Massachusetts Bankruptcy Court Confirms that Chapter 13 Debtors May “Strip Off” Second Mortgages

Recently in In re Guerra, the Bankruptcy Court for the District of Massachusetts joined the majority of courts in finding that United States Supreme Court’s decision in Bankof Am. v. Caulkett does not affect a chapter 13 debtor’s ability to strip off a second mortgage.  In Caulkett, the Supreme Court held that a debtor in a chapter 7 bankruptcy may not void a junior mortgage lien under 11 U.S.C. § 506(d) when the debt owed on a senior mortgage lien exceeds the current value of the collateral. 

Prior to Caulkett, it was well established in the First Circuit that a chapter 13 debtor could “strip off” a wholly unsecured mortgage.  In the chapter 13 plan context, “strip off” means discharging a creditor’s junior mortgage on real property where the junior mortgage has no value because the amount of senior liens and encumbrances exceeds the value of the property. 

In Guerra, the debtors sought to strip off a second mortgage through their chapter 13 plan. Under the chapter 13 plan, the second mortgage was treated as a wholly unsecured claim subject to discharge under 11 U.S.C § 1328(a).  The second mortgage holder objected and argued that Caulkett prohibits the debtor from treating an “underwater” second mortgage as unsecured. 

The Bankruptcy Court disagreed with the junior mortgage holder and concluded that Caulkett had no effect on the interpretation of the interplay between §§ 506(a) and 1322(b)(2) of the Bankruptcy Code.  As such, the ability to strip off and discharge a wholly unsecured mortgage lien in a chapter 13 plan remains an option for debtors. 

The junior mortgage holder also argued that its lien couldn’t be stripped because (according to its appraisal) the value of the property had increased during the 15+ months since the filing of the bankruptcy case, to the point where there was now enough value to recoup at least some of the second mortgage debt.  In other words, the second mortgage claim wasn’t “wholly unsecured.”  That argument didn’t work either.  For a variety of reasons, the Bankruptcy Court ruled that for lien stripping purposes, a mortgaged property should be valued at the outset of the case.  Because there was apparently no dispute that the mortgaged property was worth less than the balance outstanding on the first mortgage when the case was filed, the Court concluded that the second mortgage claim was completely underwater as of the petition date, and that the debtors’ chapter 13 plan could therefore strip the second mortgage lien and treat that claim as unsecured.

As “strip off” is still an option for debtors, in order to protect their security interest, junior creditors should be mindful of debtor estimates of value in their petition and schedules, which could tee up a chapter 13 plan to strip junior liens.   

Bodie B. Colwell practices as an associate with Preti Flaherty's Bankruptcy, Creditors’ Rights and Business Restructuring group from the Portland office. She focuses on supporting bankruptcy, insolvency, and creditors’ rights clients.

Supreme Court Rules: Even Gifts Must Play by the (Absolute Priority) Rule

Last week, the Supreme Court handed down its opinion in Czyzewski v.Jevic Holding Corp., stating that non-consensual, priority violating, structured dismissals are not allowed under the Bankruptcy Code.  In a well-reasoned opinion, the Court gave a simple answer to what has become a complex issue, especially in large Chapter 11 cases where the path out of bankruptcy is not always clear: the absolute priority rule is absolute (unless the affected parties agree otherwise).

Czyzeweski v. Jevic Holding Corp. Case

The Jevic case involved the demise of a trucking company. As it closed down and just before seeking bankruptcy protection, the debtor fired most of its employees, including a group of truck drivers (the “Petitioners”). After company’s Chapter 11 filing, the Petitioners sued the debtor and Sun Capital Partners (who had acquired Jevic in a leveraged buyout) for violation of the Worker Adjustment and Retraining Notification Acts (“WARN”).  The Petitioners won a $12.4 million summary judgment award against the debtor on their WARN claims, entitling them to (among other things) an approximately $8.3 million priority wage claim against Jevic’s estate. The Petitioners also pursued similar WARN claims against Sun outside the bankruptcy proceeding.

Separately, the unsecured creditors’ committee pursued litigation against Sun and CIT Group, a secured creditor with which Sun had refinanced the debt incurred in Jevic’s LBO, for misdeeds in effectuating the leveraged buyout, fraudulent transfers, and preferential transfers. Eventually, Sun and CIT settled with the creditors’ committee. The deal provided that the estate would receive funds for administrative and some priority tax claims, with the remainder going to general unsecured creditors—skipping the priority wage claims of the Petitioners, and violating the priorities of the Bankruptcy Code (Sun admitted it did not want to fund the Petitioners’ WARN litigation against it).  The Bankruptcy Court approved the settlement and the District Court and Third Circuit Court of Appeals affirmed the decision.  The Supreme Court reversed and remanded, ruling that a bankruptcy court could not approve a structured dismissal that violated the priorities of the Bankruptcy Code.

Facing Bankruptcy

Jevic, like many Chapter 11 debtors, was faced with the difficult decision of how to get out of bankruptcy. The estate was administratively insolvent; it had $1.7 million in cash, which was not sufficient to pay administrative claimants in full, all subject to Sun’s lien. Unable to confirm a plan, Jevic was left with two options: conversion to a case under Chapter 7 or dismissal. Conversion would have resulted in the senior secured creditors receiving everything in the liquidation. If successful, a structured dismissal could provide some of the benefits of a plan—releases for the debtor’s management and professionals and, through a mechanism commonly described as “gifting” by a secured party of a portion of its collateral, payments to junior creditors who would otherwise receive nothing in a liquidation scenario.

At the tail end of a bankruptcy case, an administratively insolvent debtor such as Jevic is often at the mercy of its secured creditor, who holds a lien over all or substantially all of the debtor’s assets. Absent a “gift” from the secured creditor, the debtor often cannot offer any incentive to induce parties in interest to settle their disputes with the debtor (or pay its professionals). In Jevic, that gift came with strings attached: Sun would not permit payments to priority claimants who were also litigating against it. The Court cut one of those strings. Under Jevic, the party funding an end-of-case structured settlement cannot dictate terms that violate the absolute priority rule unless the adversely affected classes consent.

Consensual Dismissal

However, the Court left open the possibility for consensual dismissals that violate the priority scheme of the Bankruptcy Code. In addition, the Court specifically did not rule on the permissibility of other priority violating distributions, such as “first-day” pre-petition wage and critical vendor orders and “roll-ups” in debtor-in-possession financing, that allow certain prepetition creditors to be paid first on their prepetition claims in the early days of a bankruptcy case. Pointing to the policy rationale of preserving the debtor as a going concern and promoting the possibility of a confirmable plan, the Court did not address the viability of mid-case structured settlements that violate the Bankruptcy Code’s priority scheme but do not resolve the case. Neither of these rationales applies to an end-of-case settlement with an administratively insolvent debtor.

In addition, the Jevic case may provide additional leverage for taxing authorities and other priority claimholders in plan and/or dismissal negotiations, knowing that debtors (and their secured creditors) have one less arrow in their quiver.  And it remains to be seen whether secured parties will push for conversion to Chapter 7 of an administratively insolvent debtor when they can no longer dictate the terms of a structured dismissal to the detriment of priority claimants. Restructuring professionals should plan accordingly.

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For any assistance with bankruptcy and restructuring, contact Preti Flaherty’s Bankruptcy, Creditors’ Rights, and Restructuring Practice Group.

Rue Toland practices as an associate with Preti Flaherty's Business Law and Creditors' Rights Groups from the firm's Concord, NH office. Rue provides counsel on transactional and financing matters, secured and unsecured lending, out-of-court loan workouts, bankruptcy proceedings, and other distress situations.

Massachusetts Bankruptcy Court Finds that Debtor Can Claim an Exemption in Her Home Even if She Does Not Live There

In a recent decision, the bankruptcy court for the District of Massachusetts found that a debtor who had not lived at a property for over 30 years could still claim an exemption in that property, even though her principal residence was elsewhere.

The debtor owned a one-half remainder interest in property occupied by her elderly parents. On her Schedule C, she claimed an exemption in the property in the whole value of her interest, $14,945.29 under § 522(I) of the Bankruptcy Code. The Chapter 7 Trustee objected to the debtor’s claim of exemption and argued that because neither the debtor nor her dependents resided at the property, she could not properly claim an exemption.

At hearing, the Debtor testified that she had not lived in the property for over 30 years and that her parents lived there. The debtor further testified that she lived in another town because of a medical condition and that it was her intention to move to and live at the property permanently when her medical condition permitted.

Noting that there are several cases holding that a debtor can have more than one “residence” for federal exemption purposes, the bankruptcy court found that the debtor’s intent to eventually live at the property, along with her testimony that she was often there to care for her parents and regularly stayed overnight at the property, was there to care for her parents and kept items at the property, was sufficient for the debtor to claim an exemption in the property.

This case is similar to In re Denker-Youngs, which was discussed on this blog last summer. In that case, the bankruptcy court for the Eastern District of New York found that a debtor who was ordered to vacate his home could still claim an exemption in the property. Like that case, the bankruptcy court for the District of Massachusetts gave weight to the debtor’s intent and her testimony that she intended to return to the property as soon as she was able.

Bodie B. Colwell practices as an associate with Preti Flaherty's Bankruptcy, Creditors’ Rights and Business Restructuring group from the Portland office. She focuses on supporting bankruptcy, insolvency, and creditors’ rights clients.

Exploring the Rule 3002.1 Minefield

In September 2016, the U.S. Bankruptcy Court for the District of Vermont ordered a mortgage servicer to pay a $375,000 sanction to a nonprofit legal aid organization for failing to comply with Rule 3002.1 of the Federal Rules of Bankruptcy Procedure. This appears to be the first time that a bankruptcy court has awarded sanctions after a violation of Rule 3002.1. If this decision—In re Gravel, 556 B.R. 561 (Bankr. D. Vt. 2016)—serves as a guidepost to other courts that encounter similar violations of this rule in the future, then secured creditors should pay attention. The price to pay for noncompliance may be considerable.

Until this decision, no court had considered what relief is “appropriate” for failure to comply with Rule 3002.1. In an article published recently in ABI Journal (subscription required) that I co-wrote with my colleague, Matt Libby, we explore the implications how this rule presents a number of potential pitfalls for the unwary creditor (despite its well-intentioned rationale), and we describe the creditor’s conduct in In re Gravel as well as the lessons to be learned from this case.

In sum, counsel representing mortgage servicers in chapter 13 cases must diligently advise clients on the importance of complying with Bankruptcy Rule 3002.1. Failure to do so will risk being subject to significant sanctions.

Anthony Manhart is a Partner at Preti Flaherty and serves as Co-Chair of the Bankruptcy, Creditors' Rights and Restructuring Group. His practice focuses on bankruptcy and creditors' and debtors' rights, representation of Chapter 7 trustees and various parties in formal insolvency and collection proceedings and out-of-court workouts. He also serves on the Panel of Chapter 7 Trustees for the District of Maine.

Supreme Court Hears Argument on Stale Claims and FDCPA

As reported on our blog (here and here), the Eleventh Circuit ruled that filing a time barred proof of claim does not violate the Fair Debt Collection Practices Act, an issue which has divided courts and Courts of Appeals. The Supreme Court heard argument on this issue on January 17, 2017. The transcript can be found here.

The advocates faced some tough question about the issues presented as well as the spirit and purpose of the Bankruptcy Code itself. This is bound to be an interesting opinion. We will keep you posted.

For any assistance with filing claims in bankruptcy cases, contact Preti Flaherty’s Bankruptcy, Creditors’ Rights, and Restructuring Practice Group.

Anthony Manhart is a Partner at Preti Flaherty and serves as Co-Chair of the Bankruptcy, Creditors' Rights and Restructuring Group. His practice focuses on bankruptcy and creditors' and debtors' rights, representation of Chapter 7 trustees and various parties in formal insolvency and collection proceedings and out-of-court workouts. He also serves on the Panel of Chapter 7 Trustees for the District of Maine.

Trustee Lacks Standing to Assert Legal Malpractice Claims on Behalf of Debtors

The Massachusetts Bankruptcy Court (Panos, J.) dismissed an adversarial proceeding complaint brought against debtor’s counsel which alleged legal malpractice. The trustee alleged that debtor’s counsel committed malpractice and asserted that the legal malpractice claims are assets of the bankruptcy estate. Debtor’s counsel moved to dismiss. After a hearing, the Court granted the motion to dismiss, ruling that the alleged malpractice claims were not property of the bankruptcy estate and that the trustee therefore lacked standing to assert them.

In the adversarial complaint, the trustee alleged that because debtor’s counsel failed to instruct his client to record a declaration of homestead, the debtor was only able to claim a Massachusetts homestead exemption in the amount of $125,000. Had a declaration of homestead been recorded prepetition, the debtor would have been able to claim a $500,000 exemption, which would have immunized him from a judgment obtained by the bankruptcy trustee. The trustee further claimed that by converting the case from a chapter 13 to a chapter 7 bankruptcy rather than having the matter dismissed and re-filed, the debtor missed an opportunity to have additional debt discharged.

In addressing the issue of the homestead claim, the Court ruled that the trustee lacked standing to bring his claim where the claims are not property of the estate but rather post-petition property. The Court noted that Section 541(a)(1) provides that commencing a bankruptcy case “creates an estate [that includes] all legal or equitable interests of the debtor in property as of the commencement of the case." Therefore, until the debtor filed his chapter 13 petition, no purported malpractice had yet accrued where no harm had yet been suffered by the failure to record the declaration of homestead. Accordingly, the claim did not exist until after the estate was created and therefore was post-petition property belonging to the debtor.

Moving on to the claim arising from the conversion of the case from a chapter 13 to a chapter 7 bankruptcy case, the Court similarly held that the claim was also not the property of the estate. Here, the Court found that the negligence which occurred during the pendency of the bankruptcy case logically could not have existed before the bankruptcy case commenced. Therefore, the earliest this claim could have accrued was upon conversion. Consequently, the Court held that “this was not a claim rooted in any way in the pre-bankruptcy past” and that the harmed caused by the malpractice “is entangled with [the debtor’s] ability to make a fresh start.” The Court therefore concluded that the trustee lacked standing to pursue the legal malpractice claim.

This case should remind practitioners to carefully consider the issue of standing whenever analyzing an adversarial proceeding claim. It also serves as a good reminder to all counsel that homeowners should record a declaration of homestead to be eligible take advantage of the heightened exemption amount available under Massachusetts law if things go south.

Matthew Libby is an associate in Preti Flaherty's Litigation Group, practicing from the firm's Boston office. He represents clients in commercial litigation and bankruptcy matters.

Changes to Bankruptcy Rule 3002.1 Affect Mortgage Lenders

Almost every year, changes are implemented to the Federal Rules of Bankruptcy Procedure. On December 1, 2016, this year’s changes to the Bankruptcy Rules went into effect. The changes include revisions to Bankruptcy Rule 3002.1.

Bankruptcy Rule 3002.1 requires secured creditors with an interest in the debtor’s principal residence, such as mortgage lenders, to periodically file notices of payment change in Chapter 13 cases. The changes to Bankruptcy Rule 3002.1 clarify when a secured creditor must file a payment change notice. The amended rule requires that a secured creditor file a payment change notice on all claims secured by the debtor’s primary residence for which a debtor or Chapter 13 Trustee is making post-petition payments during the bankruptcy, regardless of whether the debtor is curing a pre-petition mortgage.

Additionally, the amendments to Bankruptcy Rule 3002.1 clarify that the obligation to file a payment change notice ceases once the creditor obtains relief from the automatic stay.

Preti Flaherty frequently represents creditors in bankruptcy cases in Maine, Massachusetts and New Hampshire. For assistance with claims in bankruptcy cases, contact Preti Flaherty’s Bankruptcy, Creditors’ Rights & Business Restructuring Practice Group.

Bodie B. Colwell practices as an associate with Preti's Bankruptcy, Creditors’ Rights and Business Restructuring group from the Portland office. She focuses on supporting bankruptcy, insolvency, and creditors’ rights clients.