The Pooling and Servicing Agreement (PSA) is the document that actually creates a residential mortgage-backed securitized trust and establishes the obligations and authority of the master servicer and the primary servicer. The PSA also establishes mandatory rules and procedures for the sales and transfers of the mortgages and mortgage notes from the originators to the trust. It is this unbroken chain of assignments and negotiations that creates what I have called the “alphabet problem.”

In order to understand the alphabet problem, you must keep in mind that the primary purpose of securitization is to make sure the assets (e.g., mortgage notes) are both FDIC and bankruptcy “remote” from the originator. As a result, the common structures seek to create at least two “true sales” between the originator and the trust.

You have in the most basic securitized structure the originator, the sponsor, the depositor and the trust. I refer to these parties as the A (originator), B (sponsor), C (depositor) and D (trust). The other primary but nondesignated player in my alphabet game is the master document custodian for the trust. The MDC is entrusted with the physical custody of all of the “original” notes and mortgages and the assignment, sales and purchase agreements. The MDC must also execute representations and attestations that all of the transfers really and truly occurred “on time” and in the required “order” and that “true sales” occurred at each link in the chain.

Section 2.01 of most PSAs includes the mandatory conveyancing rules for the trust and the representations and warranties. The basic terms of this section of the standard PSA is set-forth below:

2.01 Conveyance of Mortgage Loans.

(a) The Depositor, concurrently with the execution and delivery hereof, hereby sells, transfers, assigns, sets over and otherwise conveys to the Trustee for the benefit of the Certificateholders, without recourse, all the right, title and interest of the Depositor in and to the Trust Fund, and the Trustee, on behalf of the Trust, hereby accepts the Trust Fund.

(b) In connection with the transfer and assignment of each Mortgage Loan, the Depositor has delivered or caused to be delivered to the Trustee for the benefit of the Certificateholders the following documents or instruments with respect to each Mortgage Loan so assigned:

(i) the original Mortgage Note (except for no more than up to 0.02% of the mortgage Notes for which there is a lost note affidavit and the copy of the Mortgage Note) bearing all intervening endorsements showing a complete chain of endorsement from the originator to the last endorsee, endorsed "Pay to the order of _____________, without recourse" and signed in the name of the last endorsee. To the extent that there is no room on the face of any Mortgage Note for an endorsement, the endorsement may be contained on an allonge, unless state law does not so allow and the Trustee is advised by the Responsible Party that state law does not so allow. If the Mortgage Loan was acquired by the Responsible Party in a merger, the endorsement must be by "[last endorsee], successor by merger to [name of predecessor]". If the Mortgage Loan was acquired or originated by the last endorsee while doing business under another name, the endorsement must be by "[last endorsee], formerly known as [previous name]"….

A review of all of the recent “standing” and “real party in interest” cases decided by the bankruptcy courts and the state courts in judicial foreclosure states all arise out of the inability of the mortgage servicer or the trust to “prove up” an unbroken chain of “assignments and transfers” of the mortgage notes and the mortgages from the originators to the sponsors to the depositors to the trust and to the master document custodian for the trust. As stated in the referenced PSA, the parties have represented and warranted that there is “a complete chain of endorsements from the originator to the last endorsee” for the note. In addition, the MDC must file verified reports that it in fact holds such documents with all “intervening” documents that confirm true sales at each link in the chain.

The complete inability of the mortgage servicers and the trusts to produce such unbroken chains of proof along with the original documents is the genesis for all of the recent court rulings. One would think that a simple request to the MDC would solve these problems. However, a review of the cases reveals a massive volume of transfers and assignments executed long after the “closing date” for the trust from the “originator” directly to the “trust.” I refer to these documents as “A to D” transfers and assignments.

There are some serious problems with the A-to-D documents. First, at the time these documents are executed, the A party has nothing to sell or transfer, since the PSA provides such a sale and the transfer occurred years ago. Second, the documents completely circumvent the primary objective of securitization by ignoring the “true sales” to the sponsor (the B party) and the depositor (the C party). In a true securitization, you would never have any direct transfers (A to D) from the originator to the trust. Third, these A-to-D transfers are totally inconsistent with the representations and warranties made in the PSA to the Securities and Exchange Commission and to the holders of the bonds (the “certificateholders”) issued by the trust. Fourth, in many cases the A-to-D documents are executed by parties who are not employed by the originator but who claim to have “signing authority” or some type of “agency authority” from the originator. Finally, in many of these A-to-D document cases, the originator is legally defunct at the time the document is in fact signed or the document is signed with a current date, but then states that it has an “effective date” that was one or two years earlier.

Hence, we have what I call the alphabet problem. Now, I want to admit that I have never been strong in math or in spelling. But the way I see it, all of this spells out the word “FRAUD.”

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Many bankruptcy practitioners today are faced with the often confusing and unenviable dilemma of advising their clients as to the exemptions of private disability insurance. The reality is that thousands of dollars can often be at stake with private disability insurance, depending on the timing and motivation involved in a bankruptcy filing. Bankruptcy scholars have researched the applicability of exempting privately purchased disability insurance policies and have looked to the source of disability payments through 11 U.S.C.§522(d)(10)(c) and (e) to determine if government benefits are involved vs. rights to payment that arise from the debtor’s employment. Others have considered the distinction between temporary and permanent benefits in deciding which exemption is applicable. Perhaps the most notable distinction between the various exemptions listed in §522(d)(10) is that of full and partial exemptions. As outlined below, the applicability of exempting private disability insurance policies is certainly up for debate.

When a debtor files for bankruptcy protection, an estate is created that includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. §541(a)(1). Federal bankruptcy law allows a debtor to exempt some of his or her property—mainly basic necessities—from the bankruptcy estate. The exemptions can afford the debtor some economic and social stability, which is important to the fresh-start guaranteed by bankruptcy. Williams v. U.S. Fid. & Guar. Co., 236 U.S. 549, 554-55, 35 S.Ct. 289, 59 L.Ed. 713 (1915). Any person who files a petition under federal bankruptcy law may exempt the following property from property of the estate in a bankruptcy proceeding:

11 U.S.C. §522(d)(10) the debtor’s right to receive:

(a) A social security benefit, unemployment compensation or a local public assistance benefit;
(b) A veterans’ benefit;
(c)A disability, illness or unemployment benefit;
(d) Alimony, support or separate maintenance, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor; and
(e) payment under a stock bonus, pension, profit sharing, annuity or similar plan or contract on account of illness, disability, death, age or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor.

The benefits listed in §522(d)(10)(a)-(c)) are fully exempt from the bankruptcy estate without regard to their amount. In contrast, the payments listed in 11 U.S.C. §522(d)(10)(d)-(e) are “partially exempt” in the sense that debtors are entitled to exempt these payments only to the extent that the payments are reasonably necessary for the support of the debtor and his dependents. A debtor may, of course, be entitled to exempt the full amount of a payment classified under §522(d)(10)(d)-(e) if the payment does not exceed the amount reasonably necessary for support.

The task is to decide whether payments made under a privately purchased disability insurance policy should be classified as fully exempt disability benefit(s) under 11 U.S.C. §522(d)(10)(c) or partially exempt “payment(s) under a…contract on account of” disability under 11 U.S.C. §522(d)(10)(e). Only two courts, both outside of the authors’ circuit, have discussed the treatment of disability payments under state exemption schemes molded on the federal code. In re Bari, 43 B.R. 253, 255 (Bankr. D. Minn. 1984)(classifying payments under disability insurance policy as partially exempt under Minnesota exemption 204 modeled on 11 U.S.C. §522(d)(10)(E)); Sanders v. Sanders, 711 A. 2d 124, 128 (Maine 1998)(classifying payments under disability insurance policy as partially exempt under Maine exemption modeled on 11 U.S.C. §522(d)(10)(E)).

There are two strains of thinking on the issue. Both sides believe that §522(d)(10) classifies types of disability benefits or payments as fully or partially exempt on the basis of their source, but each side argues for a different result. The respective arguments are based on the fact that the payments come from a privately purchased insurance policy rather than from the government or an employer. One analysis claims that the use of the word “benefit” in 11 U.S.C. §522(d)(10)(c) establishes that the “disability, illness or unemployment” benefits referred to therein are government benefits. That side therefore argues that the disability payments must fall under 11 U.S.C. §522(d)(10)(e) because they do not come from the government. The most obvious problem with this argument is that the word “benefit” is not restricted to government benefits. Black’s Law Dictionary defines “benefit” in part as “financial assistance that is received from an employer, insurance, or a public program (such as social security) in time of sickness, disability, or unemployment.” Black’s Law Dictionary 151 (7th ed. 1999).

The other strain of thinking is the claim that the §522(d)(10)(e) exemption covers only rights to payment that arise from the debtor’s employment. There is no case law interpreting 11 U.S.C. §522(d)(10)(e) to be limited solely to plans or contracts provided by or through the debtor’s employer.

The failure of both of these arguments means that we cannot always look to the source of the payments to tell the difference between the “disability benefits” fully exempted by §522(d)(10)(c) and the “payments under a contract on account of disability” partially-exemptible approach. A second potential way to distinguish between the two disability exemptions is on the basis of the duration of the payments rather than their source. A treatise states that 11 U.S.C. §522(d)(10)(c), covers “temporary contractual benefits.” whereas 11 U.S.C. §522(d)(10)(e) covers “permanent employment-related benefits.” 2 Norton, supra, 46:17. A Maine state court has recited this distinction in classifying certain disability insurance payments as partially exempt under a state provision modeled on 11 U.S.C. §522(d)(10)(e). Sanders, 711 A.2d at 128.Whatever the merits of this approach as a general matter, we do not find it helpful here because the payments provided by disability insurance are not readily classified as either permanent or temporary.

Some benefits, such as retirement benefits, that will continue until death are clearly permanent. However, benefits with a short, fixed duration, such as unemployment benefits, are clearly temporary. Disability payments fall somewhere in the middle. For example, disability payments could continue until death, or they might end tomorrow if the disability ends. This kind of uncertainty about the length of a disability is not uncommon, and under such circumstances courts have no principled way to decide how permanent or temporary the disability payments will be. Therefore, the conclusion that the distinction between temporary and permanent benefits is not helpful in deciding whether the §522(d)(10)(c) or the §522(d)(10)(e) exemption applies in this case.

Payments under privately-purchased disability insurance policies do not fit neatly within either 11 U.S.C. §522(d)(10)(c) or the 11 U.S.C. §522(d)(10)(e) exemption. In re Thomas, 1990 W.L. 62438 (Bankr. D. Minn. 1990). The legislative history of the federal exemption is not helpful because all payments on account of disability are meant to replace future earnings, and this history sheds no light on Congress’s decision to allow full exemption of some disability payments while allowing only partial exemption of others. In the absence of any indication of specific legislative intent about the treatment of payments under privately purchased disability contracts, we will explore whether full or partial exemptions of these payments is more consistent with the policy behind the bankruptcy exemptions. H.R. Rep. No. 95-595 at 362 (1977).

The most notable distinction between the various exemptions listed in 11 U.S.C. §522(d)(10) is that between full and partial exemptions. Sections 522(d)(10)(a)-(c) list benefits that are fully exempt, while §522(d)(10)(d)-(e) lists benefits or payments that are exempt only to the extent reasonably necessary for the support of the debtor and his dependents. We can imagine only two possible reasons why Congress would make this distinction. One is that the legislature might have believed that certain types of payments (those listed in 11 U.S.C. 522(d)(10)(a)-(c)) ought to be available to debtors even when the payments exceed the amount reasonably necessary for support, but this explanation is inconsistent with the bankruptcy policy of allowing debtors a chance to start over, exempting only the basic means to support that chance. This policy suggests that debtors are never entitled to exempt more than is reasonably necessary for support. The more logical reason for the legislature’s decision to allow full rather than partial exemption for certain types of benefits is this: The legislature believed that the fully exempt benefits (for example, social security, unemployment compensation and veterans’ benefits) listed in 11 U.S.C. §522(d)(10)(a)-(c) could be assumed to be no more than an amount reasonably necessary for the support of the debtor and his dependents. See In re Dale, 252 B.R. 430, 436 (Bankr. W.D. Mich. 2000)(“Congress simply assumed that the benefit(s) would be necessary {for the support of the debtor} without further examination”). This explanation for the structure of the statute shows why the legislature specifically classified the social security, unemployment compensation, public assistance and veterans’ benefits listed in 11 U.S.C. §522(d)(10)(a)-(b) as fully exempt. No one lives lavishly on these benefits. By the same token, workers’ compensation benefits, which are not listed in the statute, should also be classified as fully exempt under 11 U.S.C. §522(d)(10)(c), for these benefits can be assumed to be “not much higher than is necessary to keep the worker from destitution.” In re Cain, 91 B.R. 182,183 (Bankr. N.D. Ga. 1988) (internal quotation marks and citation omitted) (holding that workers’ compensation benefits are fully exempt under 11 U.S.C. §522(d)(10)(c). Accord, In re Evans, 29 B.R. 336, 338-39 (Bankr. D. N.J. 1983): In re LaBelle, 18 B.R. 169,171 (Bankr. D. Maine 1982).

In contrast to the full exemptions in §522(d)(10)(a)-(c), the exemptions in §522(d)(10)(d)-(e) are limited because alimony payments and payments under plans and contracts of the sort listed in 11 U.S.C. §522(d)(10)(e) have the potential in some cases to exceed greatly what is reasonably necessary for support, and they can be “extravagant (witness the divorces of the super-rich) or be supplemented by earnings if the bankrupt debtor also is employed.” Dale, 252 B.R. at 436.Similarly, payments from stock-bonus plans, profit-sharing plans and the like are not inherently limited to amounts reasonably necessary for support of the debtor and his dependents. In re Woodford, 73 B.R. 675, 681-82 (Bankr. N.D.N.Y.1987).Using this approach, the legislature created two categories of disability-related payments: “disability benefits” fully exempted by §522(d)(10)(c), and “payments under a contract on account of disability” partially exempted by § 522(d)(10)(e). The legislature created the two categories because it reasoned that some, but not all, disability payments could be assumed to be limited to amounts reasonably necessary for support. Accordingly, the right to receive payments under a privately-purchased disability insurance contract is fully exempt from the bankruptcy estate under 11 U.S.C. §522(d)(10)(c) only if payments of this type can be assumed to be limited to amounts reasonably necessary for the support of the debtor and his dependents. Under the federal exemptions, a bankruptcy trustee would have the ability to have the court determine what amount of the private disability insurance would be reasonably necessary for the support of the debtor and his dependents.

Determining which, if any, payments under a privately-held disability policy are “reasonably necessary for the support of the debtor and his dependents” is no easy task. Due diligence and meticulous prebankruptcy planning with a client is essential for a successful outcome in a bankruptcy case. Litigation will continue in the bankruptcy arena as each situation must be dealt with on a case-by-case basis. The interplay between benefits that are fully exempt under §522(a)-(c) and those that are exempt under §522(d)(10)(d)-(e) only to the extent reasonably necessary for support will continue to be scrutinized by bankruptcy attorneys for years to come.

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Due to the recent downturn in the real estate market, chapter 13 debtors are fabricating new tools to surrender their real estate. While surrendering a secured asset is not a novel concept in the Bankruptcy Code,[1] one new “tool” being utilized is attempting to surrender real property with excess mortgage debt in full satisfaction of the mortgage. Unfortunately for debtors, this tool is as effective as using a plastic hammer on a railroad spike. Modern case law trends suggest that, much like the surrender-in-satisfaction provisions for personal property, chapter 13 debtors may not surrender real property that is in full satisfaction of their mortgage debt.[2]

In a recent Florida case, a debtor had filed for chapter 13 bankruptcy, indicating that she wanted to surrender her property in full satisfaction of the second lienholder’s claim.[3] Section 1325(a)(5) of the Code allows a debtor to either retain collateral or surrender collateral to the creditor who holds a lien over that collateral.[4] Unfortunately, that Code section is silent when the surrender of the collateral will result in a deficiency balance on the creditor’s claim. In Hughes, the court looked to §506(a)(1) for guidance.[5] In that section, the Code clearly provides that “an allowed claim of a creditor secured by a lien in property in which the estate has an interest…is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property…and is an unsecured claim to the extent that the value of such creditor’s interest is less than the amount of such allowed claim.”[6] In rendering its decision, the court in Hughes looked to Associates Commercial Corp. v. Rash.[7] In that case, the Supreme Court ruled that in such instances where collateral is underwater, the secured creditor’s claim “is to be divided into secured and unsecured portions, with the secured portion of the claim limited to the value of the collateral.”[8] The court in Hughes ruled that a debtor may not surrender his or her real estate in full satisfaction of the mortgage debt.[9] Therefore, in using the guidance provided from Hughes, since the debtor will be unsuccessful in surrendering real property in full satisfaction of mortgage debt, a creditor will be allowed to file an unsecured deficiency claim under 11 U.S.C. §506(a)(1).[10]

Florida is not the only state that has dealt with this issue. Recently, the Eastern District of Michigan has taken up a case on very similar facts.[11] In that case, the debtor filed for chapter 13 bankruptcy, whereby she proposed to surrender her real estate in full satisfaction of her obligation to the mortgage creditor.[12] The primary difference in this case, from the Hughes decision, is that the debtor in this case only had one mortgage on her residence.[13] The debtor in the Michigan case represented to the court that the property was worth $100,000 with the value of the note being $203,236.24.[14] The debtor proposed to surrender the property to the mortgage creditor in full satisfaction of the outstanding balance to the mortgage creditor.[15] As the court pointed out, “only two courts have directly addressed the issue of whether 11 U.S.C. §506(a) applies when a debtor surrenders property that is not a debtor’s principal residence. Both cases held that the secured creditor was entitled to an allowed general unsecured claim for any deficiency balance pursuant to §506(a)(1).”[16] Therefore, the court had an important analysis to undertake. The debtor argued that since the property was not her principal residence, she should be able to modify the claim under §1322(b)(2) and surrender in full satisfaction.[17] The mortgage creditor argued that it had a right to bifurcation of the claim after surrender.[18] The court ruled that “there is no meaningful distinction, for purposes of determining the secured status of a creditor’s claim, between the surrender of real property and the surrender of a vehicle.”[19] The debtor’s request to surrender her real property in full satisfaction of the mortgage creditor’s claim was denied.

Notwithstanding recent attempts by debtors to modify or rid their estates of mortgage debt over and above market value of their real property, two courts have decided the issue in favor of the mortgage creditor. Where these decisions fall in the grand scheme of things remains unseen; however, it is more than likely that other courts facing the surrender-in-full satisfaction issue may consider these two decisions and continue the trend of disallowing debtors from surrendering property in full satisfaction of the mortgage debt. What should be alarming for debtors considering this issue is that the courts are ruling in this manner despite the value of the property being substantially less than the value of the note. For now, one rule is evident: Debtors seeking to surrender their houses in full satisfaction of their mortgage debt “can’t get no satisfaction.”