Published in Banker & Tradesmen, October 2011
The U.S. Bankruptcy Code provides lenders with powerful tools for protecting their rights in secured property. One such device is the Reaffirmation Agreement, a new contract between the secured lender and a Chapter 7 consumer debtor permitting the debtor to reaffirm its debt if it wishes to retain possession of the collateral.
Many bankruptcy courts, however, have been reluctant to approve reaffirmation agreements, and Chapter 7 debtors have been able to “ride-though” – discharge the underlying debt in bankruptcy and still keep the property. The annual financial impact of the “ride-through” option on secured creditors is staggering.
A recent bankruptcy decision, however, paves the way for creditors to enforce their rights with more certainty.
The “ride-through” practice works as follows: A debtor/borrower who is current in its secured loan payments continues making payments after receiving a discharge in bankruptcy and retains possession of the secured collateral. As long as the borrower thereafter remains current, the lender cannot repossess or foreclose on the collateral. If and when the borrower subsequently defaults, the lender is able to recover the property by virtue of its security interest. Because the underlying debt was discharged in bankruptcy, however, the borrower is off the hook for the balance of the loan.
The Bankruptcy Code allows the parties to enter into a reaffirmation agreement, permitting the debtor to formally re-acknowledge its legal obligation to the lender despite its bankruptcy discharge, subject to court approval.
Debtors’ attorneys, however, have been quick to point out the inescapable logic in not reaffirming. “Why bother to reaffirm your debt when it has already been discharged in the Chapter 7 bankruptcy? And as long as you continue to remain current in your loan payments, you can keep the secured property!”
In fact, many attorneys believe that they might be committing malpractice by recommending that a client enter into a reaffirmation agreement under those circumstances.
Section 521 of The Bankruptcy Code offers a solution, however, specifying “duties” that Chapter 7 debtors must undertake if they intend to retain possession of secured personal property.
First, the debtor must file a statement of intention regarding the surrender or retention of secured property. If the debtor intends to retain, the Code offers three options: Claim the property as exempt; redeem the property (pay off the lender’s claim); or reaffirm the loan.
Then, the debtor must actually perform its stated intention within a fixed period of time. If the debtor then fails to follow through in a timely manner, the powerful automatic stay protection afforded under the Code is lifted and the lender is then free to exercise its rights under non-bankruptcy law, including the right to repossess or foreclose.
Thus, it would seem that by invoking the powers of Section 521, a lender can compel Chapter 7 debtors wishing to retain secured property to either redeem or reaffirm. As is often the case, however, things are rarely as simple as they seem.
First, most Chapter 7 debtors do not have sufficient funds to redeem. Second, bankruptcy judges are often reluctant to approve reaffirmation agreements, even when the Code’s requirements have been met. Section 524 of the Code governs reaffirmation agreements and the standards for approval– or disapproval – by the court. There has been some controversy over the years as to whether a bankruptcy judge is required to approve such agreements, even when both parties have agreed to reaffirm, the agreement complies with the requirements of Section 524, and the Chapter 7 debtor has been represented by counsel.
A recent California bankruptcy court appellate decision provides the groundwork for consistency in future cases governing the approval of reaffirmation agreements, and may effectively eliminate “ride-throughs.” In the case of In re Reggie Ong, (2011), the 9th Circuit Appellate Court overruled a bankruptcy judge’s decision to disallow a reaffirmation agreement, even when the debtor was represented by counsel, and the agreement was otherwise in conformity with Section 524.
“`I`in cases where the debtor has an attorney and there is no presumption of undue hardship `on the debtor`, the bankruptcy court is not authorized to substitute its judgment in place of a debtor’s attorney…It may only review the reaffirmation agreement to ensure that the requirements of § 524(c) are met,” the court held.
As other courts adopt the Ong case decision, and more secured lenders invoke the power afforded to them under Section 521, the unfair and inequitable “ride-through” option may soon be a relic of the past.
Larry Plavnick is an attorney in the corporate department of the McLane Law Firm in Woburn. Email: [email protected]