The Supreme Court, apparently without resort to a calculator, decided the cramdown interest issue by employing a formula approach.

Confronted by the difficult and arcane issue of what interest rate best satisfies the requirements of §1325(a)(5)(B)(ii) that the secured creditor receive “…the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim ….”, a plurality of the Court held that the so-called formula approach (the prime rate plus a calculated risk factor) best meets the intent of Congress and the objectives of the Bankruptcy Code.

The debtor’s plan in this case, in dealing with a cramdown of a secured claim that contained a pre-petition contract rate of interest of 21 percent, proposed a three-year plan payout of cash payments equal to the $4,000 value of the collateral (a used truck) with a proposed interest rate of 9.5 percent (based on a national prime rate of 8 percent together with a court determined risk factor of 1.5 percent). The secured creditor countered with a contractual rate of its 21 percent pre-petition rate, because it represented the interest that “…it would obtain if it could foreclose on the vehicle and reinvest the proceeds in loans of equivalent duration and risk as the loan” originally made to petitioners.

Being confronted with four different approaches (the formula rate, the coerced-loan rate, the presumptive-contract rate, or the cost-of-funds rate) to determining the correct and appropriate interest rate, the Court (in an opinion by Justice Stevens, joined by Souter, Ginsberg and Breyer) determined that the least complicated approach and one most consistent with congressional intent and promoting debtor rehabilitation, is the formula approach. The Court began by emphasizing that the Code does not set forth a defined “discount rate” or even the term “interest” in connection with the property to be distributed to the secured creditor over the lifetime of the plan. Rather, the sole command is to provide value of distributable property, as of the plan's effective date, that is “…not less than the allowed amount of such claims.” In arriving at an appropriate discount rate for this “stream of differed payments,” the Court held that “…we think Congress would favor an approach that is familiar in the financial community and that minimizes the need for expensive evidentiary proceedings.” As a second consideration, the court recognized that there is a need to consider all “intervening changes and circumstances” when modifying the original terms of the loan and finally, that the cramdown provision requires resort to an objective rather than a subjective standard.

The analysis necessarily rejects the coerced-loan approach, the presumptive contract rate and the cost-of-funds approach. The court instead adopted the formula approach by explaining that adherence to a “national prime rate” and, after an evidentiary hearing where the parties may present evidence about the “appropriate risk adjustment,” the court concluded that “….there is every reason that a properly risk-adjusted prime rate will provide a better estimate of the creditor’s current cost and exposure than a contract rate set in different times.”

Justice Scalia, writing for four justices in a well reasoned dissent, essentially argues that because all of the judges (excluding Justice Thomas) argue that consideration of the risk premium is mandatory in determining a proper discount rate, adoption of the contract rate will best satisfy this requirement. Justice Thomas, while concurring in the judgment, wrote separately to say that §1325(a)(5)(B)(ii) does not require a debtor-specific risk adjustment. When all is said and done the need for evidence on the critical element of risk will assure that even resort to a formula approach will not eliminate litigation.

(Summary by Hon. Roger Whelan, ABI Resident Scholar)

The Supreme Court held that the discharge of a student loan debt, as an exercise of the bankruptcy court’s in rem jurisdiction, does not infringe the state’s sovereign immunity. The court did not address the underlying issue as to abrogation of the state's sovereign immunity from private suits under §106(a) of the Bankruptcy Code.

The underlying case involved an adversary proceeding by the debtor, Pamela Hood, seeking the discharge of her student loans as constituting an “undue hardship” under §523(a)(8). A proof of claim was originally filed by Sallie Mae and later assigned to the Tennessee Student Assistance Corporation (TSAC). Because this was a no-asset case, there was no active participation in the underlying bankruptcy case by TSAC, other than its acceptance of the assigned claim. Because the filing of a proof of claim has been held in previous cases to constitute submission to the bankruptcy court’s jurisdiction, the debtor never advanced the argument that TSAC, as an agency of the state, waived its sovereig immunity. The Supreme Court, therefore, declined to address this specific constitutional issue.

The 7-2 decision, written by Chief Justice Rehnquist, focused on the nature of the bankruptcy court’s jurisdiction with respect to the discharge of debts when it held that “a bankruptcy court’s in rem jurisdiction permits it to ‘determin(e) all claims that anyone, whether named in the action or not, has to the property or thing in question. The proceeding is ‘one against the world.'" In other words, a state, regardless of its participation in the bankruptcy case, is bound by the bankruptcy court’s discharge order and is no different than any other creditor whose debt is subject to that discharge.

Despite the acceptance of this basic concept, TSAC argued that the state’s sovereign immunity was infringed upon by reason of the commencement of the adversary proceeding against TSAC and was therefore an unauthorized lawsuit within meaning of the 11th Amendment. The Supreme Court dismissed this argument, again focusing on the exercise of the bankruptcy court's jurisdiction over the res – not the persona of the state in this case. "...the bankruptcy court's jurisdiction is premised on the res, not on the persona," the court said. A bankruptcy debtor does not seek damages or any affirmative relief from a state by seeking a discharge, nor does the debtor "subject an unwilling state to a coercive judicial process" by seeking only a discharge.

While this case upholds the bankruptcy court’s jurisdiction to determine the legal effect of a discharge in a bankruptcy case, there still remains for another day the all important issue of the application of §106(a) to issues involving sovereign immunity in proceedings where the state is seeking an affirmative recovery pursuant to a provision such as a preference action.

Dissenting Justices Thomas and Scalia would have reached this issue and held that "Congress lacks authority to abrogate state sovereign immunity."

(Summary by Hon. Roger Whelan, ABI Resident Scholar)

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In Bethea v. Robert J. Adams and Associates, 352 F.3d 1125 (7^th Cir. 2003), the Seventh Circuit has ruled that in a chapter 7 case a pre-petition agreement for payment of legal fees creates a debt subject to discharge like any other. The court rejected arguments that §329 evinces an intent to except such fees from the scope of the discharge and that public policy, including the need to facilitate the employment of counsel for chapter 7 debtors, mandated an exception for pre-petition fees.

Three different debtors had retained lawyers to file chapter 7 cases for them and entered into retainer agreements under which the agreed fee was to be paid in installments over time, some before the filing of the petitions, others after. The cases were filed and the debtors received their discharges. Post-closing, counsel sought to collect the balances due on the retainers. Proving the maxim that no good deed goes unpunished, the debtors then hired new lawyers and commenced adversary proceedings to hold their former counsel in contempt for violation of the discharge injunction. The bankruptcy court dismissed the complaints, holding that §329(b) of the Code implicitly carves out an exception to the scope of the discharge provided under §727 for attorney’s fees. The court reasoned that any other holding would render §329(b), which authorizes the court to assess the reasonable value of counsel’s fees, superfluous. The district court affirmed and the debtors appealed.

The Court of Appeals reversed, holding that §727 provides that all debts, except those specified in §523, are discharged and the latter section contains no provision for pre-petition counsel fees. The court further held that the retainer agreements each gave rise to a pre-petition claim for fees, the unpaid balance of which was discharged.
Responding to an argument that formed the basis of the holding below, the Seventh Circuit denied that finding the fees subject to discharge would render §329(b) without effect. If nothing else, the court said, it would still allow the court to examine the reasonableness of any fees paid to debtor’s counsel in the one-year period prior to the filing of the petition or during the proceeding and order any necessary disgorgement.

Defendants argued that subjecting fees due under pre-petition agreements to discharge would deprive debtors of lawyer representation. Lawyers, they contended, would be reluctant to take cases for some debtors if they could not collect fees after the conclusion of the case and many debtors would be unable to afford to pay the required fees in advance. The court responded to this public policy argument by stating that if the statute required an interpretation that had that effect, it was up to Congress, not the court to change it. In the realm of practical suggestions, the court noted that debtors could represent themselves or pay a small retainer to counsel for pre-petition work, with counsel seeking the balance from the estate after filing.

A compromise position, adopted by the Ninth Circuit in In re Hines, 147 F.3d 1185 (9th Cir. 1998), had been considered (but rejected) by the bankruptcy court under which the retainer is parsed, with only that part attributable to pre-petition work being subject to discharge. Interestingly, although the plaintiffs would have found that result acceptable, the court held it could not sanction that approach. The court viewed that position as being inconsistent both with the Bankruptcy Code and the terms of the retainer agreements entered into in the cases. The court in Hines viewed the retainer agreement as giving rise to multiple claims, each one arising only as the services were performed. The Bethea court, however, held that any claim for compensation arises out of the one contract creating a right to payment arising pre-petition and thus subject to discharge.

When considered in conjunction with the Supreme Court’s holding in January 2004 in Lamie v. United States Trustee that debtor’s counsel may not be compensated from the estate in chapter 7 cases unless hired by the trustee, the holding in Bethea, decided one month earlier, proposes some interesting challenges for debtor’s counsel. One of the suggestions offered by the Seventh Circuit, that counsel take a small retainer pre-petition and apply for the balance of the fee as an administrative expense, obviously no longer works. Other suggestions have been offered, including using an agreement that provides for a retainer for pre-petition services with an agreement to pay hourly rates for post-petition work or a fixed-fee retainer agreement that the debtor would reaffirm post-petition. Consumer Bankruptcy News, Vol. 14, No. 3, p. 4. The latter approach has obvious shortcomings. The former may or may not pass muster in a court adhering to the Bethea holding. One likely outcome of the decision is that bankruptcy courts will see more cases in which debtors have opted for another of the court’s offered solutions to the problem created by its holding – representing themselves.

In Lamie v. United States Trustee, 540 U.S. ___ (2004), the Supreme Court affirmed the Fourth Circuit and held that a chapter 7 debtor’s attorney must be appointed by the trustee, and approved by the court, pursuant to 11 U.S.C. §327, in order to receive post-petition (or post-conversion) compensation. The Court held that awkwardness created by the 1994 amendment to 11 U.S.C. §330(a)(1) did not render it ambiguous and that its plain language deprived the courts of authority to compensate debtor’s counsel, whether or not that was what Congress intended.² The Court went on to note that even if it did look at the legislative history, that history is unclear and would not necessarily lead to a different decision.

Congress amended the Bankruptcy Code in 1994. Prior to the amendment, §330(a)(1) read as follows:

(a)(1) After notice to the parties in interest and the United States Trustee and a hearing, . . ., the court may award to a trustee, to an examiner, to a professional person, or to the debtor’s attorney employed under Section 327 or 1103-
(A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, professional person, or attorney. . .

The 1994 reform act amended §330(a)(1) to read as follows:

(a)(1) After notice to the parties in interest and the United States Trustee and a hearing, . . ., the court may award to a trustee, an examiner, a professional person employed under Section 327 or 1103-
(A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, professional person, or attorney. . .

11 U.S.C. §330(a)(1).

In Lamie, the appellant represented the debtor-in-possession in a chapter 11 case that later converted to chapter 7. After conversion, the appellant continued to represent the debtor, but failed to seek employment pursuant to §327. Subsequently, the appellant applied to be compensated from the bankruptcy estate for services rendered after conversion. The trustee argued that §330(a)(1) only allowed compensation to be paid to the listed persons and professionals employed pursuant to §327. The appellant contended that the statute was ambiguous, so legislative history should have been consulted, which indicated that the deletion of “or to the debtor’s attorney” was a mistake, and that Congress’s intent was for that language to remain in the statute, as evidenced by §330(a)(1)(A), which retained a reference to “attorney.” The bankruptcy court found that §330(a)(1) was unambiguous and its plain language only provides for compensation to professional persons employed by the trustee pursuant to §327.³ The appellant appealed to the District Court and the Fourth Circuit, both of which affirmed the bankruptcy court’s holding.⁴ The Fourth Circuit determined that current §330 is unambiguous and that in a chapter 7 proceeding, a debtor’s attorney must be employed by the trustee, pursuant to §327, in order to receive post-petition (or post-conversion) compensation.

The Supreme Court agreed with the Fourth Circuit. In support of its finding that §330 was unambiguous, the Supreme Court reviewed the pre- and post-amendment statute. The 1994 amendment deleted five words at the end of what was §330(a) and is now §330(a)(1): “or to the debtor’s attorney.” This deletion affects both the grammar and the parallelism between §§330(a)(1) and 330(a)(1)(A). The Court, however, found that the existing statutory text is the relevant text in discerning congressional intent, not the statute’s previous language.

The Court observed that §330(a)(1) authorizes an award of compensation to three types of persons: trustees, examiners and §327 professional persons. The fact that §330(a)(1)(A) further defines what type of persons may render service that is eligible for compensation is irrelevant if such person does not fall into one of the named classes of persons in §330(a)(1). The Court further determined that neither the missing “or” in §330(a)(1) nor the additional fourth category of persons who can render compensable services in subsection (A) alters the text’s substance or meaning, because subsection (A)’s “attorney” can be read to refer to those attorneys whose fees are authorized by §330(a)(1), i.e., employed pursuant to §327. In addition, the Court reasoned that although the word “attorney” in subsection (A) may be surplusage since subsection (A)’s “professional persons” already includes attorneys, that was not controlling and surplusage does not always produce ambiguity. Ultimately, the Court held that the text can be interpreted in two ways – one that creates surplusage, but renders the text clear, and another that solves the surplusage problem, but creates ambiguity. In this context, the Court preferred surplusage over ambiguity.

Ultimately, the Court refused to read the absent word “attorney” into §330(a)(1) in deference to the legislature. The Court also noted that although it was unnecessary to rely on legislative history, that history in this case only created more confusion about Congress’s intent because it lends support both to appellant’s interpretation and to the Court’s holding. For example, the elimination of the phrase “or to the debtor’s attorney” could have been the result of overzealous deletion by a scrivener modifying a previous draft to reflect agreed changes in the text. On the other hand, the fact that Congress added an authorization to make a fee award to debtors’ attorneys in chapter 12 and 13 bankruptcies lends support to the interpretation that Congress intended to require debtors’ attorneys in a chapter 7 to seek approval of the trustee. Thus, adhering to the “conventional doctrines of statutory interpretation,” the Court held that the plain language of §330(a)(1) does not authorize compensation awards to debtors’ attorneys from estate funds, unless they are employed as authorized by §327. As the Court stated, “[i]f Congress enacted into law something different from what it intended, then it should amend the statute to conform to its intent.”

The Court found that compensation remains available to some debtors’ attorneys under some circumstances under the text of §330 as so interpreted and offered several suggestions. First, compensation for debtors’ attorneys in chapter 12 and 13 bankruptcies is not affected. See, e.g., 11 U.S.C. §330(a)(4)(B). Secondly, compensation for chapter 7 debtors’ attorneys is not altogether prohibited so long as the attorney has been approved by the chapter 7 trustee per §327. Finally, the Court noted that its interpretation has operated soundly in the Fifth and Eleventh Circuits by debtors paying reasonable fees or retainers for legal services before filing for bankruptcy, which it noted was common practice. Thus, the Court said, it is appropriate for a debtor to engage counsel before a chapter 7 filing or conversion and to pay reasonable compensation to counsel in advance of the chapter 7 filing or conversion.

These suggestions may present practical difficulties, including: Pursuant to §327(b), can the debtor’s attorney be employed by the trustee if the trustee is not operating a business? In a case converted to chapter 7, is it practical for a debtor’s attorney to be paid prior to the conversion? Can most chapter 7 debtors afford to pay all of the required attorney’s fees in a lump sum prior to filing? If a debtor cannot afford to pay the fees prior to filing and a debtor’s attorney is willing to enter into a retainer agreement permitting the fees to be paid over time, under Bethea v. Robert J. Adams and Associates, 352 F.3d 1125 (7th Cir. 2003), the obligation created by the pre-petition retainer agreement is discharged, rendering the balance of the fees uncollectible. These are just a few of the practical issues that may arise from the Supreme Court’s holding in Lamie, especially when read in conjunction with Bethea.

Footnotes

¹ Judge Dow would like to acknowledge the assistance of his law clerk, Lori O’Keefe Locke, in preparing this article.
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² This was also the view the Fifth and Eleventh Circuits had previously adopted, but was contrary to holdings in the Second, Third, and Ninth Circuits which held the provision was ambiguous, requiring consideration of legislative history.
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³ In re Equipment Services, Inc., 253 B.R. 724 (Bankr. W.D. Va. 2000).
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⁴ In re Equipment Services, Inc., 260 B.R. 273 (W.D. Va. 2001), aff’d 290 F.3d 739.
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Debtors in bankruptcy often retain secured collateral (such as a home or car) without redeeming the collateral or reaffirming the secured debt. In many instances, the secured creditor will allow the debtor to retain possession of the collateral and not foreclose or repossess as long as the debtor makes the monthly contract payments and meets the other obligations under the contract (e.g. insurance coverage). As such, a creditor’s continuing contact with the debtor may be necessary to maintain the debtor-creditor relationship with regard to the surviving lien. The issue is whether such contacts are proper under the Bankruptcy Code.

Many courts have found that secured creditors may send informational statements to debtors after discharge. See In re Ramirez, 273 B.R. 620 (Bankr. C.D. Cal. 2002), aff’d, 280 B.R. 252 (C.D. Cal. 2002). Nevertheless, secured creditors are apprehensive about calling or otherwise contacting the debtor after the bankruptcy discharge when the debtor fails to make the contract payments. This concern should diminish in light of the case of In re Garske, 287 B.R. 537 (9th Cir. BAP 2002), where the Ninth Circuit BAP upheld the bankruptcy court’s decision that a secured creditor’s contacts with the debtor subsequent to discharge did not violate the discharge injunction under Section 524(a)(2).¹

In In re Garske, the debtor filed chapter 7. Section 521 of the Bankruptcy Code requires a debtor to either (1) surrender the collateral, (2) redeem the collateral, or (3) reaffirm the debt. Nevertheless, some jurisdictions (like California in this case) allow the debtor to retain the collateral and continue making payments without reaffirming. This is widely known as the “ride through” option. With regard to her car loan with Arcadia Financial, the debtor selected the “ride through” option.

After receiving her discharge, the debtor made monthly payments to Arcadia Financial, but consistently fell 2 to 3 months delinquent on her account. As a result, Arcadia Financial contacted the debtor via letters and phone calls to determine whether the debtor intended to retain the collateral, or intended to surrender the collateral. Since the debtor intended to keep the car and Arcadia Financial retained a lien, Arcadia Financial requested that the debtor voluntarily make the regular monthly contract payments on time in order to retain the collateral.

The debtor subsequently filed a class action lawsuit against Arcadia Financial, alleging their post-discharge telephone calls violated the discharge injunction under Section 524(a)(2). The bankruptcy court rejected the debtor’s argument, and found that Arcadia Financial “made no threats to debtor other than to assert its right to repossess the Vehicle if payments were not timely made. Further, [creditor] never threatened to sue debtor personally.” The bankruptcy court stated that only “improper collection activity” violated the discharge injunction, and ruled that the creditor’s phone calls to the debtor were not per se improper collection activity.

The Ninth Circuit BAP agreed with the bankruptcy court that the telephone calls were proper and did not violate the Section 524 discharge injunction, because Arcadia Financial was not attempting to collect on a discharged debt. The court found that “[s]o long as the creditor is not collecting the debt as a ‘personal liability of the debtor,’ there is no violation under 524(a)(2).” In re Garske, 287 B.R. at 545. The court found that a secured creditor has a continued interest in the collateral subsequent to the bankruptcy discharge because the secured creditor has the right to repossess the collateral if the debtor fails to make payments. Since the secured creditor had rights in the collateral, its actions were proper:

“Here, notwithstanding her statement of intention, Debtor chose to retain the Vehicle by continuing to make her payments under the Contract. She understood that in order to keep the Vehicle, she had to continue to make timely payments to Arcadia. No evidence was offered that Arcadia made any demands of Debtor for payment other than as a condition for her retaining possession of the Vehicle. In fact, Debtor admitted that Arcadia never threatened to sue her personally for the payments owing on the Vehicle.” 287 B.R. at 545.

While In re Garske is a Ninth Circuit case, other courts have been more restrictive in construing secured creditor contacts with debtors. See In re Draper, 237 B.R. 502 (Bankr. M.D. Fla. 1999)(J. Jennemann)(in a chapter 13 case, the court found informational statements sent to the debtor violated the automatic stay). Nevertheless, three Circuit Courts recently have ruled that creditors may contact debtors to discuss reaffirmation agreements, as long as the creditor refrains from coercion or harassment.² In re Garske continues this view, and finds that some post-discharge contact with debtors by secured creditors is proper, although these post-discharge contacts should be limited in scope and not harass the debtor. As one court recently observed:

Undersecured creditors who make post-discharge contacts with debtors must navigate a very narrow path between legality and violation of the post-discharge injunction....The general rule provides that creditors with partially discharged claims may initiate minimal contact with the debtor to the extent necessary to service the surviving debt [citation omitted]. Normal and reasonable contacts such as mailing coupons or monthly statements to a discharged debtor in order to service the surviving secured debt do not violate the injunction. However, courts addressing this issue emphasize that any post-discharge contact by an undersecured creditor must be minimal, unobtrusive, polite and with no greater frequency than a debtor not in bankruptcy would reasonably expect. Any conduct or contact beyond this minimal standard constitutes a violation of the post-discharge injunction.” In re Bandy, 2003 WL 21781995 (Bankr. N.D. Iowa 2003).

Since the content of a phone call can be critical, secured creditors should consider preparing a “script” of questions for analysts to use when calling debtors to inquire about their intentions. In all cases, secured creditors should fully and carefully document these accounts.

Finally, it is important to remember that the holding in In re Garske and similar cases is applicable only to secured creditors. Unsecured creditors should not contact debtors post-discharge under any circumstances, absent a valid reaffirmation agreement.

Dennis LeVine is the principal of Dennis LeVine & Associates in Tampa, Florida. The firm represents creditors in bankruptcy and state court matters throughout the State of Florida. He can be contacted at (813) 253-0777 or [email protected].

A. Memo.ContactDebtor.Ridethrough.option

FOOTNOTES

¹ Section 524(a)(2), also referred to as the “discharge injunction,” states in pertinent part:

“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
such debt as a personal liability of the debtor, whether or not discharge of such debt
is waived ....”
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² Cox v. Zale Del., Inc., 239 F.3d 910, 912 (7th Cir. 2001); Pertuso v. Ford Motor Credit Co., 233 F.3d 417, 423 (6th Cir. 2000); In re Jamo, 283 F.3d 392 (1st Cir. 2002).
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In the recent case of Archer v. Warner, 123 S.Ct. 1462, 155 L.Ed2d 454 (2003), the Supreme Court reversed the Fourth Circuit Court of Appeals and found that a claim based on payments due under an agreement resulting from the settlement of fraud claims can retain its status as a nondischargeable debt. The fact that the debt was reduced to a payment under a settlement agreement did not change the character of the debt for nondischargeability purposes.

A debt is not dischargeable in bankruptcy to the extent it is for money obtained by fraud. 11 U.S.C. §523(a)(2)(A). In the Archer case, the Archers sued the Warners for fraud connected with the purchase of the Warners' company. The parties settled and released all claims with the exception of payments to be made under a $100,000 promissory note.¹ The Warners failed to make the first payment on the promissory note and the Archers sued in state court. The Warners filed bankruptcy, and the Archers filed a complaint to find the debt nondischargeable. The Bankruptcy Court decided the debt could be discharged and the District Court and the Fourth Circuit affirmed. In its opinion, the Fourth Circuit reasoned that the debt under the settlement agreement amounted to a type of "novation" that replaced the original debt to the Archers for money obtained by fraud with a new debt that was dischargeable in bankruptcy.

The Supreme Court disagreed with the Fourth Circuit and found that a debt for money promised in a settlement agreement accompanied by the release of underlying tort claims can amount to a debt for money obtained by fraud within the nondischargeability statute's terms. In support of its decision, the Supreme Court looked at the holding in a similar case, Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 205, 60 L.Ed.2d 767 (1979). In the Brown case, a state-court suit for fraud was settled prior to adjudication by a stipulated judgment providing that Felsen would pay Brown a certain amount. Neither the consent decree nor the stipulation provided that the payment was for fraud. Felsen did not pay and then filed bankruptcy. Brown asked the Bankruptcy Court to hold that the debt was nondischargeable because it was a debt for money obtained by fraud. The Court in that case found that, although claim preclusion would bar Brown from making any claim based on the same cause of action which had been brought in state court, it did not prevent the bankruptcy court from looking beyond the documents terminating the state-court proceeding to decide whether the debt was a debt for money obtained by fraud. Brown's holding means that reducing a fraud claim to judgment does not change the nature of the debt for dischargeability purposes. The Brown Court found that "the mere fact that a conscientious creditor has previously reduced his claim to judgment should not bar further inquiry into the true nature of the debt". The Supreme Court in both Brown and Archer also considered the changes in the Bankruptcy Code's nondischargeability provisions which indicated that "Congress intended the fullest possible inquiry" to ensure that "all debts arising out of" fraud are "excepted from discharge," no matter their form and that Congress also intended to allow the determination of whether a debt arises out of fraud to take place in bankruptcy court and not in state court where nondischargeability concerns "are not directly in issue and neither party has a full incentive to litigate them.” Brown at 138.

The Archer Court discussed that the only difference between Brown and the case at issue was that the relevant debt in Archer was embodied in a settlement agreement and not in a stipulation and consent judgment. The Court decided that this difference was not determinative, since the dischargeability provision applies to all debts that "aris[e] out of" fraud. A key question in this determination is the intent of the parties. Although the stipulated settlements in both Archer and Brown did not address the issue of fraud, such intent could be more easily determined if the stipulated settlement or judgment contained language clarifying that the parties agree the payment is for a claim of fraud. Plaintiffs wanting to more clearly preserve a future nondischargeability claim should provide language in any stipulation that clearly states that the parties agree the payment is for fraud. Of course, as a practical matter, defendants will probably balk at such language and that issue will have to be negotiated.

In a recent case, the Second Circuit has already had an opportunity to apply and extend the reasoning in the Archer case to an almost identical set of facts that was pending appeal when the Archer decision was issued. In In re DeTrano, 326 F.3d 319 (2d Cir. 2003), the Court discussed a situation similar to that in Archer involving a nondischargeability claim brought under Bankruptcy Code §523(a)(4), which involves a claim for fraud or defalcation committed while acting in a fiduciary capacity.² The Court extended the holding in Archer to include claims arising under this Section of the Code and determined that a settlement agreement entered into where no corresponding judgment was obtained could be nondischargeable. See also, In re Nelson, 2003 WL 1989641(N.D. Il. 2003)(court applied principles of Archer to fiduciary fraud situation under §523(a)(4) where the creditors had obtained summary judgment prior to the bankruptcy).

The decision in Archer stands for the proposition that the settlement of fraud claims in any form (stipulation, consent judgment, offer of judgment, etc.) does not preclude litigation on the nondischargeability of such claims in bankruptcy unless the parties are clear that it was intended to have such an effect. Since bankruptcy is always a possibility, counsel for both potential debtors and creditors should keep the Archer holding in mind when drafting settlement documents and should try to specifically address the issue of fraud in those documents whenever possible.

Mr. Dow would like to acknowledge the assistance of Sheryl Reynolds in the preparation of this article.

FOOTNOTES

¹ The releases stated that the parties did not admit any liability or wrongdoing, that settlement was the compromise of disputed claims and that payment was not to be construed as an admission of liability.
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² The nondischargeability claim in Archer was based upon 11 U.S.C. §523(a)(2)(A).
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ABI continues to produce high-quality resources with information of value to consumer bankruptcy practitioners. The Nuts and Bolts program conducted by ABI immediately before the Annual Spring Meeting featured presentations on the fundamentals of consumer bankruptcy law. The manual for the program, authored by Tom Yerbich, a Vice Chair of the Consumer Bankruptcy Committee, and entitled Consumer Bankruptcy – Fundamentals of Chapter 7 and Chapter 13 of the U.S. Bankruptcy Code, will soon be published by ABI. The manual, which is expected to be out at the end of July, will be available for purchase online.



In addition, Prof. Jack F. Williams of Georgia State University and former ABI scholar-in-residence, and Susan H. Seabury have authored an outstanding review of 2002 consumer bankruptcy cases of significance. The outline, entitled 2002 Year In Review Consumer Bankruptcy Cases, includes 132 pages of digests of significant decisions on issues of interest to consumer bankruptcy practitioners organized by subject matter. The outline is available on the ABI web site.

Absent special circumstances, an attorney representing a chapter 7 debtor may not limit the scope of representation. Once an attorney signs on to represent a debtor, he or she must represent the debtor in all aspects of the bankruptcy case, including any contested matters or adversary proceedings that involve the debtor’s interests and this obligation continues until the court grants a request for withdrawal or the debtor consents to the withdrawal…..at least in Georgia. See, In the Matter of Egwim, 291 B.R. 559 (Bankr. N.D. Ga. 2003); See also, In re Johnson, (Bankr. D. Minn. 02-60812 2003) and In re Castorena, 270 B.R. 504 ( Bankr. D. Idaho 2001).

Across the country, more and more courts are being asked to consider how much representation is enough and when acceptable for an attorney to limit representation by contract. Recent bankruptcy court decisions from Minnesota, Idaho and Georgia suggest that an attorney proceeds at his peril in providing anything less than full service. At the same time, state bar associations, such as the one in Washington, are amending local rules of practice to clarify the right of a lawyer to limit representation. In 2002, the American Bar Association amended the Model Rules of Professional Conduct to allow limitation of the scope of representation as opposed to simply the objectives of representation. Arguably, this change allows attorneys to be more specific in retention agreements and limit representation to exclude such matters as contested hearings without a further agreement for additional fees.

In In re Harry R. and Kally A. Johnson (Bankr. D. Minn.), Judge Dennis D. O’Brien ruled that attorneys are not allowed to discount fees by limiting the services provided. The case involved an attorney providing debtors the option of paying a lesser fee in exchange for self-representation at the meeting of creditors. Although this choice followed consultation and consent, Judge O’Brien rejected the practice holding that attendance and representation at the meeting of creditors is mandatory in most circumstances and may not be avoided by discounting compensation.

At virtually the same time, Judge O’Brien was handing down his decision in Johnson, Judge Paul W. Bonapfel in the Northern District of Georgia was coming to an even more broad conclusion in the case of Matter of Egwim. In his court, debtor’s attorneys represent the debtor for all aspects of the case until withdrawal is approved. Further, withdrawal for reasons associated with compensation will only be considered upon a showing that continued representation imposes an unreasonable burden on counsel that justifies the withdrawal.

Judge O’Brien recognized the ability of the debtor’s attorney to limit the scope of the representation but also recognized that this agreement cannot result in representation so limited as to violate the rules regarding competent representation. Under the holding of Egwim, providing any representation less than full representation throughout the bankruptcy is apparently not competent under the rules.

Aside from restrictions on limited representation created by the courts, practical limitations also exist. Consumer creditor’s lawyers often take calls from debtors in distress whose attorneys have either explicitly, or by default, limited representation. The calls are in part a result of Federal Bankruptcy Rule of Procedure 4001 (b)(3).

Under 4001(b)(3), a party bringing a motion for relief must serve any party that has requested notice and any other party as the court may direct. Most local jurisdictions have directed that the debtor be served directly with any motion for relief from stay. When the Debtor receives the motion for relief from the creditor’s counsel, the first call may be to his attorney, but to the extent representation has been limited, a call to the creditor’s lawyer is not far behind.

In the typical scenario, the PACER report reflects an attorney of record for the debtor but the debtor advises that the listed attorney is no longer his representative or at least not his representative for the pending motion. At this point the creditor’s attorney is left with the option of advising the debtor that ethical considerations prohibit further discussion and that he should call the court for assistance, or, doing the best tap dance possible to explain the basics of the motion process while not providing legal advice or violating rules controlling communication with represented parties. Adding to the drama is the state of emotion often associated with the receipt of the pleading. A motion for relief concerning the debtor’s home is certainly capable of invoking a strong emotional reaction in the debtor and the human side of any lawyer requires some effort to calm the fears and concerns of the upset caller.

The easiest solution to this problem would be to remove the creditor’s burden of service directly upon the debtor. In few other areas of the law is a moving party allowed, much less required, to serve directly a party represented by counsel. If only attorneys exchanged pleadings, then attorneys could discuss the case in a professional and efficient manner and attorneys could explain the process to their respective clients.

The most frequent response to a proposal to change the rule is that doing so would leave debtors vulnerable to the follow-up of their counsel. Whereas the concern is valid, it is no different than in any other area of the law. Is not the person seeking damages for or defending against a claim of personal injury not equally harmed by a lawyer’s failure to follow up as required by contract or by ethical rules regarding diligence and competence? Should this potential be addressed by compelling the opposing attorney to communicate directly with each party? If an attorney does not fulfill his obligation to communicate with his client, he or she should be disciplined, but opposing counsel should not be the insurer of effective communication.

If bankruptcy courts are seriously interested in compelling full service representation of debtors, then the appropriate place to begin is with the removal of the requirement that creditors directly serve parties represented by counsel. As in other areas of the law, counsel for a debtor should be entrusted to effectively communicate with his client and protect the interests of his client without the need for direct service.

Even in circumstances where limited representation is allowed, service upon counsel for the debtor is still appropriate, absent a filed withdrawal. Service upon counsel of record will provide the debtor’s attorney the opportunity to remind his client that his representation is limited and/or offer his continued service. Requiring withdrawal will also assist parties reviewing the case docket to know who is represented by counsel and who is not.

In sum, the apparent conflict between the rules of professional conduct and accepted practice in bankruptcy court will apparently be decided on a district by district basis. Whereas it is clear that many courts disfavor limited representation, freedom of contract and the desire for widely available legal services favor continued expansion of an attorney’s ability to limit representation. Counsel who seek to limit representation excluding complex or even routine matters do so at the risk of later judicial opinion that the limitation was unreasonable. Practical problems raised by limited representation, balanced against the freedom of contract, mandate review of Federal and Local Bankruptcy Rules to provide practitioners clear direction and guidance.

Lance Olsen is the Managing Attorney of Routh Crabtree Fennell, a full-service law firm servicing Washington, Oregon, Idaho and Alaska dedicated to the representation of secured creditors and the mortgage lending industry. He can be reached at 425/586-1905 or [email protected].

An increasing number of debtors in bankruptcy are raising Truth in Lending Act (“TILA”) rescission issues in an attempt to avoid the security interest of their mortgage lenders. Recently, the Federal District Court for the District of Kansas weighed in on this issue. It held that a bankruptcy court may condition a borrower’s TILA rescission right on the return of the property the debtor received from the loan transaction. Quenzer v. Advanta Mortgage Corporation USA (In re Quenzer), 288 B.R. 884 (D. Kan. 2003). Currently, there is a split of authority among the bankruptcy courts as to whether the court has the authority, either statutory or equitable, to condition rescission in this manner. Compare Wepsic v. Josephson (In re Wepsic), 231 B.R. 768 (Bankr. S.D. Cal. 1998); Apaydin v. Citibank Federal Savings Bank (In re Apaydin), 201 B.R. 716 (Bankr. E.D. Pa. 1996); Thorp Loan and Thrift Co. v. Buckles (In re Buckles), 189 B.R. 752 (1995) (finding that equity required the debtor to tender loan proceeds as condition of rescission) with Williams v. BankOne National Association (In re Williams), 291 B.R. 636 (Bankr. E.D. Pa. 2003); Whitley v. Rhodes Financial Services Inc. (In re Whitley), 177 B.R. 142 (Bankr. D. Mass. 1995); Celona v. Equitable Nat’l Bank (In re Celona), 98 B.R. 705 (E.D. Pa. 1989)(finding that the court cannot condition the debtor’s rescission on tender of loan proceeds). However, in the non-bankruptcy context, it appears the majority of circuit courts have found there is authority to modify the TILA rescission procedures. See Williams v. Homestake Mortgage Co., 968 F.2d 1137 (11th Cir. 1992); FDIC v. Hughes Development Co., 938 F.2d 889 (8th Cir. 1991); and Brown v. National Permanent Savings and Loan Assn., 683 F.2d 444 (D.C.Cir. 1982)(lien avoidance could be conditioned on tender of loan proceeds by borrower). Contra Harris v. Tower of Loan of Mississippi, Inc., 609 F.2d 120 (5th Cir. 1980)(creditor’s duties are not conditioned on tender by the borrower).

In Quenzer, the chapter 13 debtors filed an adversary action in the bankruptcy court to rescind their mortgage loan based on the mortgage company’s failure to provide the proper notice of right to cancel as required under TILA. The mortgage company agreed that the oversight was a violation of TILA, which would allow the debtors to rescind the loan. The bankruptcy court found, pursuant to §1635(a) and (b) of TILA and the supporting Federal Reserve Board Regulations, the lender’s security interest was void as of the date the debtors gave notice of their right to rescind and that the bankruptcy court had no authority to provide an alternative remedy to the lender or condition the avoidance on the debtor’s return of the loan funds. In re Quenzer, 266 B.R. 760, 763-764 (Bankr. D. Kan. 2001).

In the bankruptcy context, if the security interest is avoided, the creditor loses its secured status and its right to be paid the value of the property. The chapter 13 debtor may then propose a plan that classifies the lender as an unsecured creditor. As a result, the lender may receive a significantly reduced amount for its claim as it is now only entitled to receive its pro-rata share of the debtor’s disposable income. The lender in Quenzer appealed the bankruptcy court’s decision to the district court based on equitable considerations and certain exceptions provided within the statute.

The district court held that the bankruptcy court has discretion to condition the voiding of the lender’s security interest upon equitable and just terms and further held that the debtors were required to return the property they received in connection with the mortgage transaction as part of the rescission process. The district court’s focus was on placing the parties in the same position they were in prior to the loan transaction. The district court looked to Rachbach v. Cogswell, 547 F.2d 502 (10th Cir. 1976), which held that there is inherent authority to do equity in relation to the TILA rescission procedures, and to the language of §1635(b) in support of its position. In Rachbach, the Court of Appeals held that the court could order the borrower to pay interest on the loan funds, even though §1635(b) specifically provides that the borrower is not liable for any finance charge upon rescission. The borrower had the benefit of using the loan proceeds, and thus, on an equitable basis, should be required to pay interest for the time period of use as a condition to the rescission.

Additionally, §1635(b) provides that, “[t]he procedures prescribed in this subsection shall apply except when otherwise ordered by the court.” This sentence was added in 1994, after the holding in the Rachbach case. The district court found that this sentence applied to the provisions of both subsections (a) and (b). Thus, the Quenzer court reasoned that there was authority, both inherent and actual, to condition the debtor’s TILA rescission on the return of the loan proceeds. The alternative to this equitable relief would be that the lender’s entire claim would be given unsecured status which, the district court believed, “would exact a penalty entirely disproportionate to its offense.”

In contrast to the Quenzer decision, courts that have held the avoidance of the mortgage may not be conditioned on the borrower’s tender of the loan proceeds, such as the recent Williams v. BankOne case from Pennsylvania mentioned above, generally argue that the §1635(b) provision that allows the court to modify the rescission procedures, does not apply to the §1635(a) provision for lien avoidance. They argue that the avoidance of the lien cannot be conditioned – it occurs automatically upon receipt of the notice of rescission. Additionally, these courts rely on §226.23(d) of Regulation Z, which provides further clarification by specifically stating that only the provisions regarding return of funds by the creditor and the consumer may be modified. The separate provision that avoids the creditor’s lien is specifically omitted from the court’s modification authority. If the result of the statute’s application in the bankruptcy context is not what Congress intended, these courts suggest that Congress, not the court system, should fashion a remedy.

Mr. Dow would like to acknowledge the assistance of Kristen Trainor in the preparation of this article.

Recently, several bankruptcy courts have reviewed the issue of whether a chapter 13 plan containing a provision requiring the release of a lien if the allowed secured claim has been paid in full prior to the completion of the chapter 13 plan may be confirmed. In re Smith, --- B.R. ---, 2002 WL 31954449 (Bankr. W.D. Tex. 2002) (decided December 20, 2002); In re Castro, 285 B.R. 703 (Bankr. D. Ariz. 2002)(decided November 17, 2002); In re Gray, 285 B.R. 379 (Bankr. N.D. Tex. 2002)(decided November 14, 2002); In re Parker, 285 B.R. 394 (Bankr. E.D. Tenn. 2002)(decided October 17, 2002); and In re Moore, 275 B.R. 390 (Bankr. D. Colo. 2002)(decided March 28, 2002). After evaluating the relevant Bankruptcy Code sections and case law, these courts reach differing conclusions. The Smith and Moore courts denied confirmation of debtors’ plans that included a provision that required the secured creditor to release its lien prior to completion of the chapter 13 plan and the entry of a discharge, while the courts in Castro and Gray decided that such a plan may be confirmed. As a sort of middle ground, the court in Parker held that, although it could not confirm the plan with the early release provision, the debtor could request the early release by motion after the allowed secured claim had been paid in full. The court found that early release is possible under the Bankruptcy Code, but the issue is not ripe for decision unless and until the allowed secured claim has been paid in full. These courts are not the only ones that have been required to decide this issue. See also, In re Townsend, 256 B.R. 881 (Bankr. N.D. Ill. 2001)(debtor’s plan confirmed with provision requiring secured creditor to release its lien upon payment in full of allowed secured claim that would occur prior to the completion of the plan); In re Woods, 257 B.R. 876 (Bankr. W.D. Tenn. 2000)(court would have allowed debtor to include an early release provision in plan, however, without provision and due to lender’s objection to early release, the debtor was required to pay the expected payment on the unsecured portion of the claim before lender could be forced to release lien); In re Shorter, 237 B.R. 443 (Bankr. N.D. Ill. 1999)(court confirmed plan with an early release provision); In re Johnson, 213 B.R. 552 (Bankr. N.D. Ill. 1997)(court confirmed plan with an early release provision); In re Scheierl, 176 B.R. 498 (Bankr. D. Minn. 1995)(court denied confirmation of plan that included an early release provision). Cf. In re Vivian James, 285 B.R. 114 (Bankr. W.D. N.Y. 2002) (finding that creditor could not repossess collateral after the debtors converted case from chapter 13 to chapter 7 since the debtor paid the secured value of the vehicle in the chapter 13). This recent spate of conflicting decisions, however, suggests it may be timely to re-examine the question.

Section 1322(b)(2) allows the debtor to modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence. This provision allows the debtor to bifurcate the lender’s claim into secured and unsecured claims and treat the two claims differently in the plan. Arguably, modification of the claim also allows the early release provision so long as the other requirements of §1325(a)(5) are met. Section 1325 (a)(5) provides that for a plan to be confirmable, if the holder of an allowed secured claim does not accept the plan, it must retain its lien and be paid the value of the lien, the allowed secured amount, through the plan – “cram down” or the debtor must surrender the property securing the claim. The plain language of the Code ties the lien retained by the secured creditor in a chapter 13 plan to the allowed secured claim only. Debtors’ counsel have argued that once the allowed secured claim is paid in full, the lien has been paid in full and release of the lien prior to the completion of the plan is appropriate. Nothing in the language of §1325 provides for the release of the lien prior to the completion of the plan and the entry of discharge. A number of the courts that have reviewed this issue have held, however, that this absence of authority does not imply that an early release is prohibited.

Courts that have denied confirmation of plans with early lien release provisions have focused in part on what the debtor might do after lien release and what rights might be denied to the secured creditor. If the case is dismissed after the early release of the lender’s lien, there is an argument that the lender’s lien should be reinstated under §349(b)(1)(C). This section provides that, “[u]nless the court, for cause, orders otherwise, a dismissal of a case . . . reinstates -- any lien voided under §506(d) of this title.” Section 506(d) provides, subject to certain exceptions, that, “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” Thus, upon dismissal, arguably, the lender’s lien should be reinstated to the extent the lender still has an unsecured claim – the lender should be returned to its pre-bankruptcy status. Therefore, early release in the chapter 13 is premature as the debtor has not yet completed the plan and dismissal is still a possibility.

Courts have also predicated refusal to approve the early release provision on the grounds that the debtor has other options that would allow the court to release the lien. For example, §349(b)(1)(C) provides that the court may order the lien released for cause. Thus, at dismissal, the debtor could argue in the motion to dismiss that the lender’s lien should not be reinstated as the allowed secured claim had been paid. In that event, the court could enter the dismissal and release the lien, leaving the lender in the same position it would have been in if it had repossessed and sold the collateral outside of bankruptcy. Further,
§1328(b) allows the court to grant the debtor a discharge without completing the plan if circumstances beyond the debtor’s control prevent the debtor from making additional payments, the debtor has paid the unsecured claimants what they would have received in a chapter 7 and modification of the plan is not feasible. Thus, if the debtor cannot complete the plan, there are options other than early lien release that would protect the debtor’s ability to keep the collateral free of the secured creditor’s lien.

Other courts have held, however, that because the lien was paid in full in the chapter 13 plan, there is no lien to reinstate under §349(b)(1)(C) upon dismissal of the bankruptcy. The Castro court held that the early release is not a windfall to the debtor who later dismisses the case as the debtor retains personal liability for any claims that remain unpaid. The risk of dismissal after early release of the lien seemed minimal to the Castro court given the fact that the debtor has substantial incentive to continue to make plan payments to discharge personal liability on the remaining unsecured debts. While the lender may argue that it is not being returned to its pre-bankruptcy position, it arguably is in no worse condition than if it had repossessed and sold the vehicle. Any deficiency claim after the sale of the vehicle is an unsecured claim against the borrower.

Additionally, some lenders look to the Supreme Court decision in Dewsnup v. Timm, 502 U.S. 410 (1992) to further support their position that the early release provision should not be allowed. In Dewsnup, the Court held that, in a chapter 7 case, the debtor is prevented from stripping the creditor’s lien to its secured value. Thus, arguably, Dewsnup prevents a chapter 7 debtor from bifurcating an undersecured claim on property the debtor intends to keep. The argument is also made that as the Dewsnup court interpreted “allowed secured claim” under §506(d) to mean the full claim, both secured and unsecured, that meaning should apply to the cram-down provision of §1325(a)(5)(B) and the creditor should be allowed to keep its lien until the plan is completed and discharge is entered.

Courts that allow the early release provision counter by arguing that Dewsnup does not apply to chapter 13 cases and that the Dewsnup decision was limited to claims secured by real property. These courts point out that §1322(b)(2) specifically provides that the rights of a secured creditor may be modified unless the claim is secured only by an interest in real property that is the debtor’s principal residence. Thus, under chapter 13, the lien is avoided under §506(d) as to the portion of the claim that is greater than the value of the collateral. Additionally, the chapter 13 plan may be viewed as a form of redemption over time with interest. See Castro at 710. Because the debtor may retain the collateral by paying its fair market value through a chapter 7 redemption, the debtor should be entitled to have the lien released in the chapter 13 when the fair market value has been paid in full. Dewsnup did not address the debtor’s right to redeem under §722 as the property at issue was real property. Section 722 specifically provides for bifurcation in the chapter 7 context as the debtor is allowed to redeem personal property by paying the holder of the lien the amount of its allowed secured claim. Arguably, if the case is converted to a chapter 7 after the early lien release, the creditor has already received what it would have received if the debtor redeemed. Furthermore, §348(f)(1)(b) provides that upon conversion from a chapter 13 case to a chapter 7 case, valuations of property and of allowed secured claims in the chapter 13 case apply in the converted case, with the allowed secured claims reduced to the extent they have been paid in accordance with the chapter 13 plan. Thus, if the allowed secured claim has been paid in full in the chapter 13, conversion to a chapter 7 would appear to allow the debtor to redeem the property and have the lien released for $0.

Additionally, even though the debtor has a right to convert to a chapter 7 from a chapter 13, there is the possibility that if the debtor does so after obtaining an early release of the lien, either the court or the U.S. Trustee, or the lender may challenge the debtor’s ability to receive a discharge. For example, the court or the U.S. Trustee may file a §707(b) motion to dismiss the chapter 7 case if the granting of a discharge would be a substantial abuse of the chapter 7 provisions.

The lender’s underlying concern appears to be that the debtor is somehow abusing the chapter 13 process by seeking to have the lien released prior to discharge and that the creditor risks not receiving its fair share due to the early release. The Parker court attempted to address this concern by evaluating equitable considerations at the time the debtor requests the lien release. As stated earlier, the Parker court held that a decision did not need to be made on the early release issue unless and until the debtor actually paid the allowed secured claim in full. At that time, the debtor could pursue release and the creditor could object. The court could then evaluate any equitable considerations weighing against allowing the release. This approach may prove to be the most pragmatic way of dealing with this otherwise difficult problem.

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