estate, as of the date of the filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  Because the two parcels of real property were scheduled as estate property on the date of filing, they remained estate property upon conversion.  Moreover, the Debtors’ failure to claim any exemptions relating to the properties was binding upon them, and was ultimately inapposite, as the court concluded that the trustee could sell the property even if the exemption had been claimed.  The Debtors appealed.

On appeal, the BAP considered whether the order was interlocutory because it involved the employment of a broker, or whether the bankruptcy court’s ruling on property of the estate rendered the entire order final for appeal purposes. The BAP reasoned that an interlocutory order is one that constitutes part of the “process” of a bankruptcy case but does not otherwise substantively alter the rights of the parties.

Despite the ruling regarding property of the estate, the BAP concluded that the order was not final and appealable as a matter of right. Sales of estate property in a chapter 7 case involve a two-step process, according to the BAP.  First, the trustee must retain a broker with court approval.  Second, only after that broker has marketed the property in question, the trustee must file a separate motion for approval of the sale.  In this case, the bankruptcy court’s order represented only the first step in the process.  The BAP concluded that the Debtors’ rights were not substantively affected by the order because any decision as to the sale of the properties would require a separate motion, notice, and hearing.  “As a result,” concluded the BAP, “Appellants’ rights in the Colorado and Nebraska Properties, and any equity associated therewith, are not yet altered.”  The BAP also indicated that the Debtors would be able to seek review of “prior intermediate orders” if an order approving a sale were eventually entered.

Analysis and Conclusion

The Wolff decision is puzzling.  It certainly did not help the Debtors that they failed to claim the real property as exempt, and that their substantive arguments on the property-of-the-estate issue appeared to be weak.  Still, it is difficult to conceive of an order more “final” than one determining that an asset is property of the estate within the meaning of section 541 of the Bankruptcy Code.  Under the Wolff decision, such a determination may be deemed non-final if it is tied to a matter (e.g., retention of a broker) typically the subject of interlocutory orders.  Crafty litigants could use such a rule to deprive affected parties of immediate appellate review, even with respect to key issues if they are included in an order resolving other, interlocutory matters.

Moreover, the BAP failed to consider the impact of its ruling on the value of the properties. No rational buyer will bid as much when they learn that their bid could be held up in litigation, and appeals, over whether the property can be sold at all.  Buyers will discount their price for the likely attendant risk, and the fact that they may be “on hold” for months or years of litigation and appeals over a threshold issue.  If that threshold issue had been resolved, much of the cloud would be lifted over the property, and buyers obviously tend to bid more for a certainty.

In Wolff, the BAP appears to have justified the inclusion of a section 541 finding in a broker’s retention order on the rationale that if an asset “is not property of the estate, generally there would be no reason for a trustee to retain a broker to sell the property and the bankruptcy court would not approve a sale.”  But that somewhat circular reasoning does not consider the procedurally proper (and arguably more orderly) possibility of resolving the threshold question—whether the real estate was property of the estate—in an adversary proceeding and deferring the motion to retain a broker until after resolution of that fundamental question.[1]  As a middle ground, the court perhaps could have approved the broker’s retention conditionally, pending a ruling on property of the estate.  In fairness, the Debtors do not appear to have raised these possibilities, nor did they insist that resolution of a section 541 issue requires a properly filed adversary proceeding.  Had they done so, the result may have been quite different.

As the Wolff decision demonstrates, litigants in bankruptcy cases would be wise to identify important issues that a debtor, trustee, or other adverse party might attempt to bootstrap into a non-final order.  In particular, litigants should identify and zealously guard those matters subject to adversary-proceeding requirements under Federal Rule of Bankruptcy Procedure 7001.  Absent resolution of “final” matters in separate proceedings and orders, litigants could find themselves forced to await appellate review on key issues until far later in a bankruptcy case, when subsequent events could weaken the relevance of their appeal or simply render the appeal moot.

[1]    Contested issues regarding property of the estate generally require an adversary proceeding and all of the procedural safeguards associated therewith. See Fed. R. Bankr. P. 7001(2).

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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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Sabine – A New York Bankruptcy Judge’s Interpretation of Texas Property Law Encourages Compromise and Leaves an Industry in Limbo

On March 9, 2016, Bankruptcy Judge Shelley Chapman of the Southern District of New York issued her decision on the Debtor’s motion to reject certain contracts in Sabine Oil & Gas Corporation’s Chapter 11 case.[i]  The decision, which allowed Sabine to reject “gathering agreements”[ii] between it and two “midstream operators,”[iii] Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, under Section 365(a) of the Bankruptcy Code, sent shockwaves through the midstream energy sector and leveled the playing field for bankrupt production companies.  Yet, the case leaves undecided the ultimate question – what midstream contracts are protected as real covenants running with the land?  That question may be months, or even years, away from any resolution.[iv]  In the interim, energy companies are left with Sabine, which implies producers can renegotiate midstream contracts in a slumping energy market, using the threat of bankruptcy and rejection as a powerful bargaining chip to bring midstream operators to the table.

The Decision

By its Motion, Sabine sought to reject four contracts under Section 365, two with Nordheim and two with HPIP. Under all four agreements, Sabine agreed to “dedicate” to the “performance” of the agreement certain leases owned by Sabine and the hydrocarbons from the wells located on the land subject to those leases.  For their part, Nordheim and HPIP agreed to construct, operate, and maintain gathering facilities for the respective leases.

When it addressed the Motion, the Court undertook a two part analysis to determine whether Sabine could reject the contracts. First, the Court deferred to Sabine’s business judgment and found “that the Debtors have properly and adequately considered the business and legal risks associated with rejection of the Nordheim Agreements and the HPIP Agreements.”[v]  There was little question that rejection would benefit the estate as Sabine indicated that rejection could save it up to $200,000 a month.

The second part of the Court’s analysis was more involved. There the Court was forced to determine whether any of the contracts were real covenants or equitable servitudes that ran with the land.  Both Nordheim and HPIP argued that Sabine could not reject the contracts because they were real property interests that cannot be rejected under Section 365.  While Judge Chapman acknowledged her inability to decide substantive legal issues under Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), and In re The Great Atlantic & Pacific Tea Co.[vi] without an accompanying adversary proceeding, she dove into an analysis of what constituted a covenant running with the land under Texas law.

After applying Texas’ four-part test for determining whether a covenant runs with the land, the Court rejected HPIP and Nordheim’s contention that their contracts were real property interests. The Court found that the covenants in Nordheim’s and HPIP’s contracts did not satisfy the “touch and concern” prong of Texas’ test for a covenant running with the land.  Instead, the interest in the extracted minerals was a personal property interest.  The Court also determined that the covenants “do not readily fit into the traditional paradigm for horizontal privity of estate.”[vii]  Consequently, the Court made a “preliminary” determination that the contracts between Sabine and the two gathering companies could be rejected.

The Fallout

Despite Judge Chapman’s later statement that “this was not a broad sweeping pronouncement,”[viii] the ruling may significantly impact the energy industry. Moreover, the case and its progeny could shape jurisprudence on the rejection of similar contracts in several energy sector bankruptcy cases while an appeal works its way up the chain.  Until Sabine, agreements between producers and midstream companies were generally treated as constants, not subject to renegotiation upon insolvency.  That paradigm may now be realigned.

Upstream producers, many of whom are suffering under today’s low energy prices, can now seek concessions from their midstream partners. This places the parties on more equal footing and could actually be a catalyst for negotiated resolution.  In fact, courts dealing with the issue may actually prefer the parties resolve the issue through compromise. Sabine has already had an impact in this respect.  In In re Magnum Hunter Resources Corp., Bankruptcy Judge Kevin Gross encouraged the parties to resolve a similar dispute before the Court had to weigh in on the motion to reject.[ix]  Likewise, in In re Quicksilver Resources Inc., the purchaser of the debtor’s assets was able to reach a compromise with its midstream operator before the Court had to rule on a Section 365 motion.[x]  Both cases are examples of how producers have greater power to negotiate terms with midstream companies in the wake of Sabine.

Finally, Sabine is not over.  Nordheim’s and HPIP’s adversary case was decided on May 3, 2016.[xi]  Once again, in a decision located here, Judge Chapman found “that the covenants at issue in the Nordheim Agreements and the HPIP Agreements do not run with the land either as real covenants or as equitable servitudes.”[xii]  On June 1, 2016, Nordheim and HPIP sought Judge Chapman’s consent to appeal that decision.  The midstream operators argued that an appeal to the Second Circuit and a subsequent reference to the Texas Supreme Court to decide the state property law issues were appropriate.  The Court has not yet ruled on the request, but no one believes that this will be the end of the debate.  Upstream producers will continue to pursue rejection of midstream contracts that are overly burdensome and midstream operators will continue to argue that rejection is improper until more concrete guidance is issued by District and Circuit Courts.

[i]            In re Sabine Oil & Gas Corp., 547 B.R. 66, 69 (Bankr. S.D.N.Y. 2016).

[ii]           Gathering Agreement means an agreement by which one party agrees to collect oil, gas or other hydrocarbons at the wellhead and transport such oil, gas or other hydrocarbons through a network of pipelines to a central point, often a processing system or an inlet to a larger transportation pipeline.

[iii]           Midstream Operator means a company that gathers, transports and processes oil, gas or other hydrocarbons by pipeline, rail, trucks or otherwise.

[iv]          On June 1, 2016, Judge Chapman declined to rule on Nordheim’s request for an immediate appeal her decision to the Second Circuit Court of Appeals.  While the Court determined that the contracts at issue in the case do not run with the land, in both its preliminary decision and in a later adversary opinion, it left open the question of what type of midstream contract would run with the land such that it constituted a real property interest.

[v]           Sabine Oil, 547 B.R. at 74.

[vi]          4 F.3d 1095, 1098 (2d Cir. 1993) and 544 B.R. 43 (Bankr. S.D.N.Y. 2016).

[vii]          Sabine Oil, 547 B.R. at 79.

[viii]         See Judge Skeptical of Quick Appeal in Sabine Midstream Dispute located at http://www.law360.com/articles/802504/judge-skeptical-of-quick-appeal-in-sabine-midstream-dispute.

[ix]          In re: Magnum Hunter Resources Corp. et al., No. 15-12533, in the U.S. Bankruptcy Court for the District of Delaware.

[x]           See Jones Day’s advisory, Quicksilver Drops Motion to Reject Midstream Agreements in Connection with Closing of Sale to Bluestone Natural Resourcesfor a more in depth discussion.

[xi]          Following the Court’s decision to grant Sabine’s Motion to Reject, Nordheim and HPIP filed an adversary proceeding in which they sought a declaration that the their respective leases were “covenants running with the land.”  The Court, once again, rejected the midstream operators’ argument and issued a final ruling that the leases did not convey a real property interest to the midstream operators.

[xii]          In re Sabine Oil & Gas Corp., No. 15-11835 (SCC), 2016 WL 2603203, at *8 (Bankr. S.D.N.Y. May 3, 2016).

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7th Circuit Disrupts Commercial Certainty in Lease Terminations; Landlords, We Hate That You Have to Read this Blog Post

There are many tenants that are, shall we say, “problem children.” They pay late, open late, breach, junk up your strip or building, threaten, the works. Sometimes, the landlord finds it easier just to reach a lease termination agreement with such a tenant, with the parties walking away with a mutual release. If the lease is below market, or the landlord is really motivated to move this tenant along, the landlord even provides some “keys money” to terminate the lease.

This normal practice may now be turned on its head. In a recent opinion, the Seventh Circuit ruled that a pre-bankruptcy lease termination was a “transfer” under the Bankruptcy Code. Because it was a “transfer,” if the tenant did not receive “reasonably equivalent value” for the value of the lease (such as where the tenant alleges it was a below market lease, which could have been assigned in bankruptcy for cash, or even for more cash than the tenant/debtor received), then the landlord can be sued. The damages? The difference between that which the ne’er-do-well tenant received (even if that amount is $0) and the amount that the tenant’s expert witness says could have been received had the lease not been terminated, and the debtor had instead assigned it to a third party during the bankruptcy in an open sale process.[1] In re Great Lakes Quick Lube LP, 2016 WL 930298 (7th Cir. March 11, 2016).

The Seventh’s Circuit’s opinion in Quick Lube is very problematic because it ignores:

First, Section 8(e)(1) of the Uniform Fraudulent Transfer Act, which states a transfer is not voidable if it “results from . . . termination of a lease upon default by the debtor when the termination is pursuant to the lease and applicable law.”  Indeed, the drafters of this uniform law, promulgated all the way back in 1984, noted in their commentary (see page 32 of this link) that Section 8(e)(i) of UFTA was intended to “reject[] the rule adopted in Darby v. Atkinson (In re Farris), 415 F.Supp. 33, 39-41 (W.D. Okla. 1976), that termination of a lease on default in accordance with its terms and applicable law may constitute a fraudulent transfer.”

Second, as Judge Markell once noted, the much wiser approach to transactions of this type is that “a noncollusive termination of a lease is not a transfer at all” and hence cannot be avoided by mischievous debtors and their hired guns experts. See here for the full opinion.

Third, Section 365(c)(3) of the Bankruptcy Code provides that the “trustee … may not assume or assign any … unexpired lease of the debtor … if … such lease . . . has been terminated under applicable nonbankrupty law prior to” the bankruptcy case. See 11 U.S.C. § 365(c)(3). That is, if a properly terminated lease cannot be assumed or assigned in bankruptcy by one very specific section of the Code, then how can its pre-bankruptcy termination be voided due to a generic separate section of the Code? The Seventh Circuit side-stepped this argument too in Quick Lube, by saying the debtor and its creditors simply wanted the value of the lease and not the actual lease itself. That’s a tautology – how can there be value in a lease that no longer exists?

Finally, and most importantly, this entire line of reasoning ignores the need for certainty in commercial transactions involving lease transactions.   So what do we do?

First, be aware of this decision, and make the client aware if it is ever negotiating over a lease termination with a tenant, especially a financially troubled tenant. There are no foolproof workarounds to this decision, and so the client needs to be fully aware of this risk. Maybe it is just easier to declare a default and go through a dispossessory, if weeks (months?) of careful negotiation over termination can be up-ended by a later litigation against the landlord to pay for the “actual value” of the lease?

Second, thoroughly document in the termination agreement the benefits the tenant is receiving. Bankruptcy trustees and creditors like easy cases, not hard ones. If they can see more benefit that the tenant received in the termination agreement, or clearly spelled out provisions showing the tenant’s ability to forego late fees, attorneys’ fees, ongoing rent, other charges, and the like through the lease termination, a litigious trustee may think twice.

Third, if a lease termination is accompanied by any “keys money,” make sure it is paid to the actual tenant, and not any affiliate. A sure-fire path to litigation begins with paying the wrong tenant or an affiliate, instead of the actual obligor on the lease. (This is fundamental, we know, but we have seen unsuspecting parties many times be persuaded to pay a parent company, or affiliate.)

The Seventh Circuit has long been a leading court on bankruptcy issues. We at The Bankruptcy Cave will continue to monitor this decision, which we think, unfortunately, is going to be used often in the upcoming downturn.

[1]           Recall that a lease’s anti-assignment provisions are worthless to a landlord in a tenant’s bankruptcy case. See 11 U.S.C. § 365(f) (“. . . notwithstanding a provision in an . . . unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such . . . lease . . .”). Of course, 1984’s “shopping center” amendments to the Bankruptcy Code prohibit an assignment that disrupts the tenant mix or balance in the shopping center, would substantially reduce percentage rent, or that violates any radius or use provision in the lease. See 11 U.S.C. § 365(b)(3).  (A great discussion of the “shopping center” amendments to the Bankruptcy Code in practice can be found here.)  But still, the nullification of anti-assignment clauses in bankruptcy make leases far more valuable in the bankruptcy case than they would be outside of bankruptcy.

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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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Managing Property Managers — A Guide for Lenders

Lenders are frequently confronted with questionable lender-liability claims not only from borrowers (usually in connection with collection or foreclosure procedures) but also from property managers unable to recover from borrowers. Claims property managers assert directly against lenders include those for breach of oral or written contract, fraud, and unjust enrichment (particularly if the lender has foreclosed its interest in the borrower’s property). Lenders can hedge against the risk of claims by property managers through a variety of methods, both pre- and post-borrower default.

 

As part of origination (or any subsequent review of the borrower’s property management agreement), the lender should ensure that the property management agreement clearly defines that the property manager can turn solely to the borrower for satisfaction of the property manager’s fees and expenses. Thorough property management agreements will also cap expenses the property manager is allowed to incur absent approval, which can help avoid successful assertion of contractor liens.

 

The lender can also obtain a three-party subordination agreement among the lender, borrower and property manager that subordinates the property manager’s rights to those of the lender and allows the lender to, among other things, (i) seize rents immediately upon default, and (ii) terminate the property management agreement and appoint its own property manager. Termination of the property manager and appointment of the lender’s desired property manager is preferred to the lender directing the actions of the borrower’s property manager, as a lender should take care to avoid a direct relationship with the borrower’s property manager.

 

Post-default, the lender should send a reservation of rights letter that defines the parties’ relationships and limits a property manager’s authority. This is particularly true where a property manager has exceeded the scope of mere management and may have undertaken an ownership role at a property or asserted liens against the property, potentially relying on credit support from a lender for repayment of expenses.

 

Lenders should also consider seeking a court-appointed receiver to operate the property and act as a buffer. The court can grant a receiver the authority to terminate the existing property manager and appoint a new property manager, often of the lender’s choosing. Because a receiver is cloaked with a certain level of immunity (although acts of gross negligence or wilful misconduct are often excepted), a receivership offers a prudent method through which a lender can eliminate a troublesome property manager. A receivership also offers a lender a trial period during which the lender can examine the performance of a property manager of the lender’s choosing that it may decide to retain following foreclosure or a receivership sale. For example, Bryan Cave has extensive experience in obtaining receivers, as well as drafting and revising property management agreements, all of which can protect a lender before meritless claims are asserted.

 

In the event that a property manager asserts claims directly against a lender, such claims are commonly derivative of claims properly held by the borrower (the property manager’s principal) and, if based in contract, are often not properly memorialized. For example, among other successfully asserted defenses, Bryan Cave has obtained summary dismissal of property manager’s claims against lenders due to (i) failure to comply with the statute of frauds (which requires certain contracts to be in writing); (ii) lack of privity between the lender and the property manager; and (iii) the property manager’s lack of standing to assert the principal’s claims. Although unpaid property managers will always try to look to a deep pocket for recompense, judicious planning can reduce the risk and merit of any such claims.

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