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Wednesday, March 4, 2015

Erasing The Invisible Line In The Sand: The Need To Amend Section 1307(C) Of The Bankruptcy Code To Establish A Statutory Basis Of Bad Faith And Dismissal In Foreclosure Driven Chapter 13 Cases

By: Eric A. Rosen

Bad faith. These two words alone are troublesome to almost all attorneys, especially those who regularly practice in bankruptcy court. Yet there have always been Petitions for Relief filed for improper reasons. This article addresses a scenario that occurs, especially in Florida and other jurisdictions with high rates of residential loan foreclosures, with disturbing frequency. It discusses case law that warrants forfeiture of the Debtor's right to proceed with a Chapter 13 case when it is filed solely to avoid an impending foreclosure sale and specific factors courts consider in this context, and seeks the imposition of an automated mechanism to streamline the process of dismissing a Chapter 13 case on the basis that the Petition for Relief was filed in bad faith. 

The Concept of  a Fresh Start and the "Honest But Unfortunate" Debtor

Unfortunate things happen to people, and by and large they are entitled to the "fresh start" provided by the Bankruptcy Code.[1] Judges sitting in bankruptcy courts often go to great lengths to provide such a fresh start, as they should, to what is commonly referred to as the "honest but unfortunate debtor," even if the individual's debts have been incurred under circumstances that many people would consider unacceptable, such as gambling, substance abuse and the like.

The Function of Chapter 13

Chapter 13 cases often involve efforts of debtors to retain real estate, especially homestead property.[2] Chapter 13 plans were traditionally referred to as "wage earner plans" and were intended to be utilized by debtors who were  subject to unforeseen circumstances that were beyond their control, such as illness, divorce, the death of a wage earning spouse and loss of employment. Such people should be able to properly utilize the provisions of Chapter 13 in order to reorganize their personal affairs and save their homes.

Changes In Mortgage Loans and Resulting Defaults

The advent of what are referred to as "exotic" mortgages: negative amortization loans,  interest-only loans, adjustable interest rates, loans where the loan to value ratio[3] may have been 100% and on occasion more than 100%, combined with a compensation structure where representatives of commercial lenders were paid on a commission-like basis and thus encouraged to essentially act as salespeople rather than brokers, the allowance of applications for loans which did not require documentation supporting income and/or assets (resulting in higher interest rates), along with lax appraisal standards, created an entire group of borrowers that may not have previously qualified to buy a home.  The failure - intentional or not - of sellers to disclose facts such as that in Florida, real estate taxes are paid in arrears, contributed to a situation where an unusually large number of borrowers purchased homes they could not afford.

The inevitable result of this scenario, combined with a downturn in the economy in general, was a substantial increase in the filing of residential foreclosure cases. Issues such as the  well-publicized "robo-signing" debacle, inefficiencies of certain loan servicers, and high volume lending combined with ever - increasing use of automation created a situation where borrowers - often with the assistance of attorneys who became well versed in foreclosure defense – went years without making a mortgage payment.

Some of these borrowers had the ability to make their payments but intentionally did not, opting instead to play the game for as long as possible, until the foreclosure sale date arrived, only to then file a Petition for Relief under Chapter 13 of the Bankruptcy Code. At its worst (or best depending on your point of view), one spouse will file a Chapter 13 case only to allow it to be dismissed, seek an extended sale date in order for his or her to have sufficient time to relocate, and then the other spouse files a Chapter 13 case, which is also dismised either automatically or upon motion, and then the first spouse files another Chapter 13 case since the six month prejudice period that derives from an automatically dismissed case has expired, creating an endless merry go round.

It is the members of this group who become debtors in Chapter 13 cases, and particularly those who file Schedules that demonstrate on their face that the debtor does not have, and has not had, disposable household income necessary to meet the requirements to confirm a plan under Chapter 13 of the Bankruptcy Code that are the reason for this article and the suggested amended to the Bankruptcy Code.[4]

Bad Faith

The concept of "bad faith" is not found in the Bankruptcy Code itself. Rather, it is something of a catch-all that courts have utilized when considering a motion to dismiss.[5]

Motions to dismiss have been made, and granted, in the context of Chapter 11 cases for decades, and the law in the 11th Circuit is well established insofar as the analysis that a court will employ.[6]

Section 1307 (c) of the Bankruptcy Code applies in Chapter 13 cases, and it provides in pertinent part: "[O]n request of a party in interest…and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 7 of this title, or may dismiss a case under this chapter, whichever is in the best interests of creditors and estate, for cause, including unreasonable delay by the debtor that is prejudicial to creditors…." [7] "The list of grounds for dismissal or conversion found in section 1307 is not exhaustive; the court is not limited by the specific circumstances specifically mentioned there."[8]

While "bad faith" is not an enumerated "cause" under sections 1307(c)(1)-(11) of the Code, it is well established that a lack of good faith (i.e., bad faith) is cause for conversion or dismissal of a Chapter 13 case.[9]  Good faith, however, is a concept, and it is one that must derive from equity. What this means in practice is that a bankruptcy court judge currently should consider the totality of the circumstances, and then make what is inherently a fact-intensive inquiry on a case by case basis in order to determine whether a Chapter 13 case should be dismissed for lack of good faith.

Courts typically consider the following factors in making such a determination in Chapter 13 cases:

(1)[the] debtor's accuracy in stating debts and expenses, (2) honesty in the bankruptcy process, including whether the debtor has attempted to mislead the court and whether the debtor has made any misrepresentations, (3) whether the Bankruptcy Code is being unfairly manipulated, the type of debt sought to be discharged, (5) whether the debt would be dischargeable in a Chapter 7 case and (6) the debtor's motivation and sincerity in seeking Chapter 13 relief.[10]

It is this sixth factor that has lead courts to consider two additional factors when examining the totality of the circumstances regarding a debtor's commencement of a case: (1) a debtor's history of filings and dismissals and (2) whether a debtor only intended to defeat or circumvent state court litigation.[11] The bottom line is whether the debtor is attempting to thwart creditors, or is making an honest effort to repay them to the best of his or her ability. [12]

A Proposal For A Solution

All debtors must file what are commonly referred to as "Schedules." The Schedules, which generally consist of statements of assets, liabilities, income, expenses, a Statement of Financial Affairs, a Statement of Intention and other documents must, if not filed with the Petition for Relief, be filed within fifteen days thereof or the case will automatically be dismissed, unless an extension of time is granted by court order entered within the fifteen day period. Household income must be included in the schedule of income, regardless of whether or not the filing is individual or joint. Applications to extend the time to file Schedules are routinely granted.

Automatically is the operative word. Our bankruptcy courts are highly automated, and as a result very efficient with regard to the overwhelming majority of cases that are filed, which are "no asset" consumer Chapter 7 cases, or fairly simple Chapter 13 cases. Unlike Chapter 11 cases, in these cases debtors and their attorneys rarely see a judge. If the Chapter 13 case moves through its paces in the normal course of events, everything other than the meeting of creditors conducted by a standing Chapter 13 Trustee, any objection to confirmation by a standing Chapter 13 Trustee (which is usually a form with checklists transmitted electronically) by the standing Chapter 13 Trustee to a proposed plan and a confirmation hearing - often without a judge present in a Chapter 13 case – is automated.

In order for a creditor or other party in interest to seek relief the creditor must be proactive and file a motion as required by Section 1307(c) of the Bankruptcy Code. The creditor must then schedule a hearing and physically attend it. This creates an additional expense to an already frustrated creditor-client that can be avoided.

In the event of a true bad faith filing, this process can be streamlined. In the event a debtor's household income, as provided on Schedules which are sworn to under penalty of perjury, is facially insufficient to confirm a plan, and the overwhelming majority of debts are attributable to the mortgage debt that was the subject of the foreclosure sale stayed by the commencement of the case, and the Statement of Financial Affairs in the Schedules provides that a judgment of foreclosure was entered in state (or federal) court, the court's software can be programmed to provide that the case appears ripe for dismissal.

In that instance, an order to show cause can be automatically generated (in accordance with a form that the court has prepared and approved pursuant to applicable provisions, just as a notice of meeting of creditors or an order providing for discharge is a form) requiring the debtor(s) to appear and demonstrate why his, her or their case should not be dismissed, as to the debtor and his or her spouse, with a prejudice period of sufficient length to prevent a subsequent filing by a debtor or a non-debtor spouse.

Presently, under Bankruptcy Code Section 1307(c), the objecting creditor has the burden of proving a lack of good faith on behalf of the Debtor.  As a result the suggested mechanism cannot be implemented absent an amendment to the statute. In view of the disturbing frequency with which the factual scenario described above has occurred and will continue to occur, the time is ripe for such an amendment to the Bankruptcy Code to be effectuated.

Eric A. Rosen is a Shareholder and the Chairperson of the Bankruptcy, Creditors' Rights and Business Reorganizations practice group at Fowler White Burnett, P.A. He has practiced in these areas for almost thirty years.

[1] See generally, 11 U.S.C. Section 301.

[2] Florida's unique, constitutionally-created homestead exemption has made often served as an alleged justification for attorneys to file Petitions for Relief notwithstanding facts which may warrant a finding that the filing of the case was in bad faith.
A loan to value ratio compares the amount of the loan to the value of the real estate used as collateral. Traditionally, residential mortgage lenders required that the amount of the loan be no greater than 80% of the appraised value of the home that serves as collateral. Appraisals performed in connection with residential loans usually utilize what is referred to as the comparative sales method – reviewing homes of similar size, age and locale  - in order to determine the fair market value of the potential collateral. The creation of more planned urban developments, and subdivisions within them, has made this easier.
Similarly, the Bankruptcy Code was  amended to expand Section 362 (d) , in order to  add subsection (3) thereof, which applies only to single asset real estate cases in the Chapter 11 context. This was the result of certain bad faith filings by in single asset real estate cases.
See 11 U.S.C. Section 1307 (c); see also 11 U.S.C Section 1112(b), which applies to Chapter 11 cases. In this regardthe anlaysis is effectively interchangeable with that of providing relief from the automatic stay for cause under Bankruptcy Code Section 362(d)(1).
In re Phoenix Picadilly, Ltd., 849 F. 2d 1393, 1394 (11th Cir. 1988), citing In re Albany Partners, Ltd., 749 F. 2d 670, 674 (11th Cir. 1984).
See Bankruptcy Code Section 1307(c).
Gonzales-Ruiz v. Doral Fin. Corp. (In re Gonzales-Ruiz), 341 B.R. 371, 382 (B.A.P. 1st Cir. 2006).
  Sullivan v. Solimini (In re Sullivan), 326 B.R. 204, 211 (B.A.P. 1st Cir. 2005).
In re Visconti, 488 B.R. 617,622 (Bankr. D.N.H. 2011)
See Sullivan, 326 B.R. at 211-12 (emphasis supplied).
[12] In re Virden, 279 B.R. 401 407 (Bankr. D. Mass. 2002).

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