The U.S. Court of Appeals for the First Circuit recently held that a creditor with a lien on real estate surrendered by borrowers after their bankruptcy discharge was not obligated to foreclose or release its lien on the property, and thus did not violate the bankruptcy court's discharge injunction by offering foreclosure alternatives.
Specifically, in so ruling, the Court reasoned that, because the property still had value and the creditor was willing to enter into a settlement or a short sale arrangement, the creditor was merely seeking to recover the value of its lien and not to enforce the borrowers' discharged personal obligation on the loan.
A copy of the opinion is available at: http://www.ca1.uscourts.gov/pdf.opinions/12-9002P-01A.pdf.
Two borrowers ("Debtors"), having unsuccessfully attempted to refinance their mortgage loan, eventually defaulted on their obligation. The holder of the mortgage ("Lender") later initiated foreclosure proceedings against Debtors, who then filed for Chapter 7 bankruptcy protection. At the time of the foreclosure, the value of Debtors' home had plummeted to a level far below what they owed on the mortgage loan, and, according to their bankruptcy filings, Debtors intended to surrender the property to Lender.
As a result of Debtors' bankruptcy filing, Lender voluntarily dismissed without prejudice the foreclosure proceedings, and Debtors received a bankruptcy discharge releasing them from their personal obligation on the mortgage loan.
Following the discharge, however, Lender informed Debtors that, although it would not foreclose on Debtors' residence and Debtors would retain ownership of the property, Lender would no longer make any payments for taxes, insurance, or property maintenance.
In response, Debtors demanded that Lender either commence foreclosure proceedings or release its lien, reminding Lender of their bankruptcy discharge and their right to a "fresh start." Stating that it was not seeking to enforce Debtors' personal liability on the loan, Lender informed Debtors that it would not release the lien on the property, but that Lender would consider some sort of a settlement option or a short sale of the property.
Debtors subsequently abandoned the property and had all the utilities turned off. Based on Lender's alleged failure to foreclose or take possession of the property, and claiming Lender's letter was a violation of the bankruptcy discharge, Debtors filed an adversary action against Lender, seeking damages and a declaratory judgment ordering Lender to either recover possession of the property or to give them clear title to it.
The bankruptcy court ruled in favor of Lender, rejecting Debtors' argument that this case was factually indistinguishable from another case in which a secured creditor had refused to foreclose or release its lien. See Pratt v. General Motors Acceptance Corp. (In re Pratt), 462 F.3d 14 (1st Cir. 2006)("Pratt")(holding that a secured creditor's refusal to foreclose or to release the lien on a worthless automobile violated the discharge injunction because as it was intended to coerce the debtor into paying the discharged debt).
In so doing, the bankruptcy court pointed out that Debtors' demand to either foreclose or release the lien ignored the fluctuating nature of real estate values, and that Lender did not simply demand immediate payment in full, but instead was willing to consider a voluntary settlement or a short sale of the property. This latter fact, the bankruptcy court reasoned, indicated that Lender simply wanted to collect only the value of its lien. The bankruptcy court additionally noted that, although bankruptcy discharge relieves debtors of personal liability, bankruptcy does not force creditors to assume ownership or take possession of collateral or discharge the owner's ongoing obligations to pay taxes and homeowner's insurance.
Debtors appealed to the bankruptcy appellate panel ("BAP"), which affirmed. Debtors then appealed to the First Circuit, again asserting that the facts of Pratt mirrored those in this case. The Court of Appeals also affirmed.
As you may recall, the discharge injunction provision of the bankruptcy code broadly prohibits attempts to collects debts that have been discharged. 11 U.S.C. § 524(a). Enforcement mechanisms employed by bankruptcy courts include sanctions for civil contempt. See 11 U.S.C. § 105.
Noting that the discharge injunction does not enjoin a secured creditor from recovering on valid prepetition liens not modified or otherwise avoided, the First Circuit emphasized that such liens are enforceable in accordance with state law, but that one way debtors could eliminate the prepetition lien is to surrender the collateral as long as the secured creditor agrees to allow the debtor to do so.
Nevertheless, the First Circuit observed that a creditor's decision in this regard must not serve as a means to coerce payment of a discharged debt, and that the debtor bears the burden of proof with respect to allegations of violations of discharge injunction. See Pratt, 462 F.3d at 19-20; ZiLOG, Inc. v. Corning (In re ZiLOG, Inc.), 450 F.3d 996, 1007 (9th Cir. 2006).
Noting that this case lacked the exclusive "pay in full" conditional release present in Pratt, which, according to the Court, amounted to an impermissible forced reaffirmation of discharged debt, the Court explained that the minimal value of the collateral in Pratt and the unlikelihood that the collateral could ever be sold to generate attachable sale proceeds was the factually significant difference between the two cases.
The First Circuit thus stressed that here the secured creditor offered to release its lien through either a settlement offer or a short sale, which according to the Court, was an indication that Lender intended to collect no more than the value secured by the underlying lien, but also a willingness to settle on terms agreeable to Debtors.
Accordingly, the Court rejected Debtors' assertion that Lender's position contradicted the "fresh start" they received through their discharge, which they argued permitted them to simply abandon the property.
Stressing that bankruptcy law does not alter the rights of secured creditors who are in compliance with state law, the Court, citing a lack of evidence as to why Debtors would not accept a short sale or settlement or any other indicia of coercion on Lender's part, noted that unlike in Pratt, there was a real possibility in this case that the collateral could be sold.
Finally, the Court also emphasized that its ruling should not be relied on as a basis for secured creditors to refuse to negotiate in good faith, reiterating that, given the difficulty in seeing the distinction between forceful negotiation and improper coercion to collect on a discharged debt, each case should be evaluated on its unique facts.
Accordingly, the First Circuit affirmed in all respects.
Ralph T. Wutscher
McGinnis Wutscher LLP
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