Consumer Chapter 7

Consumer Chapter 7

A secured creditor's lien will survive the debtor's bankruptcy unless avoided. In a Chapter 7 this is true even though the debtor's personal liability on the debt is discharged. At first blush it may seem odd that a lien survives even though the debt it secures is discharged; after all, the lien arose to secure a debt and, if the debt is now eliminated, how can the lien have any meaning? It may help for you to think that the in personam liability of the debtor is discharged but the in rem liability of the collateral remains to the extent of the amount of the debt that has been discharged, or to the extent of the value of the collateral, whichever is less. This is what section 524(a)(2) of the Bankruptcy Code means when it says: "A discharge . . . operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any [debt discharged in Chapter 7] as a personal liability of the debtor . . . (emphasis added)."

Consider two typical examples involving a Chapter 7 debtor who is a natural person.

(1) The debtor's debts include $10,000 owed to Bank, secured by a purchase-money security interest in an automobile. In the usual case (a case in which neither creditors nor the trustee object to the debtor's discharge or to the discharge of any particular debt) the debtor's personal liability on the $10,000 debt will be discharged. The security interest typically cannot be avoided because in most cases it was timely perfected. Accordingly, the security interest will remain. If the automobile is worth $12,000, the lien is "worth" $10,000. If the car is worth $8,000, the lien is "worth" $8,000. This means that following termination of or relief from the automatic stay Bank may repossess the car and keep up to $10,000 of the proceeds of sale of the car.

(2) The debtor's debts include $150,000 borrowed from Savings and Loan to finance purchase of a residence; the debt is secured by a mortgage (in some states a deed of trust) on the residence. The debtor's personal liability on the debt, if any, will be discharged. The lien of the mortgage typically cannot be avoided because in most cases it was timely recorded. Accordingly, the lien will remain. Following termination of or relief from the automatic stay Savings and Loan may foreclose on the property.

If the security interest cannot be avoided, the Bankruptcy Code offers the debtor three alternatives to repossession or foreclosure, as the case may be. The options are specified in Bankr. Code 521(2), a section that requires the debtor to timely notify the secured creditor of the debtor's intentions with respect to collateral.

First, the debtor may surrender collateral to the secured creditor or, in the case of real property, not oppose foreclosure.

Second, under certain conditions, a debtor may redeem certain personal property collateral from the lien by paying the secured creditor an amount equal to the value of the collateral or the amount of the debt, whichever is less. See Bankr. Code 722. This offers little solace to the debtor in many cases because, absent creditor agreement to the contrary, the debtor may not redeem through installment payments but may only redeem through lump sum payment. Typically, a debtor who has just filed bankruptcy does not have the resources to make that payment. In our illustration above, the debtor will likely be unable to pay $10,000, or $8,000, as the case may be, in a lump sum payment shortly after filing the bankruptcy petition.

The debtor's third alternative is to negotiate a reaffirmation agreement with the creditor. Through such an agreement, the debtor obligates himself or herself anew to pay the debt that has been discharged and typically agrees that this reaffirmed debt will be secured by the same collateral that secured the discharged debt. With respect to automobiles, creditors almost always require that the debt repayment be on the same terms as the old (same outstanding balance, monthly payments, interest rate, and all the other provisions of the original retail installment contract). The debtor is not entitled to a reaffirmation agreement; creditors are free to decline and assert their right to the collateral. In most cases, however, the creditor prefers the debtor's payment under the reaffirmation agreement (now more likely because the Chapter 7 discharge has lightened the debtor's financial burdens) to the prospect of a smaller recovery following repossession and foreclosure sale.

In some circuits, debtors have successfully invoked a fourth alternative to repossession of personal property: continue making payments called for under the original contract and resist the creditor's request for a reaffirmation agreement. This strategy (sometimes colloquially referred to as "ride through"), where successful, avoids the debtor's potential liability for a deficiency under the reaffirmation agreement in the event the debtor defaults on the reaffirmation agreement.

Empirical evidence suggests the percentage of debtors nationwide exercising each of the alternatives. Based on a statistically significant random sample of consumer Chapter 7 cases filed in bankruptcy courts in seven districts in 1995, law professors Marianne Culhane and Michaela White, of Creighton University School of Law, report the following in M.Culhane & M. White, Debt After Discharge: An Empirical Study of Reaffirmation, 73 Amer. Bankr. L.J. 709 (1999):

(1) Motor vehicles: Approximately 50% of debtors entered Chapter 7 with automobiles, trucks, or motorcycles subject to a lien. The mean amount of debt secured by a motor vehicle was $7,607 and the median amount of debt secured by a motor vehicle was $7,265. With respect to these secured debts, approximately 22% of debtors surrendered the vehicle to the secured party or lost possession of the vehicle through repossession following relief from the automatic stay. Another 21% reaffirmed the debt. Another 3% proposed to redeem the vehicle from the lien but the bankruptcy files of those debtors need not and do not contain information about whether redemption in fact occurred. In the remaining cases (55% of those in which the vehicle was subject to a lien), the files contain no information about what happened to the vehicle. One is left to infer that in most of these remaining cases the debtor either retained the vehicle by continuing to make payments without reaffirming the debt or signed a reaffirmation agreement which, because it was not filed in the bankruptcy case, is unenforceable (although the debtor may not know that the agreement is unenforceable).

(2) Residences: 30% of the debtors owned homes (including mobile homes) subject to a lien. 25% of those debtors either proposed to surrender their home or likely lost it through foreclosure following lifting of the automatic stay. 15% of those debtors reaffirmed the debt secured by their home, but none of the debtors in the sample drawn from the Northern District of California did so. The absence of reaffirmations in California for debts secured by residences might be attributable in part to relevant anti-deficiency legislation that would make such an agreement unenforceable. There is likely an alternative explanation. An Omaha, Nebraska practitioner representing approximately a dozen residential lenders offers this explanation for the absence of agreements reaffirming loans secured by residences: Often a residential mortgage lender no longer owns the loan (having sold it to Fannie Mae and Freddie Mac) or the loan has been guaranteed by the FHA. Consequently, the original lender is often just servicing the loan (collecting and forwarding payments, sending reminders in case of late payments, pursuing foreclosure and collection) and is reimbursed by the loan's owner for only about 90% of the costs of loan collection they incur. If a debtor's payments are current, such "servicing lenders" have little or no incentive to seek a reaffirmation because they will eat 10% of the processing costs. (Note, however, that in Nebraska 31% of debtors reaffirmed the debt secured by a lien on a residence).

The files in these cases contain no information about what happened to the home in the remaining 60% of the cases. One is left to infer that in most of these remaining cases the debtor retained the home by continuing to make payments without reaffirming the debt. Generally, creditors holding liens on residences probably are content to continue to receive timely mortgage payments. The debtor who defaults in mortgage payments will, ultimately, lose the home in foreclosure absent reinstatement, a mutually agreeable arrangement with the creditor to cure the arrearage, or a cure that might be forced on the creditor if the debtor invokes Chapter 13 of the Bankruptcy Code

To summarize:

1. Most Chapter 7 debtors are natural persons whose in personnam liability on debt is discharged;

2. If properly perfected, consensual purchase-money liens on automobiles and residences cannot be avoided in bankruptcy;

3. More than half of Chapter 7 debtors appear to keep their motor vehicle by reaffirming the debt incurred to purchase the vehicle on the same terms and conditions as the original contract or by continuing to make payments required under the original contract without reaffirmation.

4. More than half of Chapter 7 debtors who own a home will keep their home without reaffirmation by continuing to make timely mortgage payments, but lose their home if unable to continue making mortgage payments. A debtor facing arrearages in mortgage payments must negotiate a cure with the creditor or consider forcing a cure on the creditor under Chapter 13, either following or in lieu of Chapter 7.