5.1 Bankruptcy

Competent representation of a defendant involved in a state-court foreclosure lawsuit requires a review and analysis of the options available under Title 11 of the United States Code (i.e., the Bankruptcy Code), specifically chapters 7, 11, 12, or 13.

Generally, the filing of a petition for relief in bankruptcy court creates an “automatic stay” pursuant to 11 U.S.C. § 362. This automatic stay temporarily halts further proceedings in the state foreclosure case without the necessity of posting security and makes a preliminary injunction to arrest the seizure and sale of the debtor’s home unnecessary. If the homeowner filed another bankruptcy in the recent past, the automatic stay may not apply or may only apply for a very limited period. In addition, a homeowner who has been found to have abused the bankruptcy process in the past may be prohibited from filing another bankruptcy for as long as 5 years. The attorney should always run the client’s name through the federal PACER or CM/ECF system to determine whether a foreclosure client has ever filed bankruptcy in the past. Do not simply rely on the client’s statements.

All creditors, including the foreclosing creditor, must file a proof of claim within 70 days of the date of the initial Chapter 13 bankruptcy filing. When a debtor’s home is involved in foreclosure proceedings, the creditor’s proof of claim must account for every charge incurred and every payment made by the debtor going back to the last time the debtor was current on the mortgage. This proof of claim contains much information that the debtor could only have obtained by lengthy discovery in state court.

The bankruptcy debtor is given the opportunity to object to the foreclosing creditor’s proof of claim, and a federal bankruptcy judge will decide to the penny the amount of mortgage arrearages. The bankruptcy debtor can also raise any defense to the foreclosure that the debtor might have had in state court. Under Chapter 13, the mortgage debtor can propose a plan to pay the back-due mortgage payments over a period of up to five years, frequently with little or no interest.

Chapter 13 allows a debtor to modify other secured debts, such as a motor vehicle loan, to lower the monthly payments due on those debts, thereby freeing up funds that the debtor can use to save the home. Chapter 13 may allow a debtor to pay little or nothing on unsecured debt, such as credit cards, payday loans, and bank and credit union loans; eliminating or significantly reducing unsecured debt can also make more cash available to save the home.

To qualify for a Chapter 13 bankruptcy, a client must have “sufficient regular income.” This income may be wages, government benefits, or financial help from family. The client must also have filed all required federal tax returns for the past four years.

A debtor is usually required to make the payments due under a confirmed Chapter 13 plan to the trustee by automatic deduction from the debtor’s checking account. If necessary, the court will order the debtor’s employer pay the trustee directly. In many cases, this financial discipline is necessary and ensures the likelihood of successful completion of the debtor’s plan. While a debtor is making payment under a Chapter 13 plan, the debtor must give up any credit cards and is not allowed to incur any new debt on credit (with the exception of emergency medical and other expenses) without prior approval of the bankruptcy court.

Although bankruptcy is frequently considered a “nuclear option” for a client confronted with substantial debt and potentially facing foreclosure, the benefits of filing a Chapter 13 generally outweigh any disadvantage. Chapter 13 does not prohibit the debtor from applying for any loan modifications that the client would otherwise be otherwise eligible for. If the client wants to sell the home, the bankruptcy court will usually give the client 6 to 12 months to do so if listing with an established commercial real estate brokerage firm. Chapter 13 stops wage garnishments and other collection activities and prohibits a creditor from filing collection suits and foreclosure actions as long as the plan is pending. Under Chapter 13, a debtor can provide for the payment of unpaid federal and state taxes over a period of up to five years. However, the IRS will cancel any open installment agreement or offer in compromise if the debtor files for relief under any bankruptcy chapter. The debtor can defer payment of student loans until the end of the plan. Although this can create a substantial arrearage later, it frees up additional funds that the debtor can use to save the home.

Nevertheless, there are some disadvantages to Chapter 13 that may be insurmountable for some debtors. Bankruptcy under any chapter negatively affects an individual’s credit. However, any damage will likely be minimal in view of the damage already done by the filing of the foreclosure suit. A Chapter 13 debtor is required to live on a strict budget that does not allow for the payment of private or parochial school tuition or college tuition for child over 18 years of age. Chapter 13 does not allow special treatment for cosigned debts. However, creditors are prevented from suing a cosigner if the cosigned debt is paid in full under the plan. If a cosigned debt is only partially paid in the plan, the creditor may sue a cosigner for the unpaid amount of the debt. In practical terms, this means is that a debtor who modifies a cosigned loan will subject his guarantors (usually a close relative, fellow employee, or friend) to a lawsuit.