Articles Posted in Personal and Business Bankruptcy

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DefaultBankruptcy offers a way to obtain relief when one’s available income is not sufficient to cover one’s required debt payments. Federal bankruptcy law offers several options for businesses, including a restructuring of debts through Chapter 11 of the Bankruptcy Code. The goal of a Chapter 11 bankruptcy is to create a plan that pays down much of a business’ debt, discharges some remaining debts, and allows continued business operations once the bankruptcy case closes. Creating a Chapter 11 reorganization plan can be a complex task, depending on the size of the business and the extent of its debts. The Ninth Circuit recently considered a question about whether a default interest rate should still apply after a Chapter 11 debtor cures the default. The court reversed its own precedent, ruling that curing the default does not wipe out the default interest rate. In re New Investments, Inc., No. 13-36194, slip op. (9th Cir., Nov. 4, 2016).

Many secured loan or credit agreements require a debtor to pay a higher interest rate after a default. Almost 30 years ago, the Ninth Circuit held that a debtor who cures the default could eliminate their obligation to pay the default interest in a Chapter 11 bankruptcy. In re Entz-White Lumber & Supply, Inc., 850 F.2d 1338 (9th Cir. 1988). The court based its decision in part on language in the Bankruptcy Code stating that a Chapter 11 bankruptcy plan “shall…provide adequate means for the plan’s implementation, such as…curing or waiving of any default.” 11 U.S.C. § 1123(a)(5)(G).

The Bankruptcy Code does not define “cure,” so the court applied the common meaning of “taking care of the triggering event and returning to pre-default conditions.” Entz-White, 850 F.2d at 1340 (internal quotations omitted). It held that the interest owed by the debtor should be “at the market rate or at the pre-default rate provided for in the contract,” rather than the higher default interest rate. Id. at 1343.

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4753524621_b49d53de46_z.jpgA corporate insider who personally guaranteed a loan, but also waived any right to indemnification by the company, was not subject to “preference liability” in the company’s Chapter 11 bankruptcy proceeding, according to the Ninth Circuit Court of Appeals. In re Adamson Apparel, Inc., No. 12-57059, slip op. (9th Cir., May 6, 2015). The Bankruptcy Code allows a bankruptcy trustee to avoid “preferences,” defined as certain types of transfers made by a debtor to a creditor before filing a bankruptcy petition. If the preference was made for the benefit of an insider, federal law states that the trustee may only recover avoided transfers from the insider in certain situations. The Ninth Circuit distinguished this case from prior decisions and ruled that the guarantor insider was not liable, finding the waiver of indemnification to be the key distinction.

The debtor, a clothing manufacturer, took out a large loan in 2002. The debtor’s president and CEO guaranteed the loan, stating that he would be personally liable for the loan if the company was unable to repay it in full. Normally, he would be entitled to indemnification, meaning the debtor would reimburse him for payments to the lender to settle the loan, but the guaranty agreements included waivers of that right.

In late 2003, the debtor received a very large order from a purchaser. It instructed the purchaser to pay the purchase price–slightly less than $5 million–directly to the lender. The guarantor paid the balance of the loan–more than $3.5 million–out of his own money in March 2004. In September 2004, nine months after directing the purchaser to make a payment on the loan, the debtor filed for Chapter 11 bankruptcy.
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mortgage-295211_640.pngThe U.S. Supreme Court recently issued an opinion, Bank of America v. Caulkett, 575 U.S. ___ (2015), addressing a controversial bankruptcy procedure known as “lien stripping.” This procedure involves removing the portion of a lien on real property securing a debt, such as a mortgage loan, that exceeds the fair market value of the property. Lien stripping is generally permitted in Chapter 13 bankruptcy cases, but the Supreme Court prohibited it in Chapter 7 cases in Dewsnup v. Timm, 502 U.S. 402 (1992). The Dewsnup decision, however, left several loopholes, which Caulkett appears to have closed.

When the fair market value of the property securing a debt is less than the amount owed, that debt and the associated lien are described as “underwater.” The creditor in this situation essentially has two claims: a secured claim equal to the fair market value of the property, and an unsecured claim equal to the remaining debt amount. Lien stripping involves asking the court to find that the underwater portion of a lien on real property is unsecured. 11 U.S.C. § 506(a)(1). That portion then joins the other unsecured claims, which are subject to discharge at the conclusion of the case. The lien associated with the unsecured claim is void under 11 U.S.C. § 506(d).

The provision of the Bankruptcy Code that voids the unsecured portion of the lien only applies if the underlying claim “is not an allowed secured claim.” Id. In Dewsnup, the Supreme Court looked at the “allowed” requirement of § 506(d), rather than treating “allowed required claim” as a single requirement. It found that, since the claim at issue was “allowed” within the meaning of 11 U.S.C. § 502, it was not covered by § 506(d) whether or not it was “secured.” This led to a holding that lien stripping is not permitted in Chapter 7 cases.
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Caja_de_las_Letras_(Instituto_Cervantes,_Madrid)_03.jpgA debtor in a Chapter 7 personal bankruptcy case argued that the court should discharge his debts over the objection of a creditor, which claimed that he transferred money before filing bankruptcy with fraudulent intent. The debtor claimed that the transfer, which involved withdrawing cash from a personal checking account and placing it in a safe deposit box, was necessary because of allegedly unlawful collection activities by the creditor. The bankruptcy court denied the discharge, and the Bankruptcy Appellate Panel (BAP) affirmed the ruling. In re Haag (“Haag 1“), Nos. AZ-11-1661, AZ-11-1662, AZ-11-1663, memorandum (BAP 9th Cir., Sep. 27, 2012) (PDF file). The BAP held that the record supported a finding of fraudulent intent, whatever the debtor’s good intentions might have been. The Ninth Circuit affirmed the BAP and the bankruptcy court. In re Haag (“Haag 2“), No. 12-60074, memorandum (9th Cir., Aug. 20, 2014).

According to the BAP’s ruling, the debtor was the sole shareholder of a Michigan corporation involved in wastewater treatment plants construction. When the housing market collapsed in 2007, the corporation owed a substantial sum to Northwestern Bank (NWB) through a line of credit, with the debtor as guarantor. The debtor eventually shut down the business and surrendered all of its assets to NWB. He even surrendered his residence in late 2008 and moved to Arizona. In July 2009, NWB obtained a judgment in a Michigan court against the debtor, based on his guaranty, in the amount of $1.7 million. It obtained a domesticated judgment from an Arizona court in February 2010.

In early 2009, the debtor received almost $250,000 in tax refunds from the federal government and the state of Michigan. He deposited these funds in his personal account at the Bank of Tucson. A few weeks before NWB obtained the Michigan judgment, the debtor withdrew $120,000 in cash and placed it in a safe deposit box, which he held jointly with his wife, at Wachovia Bank. He filed a petition for Chapter 7 bankruptcy shortly after NWB domesticated its judgment, and he claimed that by then the money in the safe deposit box was gone, mainly spent on personal expenses.
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1193075_monthly_fees_2.jpgMortgage discrimination is against the law. The federal Equal Credit Opportunity Act (ECOA) makes it illegal for a creditor to discriminate against an applicant on the basis of race, color, religion, national origin, sex, marital status, age, or whether an individual receives public assistance. Notably, if an adverse action is taken against an applicant, even if the applicant is not a member of a protected class listed above, the applicant is entitled to a statement of reasons for the adverse action. In this context, an “adverse action” includes the following: (1) denial or revocation of credit, (2) a change in the terms of an existing credit arrangement, or (3) a refusal to grant credit in substantially the same amount or terms requested. Importantly, a creditor is not required to provide notice of the “adverse action” if the applicant is delinquent or otherwise in default.

A recent decision by the Court of Appeals for the 9th Circuit ruled that a lender who forgot they modified a loan and began foreclosure might be in violation of the Equal Credit Opportunity Act. More specifically, in Schlegel v. Wells Fargo Bank NA, the borrowers took out a $157,000 loan in 2009. The loan, secured by their home, was assigned to Wells Fargo. The borrowers thereafter went into default and filed bankruptcy in 2010.

At that time, Wells Fargo offered to extend the term of the mortgage. The loan modification was then approved by the bankruptcy court and became effective July 1, 2010. Despite all of this, before the first payment was due, and only 10 days after the bankruptcy charge was entered, Wells Fargo sent a default notice threatening to accelerate the full balance of the loan. When the Schlegels received the notice, they contacted the bank, which told them to proceed with the loan modification.
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graduation.jpgStudent loans are the largest form of consumer debt. In 2011, student debt surpassed $1 trillion nationally, which amounts to an average of $17,000 in student loan debt per person. On average, the amount of loan debt a student graduated with in 2010 was $25,250. Unfortunately, unlike almost all other kinds of debt, getting rid of either public or private student loan debt without dying or paying it in full is nearly impossible. In fact, federal loans have not been eligible for discharge in bankruptcy since 1978 and, in 2005, this treatment was extended to private student loans as well.

Specifically, student loan debt can currently only be discharged upon a showing of “undue financial hardship.” The usual standard to determine whether an individual has a claim of undue hardship is based on the three-part “Brunner Test.” The “Brunner Test” requires a debtor to prove each of the following:

1. Based on current income and expenses, the debtor cannot maintain a minimal standard of living for the debtor and dependents if forced to pay off student loans;

2. Additional circumstances exist indicating that the debtor’s current state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and

3. The debtor has made good faith efforts to repay loans.

Courts generally apply the three prongs very stringently. However, a recent court ruling and proposed California and federal legislation may affect the dischargeability of student loans for both Californians and other Americans alike.

Hedlund v. The Educational Resources Institute and Pennsylvania Higher Education Assistance Agency

Nearly ten years after Hedlund initially brought his lawsuit to determine the dischargeability of his student loan debt, on May 22, 2013, the Ninth Circuit Court of Appeals released its opinion in Hedlund v. The Educational Resources Institute, Inc., and Pennsylvania Higher Education Assistance Agency. The case may make it easier for student loan debtors to have their student loans discharged in bankruptcy.

In Hedlund, the Ninth Circuit found that the Bankruptcy Court had properly applied the Brunner test when it examined Hedlund’s efforts to find a better job and found that his expenses were mostly reasonable. In addition, the Ninth Circuit Court also ruled that the Bankruptcy Court correctly examined Hedlund’s efforts to negotiate a payment plan, and that his only option would create an undue hardship that would require the then-35 year old Hedlund to make loans until he was at least 65 years old. The recent decision by the Ninth Circuit establishes that debtors may not have to go to extreme efforts to repay their loans, a debtor may have some unreasonable expenses, and a 30-year repayment term may not be reasonable.

Proposed Federal Legislation

The Private Loan Bankruptcy Fairness Act of 2013 (H.R. 532) and The Fairness for Struggling Students Act of 2013 (S. 114)

These bills were introduced to the U.S. House of Representatives and U.S. Senate in February 2013 and January 2013 respectively. The proposed legislation hopes to have private student loans lumped with all other kinds of debt, making student loan debt fully dischargeable in bankruptcy. The bills would repeal the portion of the 2005 bankruptcy law overhaul, which removed the option for debtors to discharge outstanding private student loans in bankruptcy court. Notably, federal loans would not be impacted by this legislation.
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