Our firm serves as the outside in-house legal counsel for many financial institution clients. In that capacity, we receive calls and emails from our clients every day with questions relating to all aspects of banking. Sometimes, these questions are unique to a specific client, or a certain type of client, or a certain geographic location. From time to time, however, we see trends where the same type of question keeps popping up from our financial institution clients of all sizes and geographic location. The following is one such question:
A lender makes a loan to a borrower who executes a promissory note in favor of the lender. The note is secured by a mortgage or deed-of-trust on the borrower’s home. The borrower subsequently files for bankruptcy. For whatever reason, the borrower fails to reaffirm the debt evidenced by the note prior to receiving a bankruptcy discharge. Following discharge, the debt evidenced by the note is extinguished, but the lien of the mortgage or the deed-of-trust remains in place. Despite the failure to reaffirm the debt, the borrower and lender want to enter into some agreement whereby the borrower can continue to make payments to the lender, and the lender agrees to forebear on its right to foreclose the lien of the mortgage or deed-of-trust.
Based on the foregoing fact-scenario, what options do the lender and borrower have which would allow the borrower to stay in the home and the lender to continue collecting payments from the borrower? Furthermore, what advantages and risks are associated with each option?
The controlling law in this area is unsettled and uncertain. Unfortunately, neither the Bankruptcy Code nor the Bankruptcy Courts have offered a clear solution to this all too common issue. In this article, we discuss three options the lender and borrower may use to attempt to carry out the intent of the parties to have the borrower stay in the home and continue to make post-discharge payments. The first option is for the lender to simply passively allow the borrower to continue to make voluntary payments to the lender and, in exchange, the lender will forbear its right of foreclosure. The second option is for the lender and borrower to enter into a formal written agreement post-discharge (this article will refer to such agreements as “Post-Discharge Agreements”). The third option, which, as best we can tell has never been discussed by the courts, is to have the lender take ownership of the property pursuant to its lien rights and then sell the property back to the borrower. The first and second options may be available to lenders in both first-priority and junior lien positions. The third option is only available to lenders in first-priority lien positions. This article discusses the risks, advantages, and likelihood of enforceability of each option.
Before we dive into the various options, we want to first note that the difficulty of this scenario can be avoided by making sure that a proper reaffirmation agreement is signed in the time and manner required by the Bankruptcy Code. Once the lender receives notice that a borrower has filed for bankruptcy, the Petition will advise the lender how the borrower intends to treat the debt owing to lender. If the borrower indicates an intent to reaffirm, the lender should start working with the borrower and borrower’s attorney on a reaffirmation agreement. Among other requirements, the reaffirmation agreement must be signed by the lender, borrower, and borrower’s attorney. Then, it must be filed with the Court and approved prior to discharge. In some situations, however, the Bankruptcy Court will not approve a reaffirmation agreement even if the borrower wants to reaffirm. The most commonly cited reason a Court will not approve a reaffirmation agreement is when the Court determines it would not be in the best interest of the borrower.
Option 1: Acquiesce to voluntary post-discharge payments
Although a bankruptcy debtor is not legally obligated to repay discharged debt, nothing in the Bankruptcy Code prevents a borrower from voluntarily repaying any debt. Furthermore, a lender can voluntarily accept a borrower’s payments without violating the discharge injunction. In other words, nothing prevents the lender from electing to forebear its right to foreclose its lien and, instead, continue to accept voluntary payment from the borrower. This structure is sometimes referred to as a “voluntary ride-through” or “creditor acquiescence”.
The key here is that the arrangement is entirely voluntary. The lender cannot force, coerce, or even request a borrower continue to make payments. The lender’s involvement and interaction with the borrower should be limited, as much as possible, to facilitating the intent of the borrower to continue to make payments and stay in the home. For example, courts have found it allowable for a lender to send a periodic account statement to the borrower letting them know the amount outstanding on the lien. However, lenders must be careful not to state or imply that the borrower is required to make payments, or threaten borrowers with the consequences of failing to make payments. Evidence of coercion or harassment could subject the lender to being found in violation of the discharge injunction. Payments by the borrower made under duress can be viewed as involuntarily payments and may have to be returned by the lender. Similarly, attorneys’ fees and punitive damages are possible depending on the severity of the lender’s actions. Accordingly, the lender’s loan file should contain evidence supporting the voluntary nature of payments received.
One disadvantage of this arrangement is that it may cause some internal accounting problems for the lender. For example, the note evidencing the debt should have been “charged-off” upon the borrower receiving the bankruptcy discharge, which means there is no active loan on the books for which to apply the voluntary payments. Financial institutions should consult with their accountants regarding how to internally account for voluntary payments received on discharged debt.
Option 2: Post-Discharge Agreement
The second option is for the lender and borrower to enter into a new, formal written agreement post-discharge whereby the borrower agrees to make payments to the lender and the lender agrees to forbear its rights of foreclosure (again, this article will refer to such agreements as “Post-Discharge Agreements”).
Broadly speaking, Post-Discharge Agreements can be divided into two categories: (1) Post-Discharge Agreements that are (or, at least, intended to be) enforceable against the borrower; and (2) Post-Discharge Agreements that are most likely unenforceable against the borrower and merely intended to document the “voluntary ride-through” or “creditor acquiescence” arrangement (See Option 1, above).
strong>1.Post-Discharge Agreements intended to be enforceable
The purpose of the bankruptcy discharge is to provide the borrower with a “fresh start”. Therefore, agreements which continue to obligate the borrower following the discharge are highly scrutinized by Bankruptcy Courts. Under the Bankruptcy Code, a Post-Discharge Agreement is unenforceable if the consideration for the Post-Discharge Agreement, in whole or in part, is based on discharged debt. In other words, if the Post-Discharge Agreement is essentially a restatement of a pre-discharge obligation, the Post-Discharge Agreement will likely be unenforceable.
However, there is a narrow line of bankruptcy cases which have found Post-Discharge Agreements to be enforceable where the consideration for the Post-Discharge Agreement is based not on discharged debt, but entirely on a separate and distinct obligation that survived the bankruptcy discharge. In one such case, the borrower executed a promissory note in favor of the lender in the amount of $15,000, which was secured by a second mortgage on the borrower’s home. The borrower then filed for bankruptcy and was granted a discharge. As no reaffirmation agreement was submitted, the discharge released the borrower of any personal obligation on the note. The discharge, however, did not affect the lien of the mortgage. Three weeks after discharge, in consideration of the lender agreeing not to foreclose its mortgage, the borrower executed a new promissory note, as well as an accompanying new mortgage encumbering the borrower’s home. The proceeds of the new note were used to pay off the borrower’s previous note, thereby extinguishing the previous mortgage which was replaced by the new mortgage. Subsequently, the borrower defaulted on the payment of the new note and the lender sought to recover amounts owing on the new note. The borrower argued that the new note was invalid and that his debt had been discharged in bankruptcy.
The court held that the lender’s decision to forego foreclosure represented new and sufficient consideration to support a binding post-discharge obligation. Therefore, the second note was a valid contract that was completely separate from the initial note that was discharged in bankruptcy.
This case,and the few cases like it,offer support for the argument that Post-Discharge Agreements can be valid and enforceable if based entirely on sufficient new consideration. This is sometimes referred to as the “new and independent consideration test”. However, more recently, the majority of courts that have taken up the issue related to a Post-Discharge Agreement have found such agreements to be unenforceable. Generally speaking, these courts have held that the reaffirmation process provided in the Bankruptcy Code is the only way to obligate a borrower following the discharge, and Post-Discharge Agreements are more-or-less an attempt to get around the strict requirements of the reaffirmation process. In summary, there is legal support out there for enforceable Post-Discharge Agreements where the agreement is based on new consideration; however, there seems to be a trend throughout the country which disfavors Post-Discharge Agreements of all forms.
All told, the law does not tell us what type of agreement definitely will be enforceable. However, the analysis of the applicable law suggests that the likelihood of enforceability is a sliding-scale. The more a lender can show that the consideration for the Post-Discharge Agreement is based solely on non-discharged obligations, such as the lender’s lien rights, the more likely it is that the Post-Discharge Agreement will be found enforceable. Conversely, a Post-Discharge Agreement that appears to be merely a re-write or a re-structure of a discharged obligation is less likely to be found enforceable.
Therefore, when looking to enter into a Post-Discharge Agreement, step one is determining what obligations survived discharge. In most cases, this will be the rights and obligations associated with the lender’s lien on the real property. The next step is to determine the value of the non-discharged rights and obligations; in other words, determine the present value of the lender’s lien rights. Unfortunately, the courts do not offer any guidance on how to undertake the valuation analysis. Presumably, where there is sufficient value in the encumbered real property to fully secure the lien amount, the present value of the lien would be the full amount of the lien. For example, if the lender has a first priority lien for $100,000 against property worth $200,000, the present value of the lien is likely $100,000. However, if the lender has a first priority lien for $100,000 against property worth $50,000, the present value of the lien is likely only $50,000. Moreover, if the property is worth $50,000, and is encumbered by a first-priority lien in the amount of $100,000, and the lender has a second priority lien against the same property in the amount of $50,000, the present value of the lender’s lien is $0.
o the extent possible, and true, the Post-Discharge Agreement should recite that the consideration for the agreement is based entirely on the present value of the non-discharged obligation (such as the value of the lender’s forbearance of its lien rights), and not based on the debt which existed before the discharge. The more the Post-Discharge Agreement looks like the discharged promissory note, as opposed to an arm’s length fair trade of the rights and obligations associated with the non-discharged lien rights, the less likely the Post-Discharge Agreement will be deemed enforceable against the borrower.
2. Post-Discharge Agreements not intended to be enforceable
We note that, as we have discussed with many of our financial institution clients, sometimes enforcement of the Post-Discharge Agreement is not a possible reality, or necessarily even the goal. For example, the lender’s lien may be so underwater that the lender understands that any Post-Discharge Agreement supported by forbearance of the lien cannot withstand scrutiny. However, the lender and borrower still desire to formalize the transaction in writing, albeit an unenforceable writing. In such an instance, the lender and borrower are essentially carrying out Option 1 (acquiescence to voluntary post-discharge payments), just in a more formalized manner. A lender may find this option more appealing than Option 1 in that at least the lender has some paper evidence of the transaction and obligation.
Advantages and Risks of Post-Discharge Agreements
One advantage of a Post-Discharge Agreement is that it may create a new, enforceable debt obligation against the borrower. Formally documenting the Post-Discharge Agreement also gives the lender new documentation evidencing the debt, which allows the lender to put a new loan onto its books for tracking and accounting purposes. Again, financial institutions should consult with their accountants as to how to account for Post-Discharge Agreements.
The primary disadvantage of Post-Discharge Agreements is that they may be found unenforceable. In some cases, the lender is fine with this because they had no enforceable agreement following the bankruptcy discharge anyway, so nothing is really lost by trying to document a new obligation. However, the lender should consider the implications of a new agreement being found unenforceable where the lender documents a Post-Discharge Agreement in the form of a completely new set of loan documents: a new note is used to pay off the old note, and the old mortgage is satisfied and replaced with a new mortgage. If the court finds that the new note is unenforceable, the lender is left with nothing. The old mortgage is gone and the new mortgage secures an unenforceable debt. In such a case, the lender replaced the only certain obligation (the lien of the old mortgage) with a new obligation with questionable enforceability (the new note and mortgage). This risk must be considered when documenting Post-Discharge Agreements.
Further, courts in some instances have found lenders to be in violation of the discharge injunction based on Post-Discharge Agreements. The Bankruptcy Code provides that the borrower’s bankruptcy 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 dischargeable debt”. Once a discharge is granted, a creditor that proceeds in collection on a discharged debt may be found in civil contempt of the discharge injunction. Depending on the circumstances, courts have also required lenders to repay borrowers for amounts paid by the borrowers.
strong>Option 3: Acquire ownership of the property and sell it back to the borrower (only available if lender has a first-priority lien position)
As discussed above, the key to creating an enforceable obligation post-discharge is adequate new consideration. One way that adequate new consideration may be created is through having the borrower transfer the property back to the lender voluntarily via a quit claim deed, deed in lieu of foreclosure, or other similar document. The lender may then opt to sell the property back to the borrower under terms and conditions acceptable to both the borrower and the lender. Of course, this option is only available if the lender has a first-priority lien position. Like a Post-Discharge Agreement, the terms of the sale back to the borrower, most importantly the purchase price, should reflect an arm’s length transaction supported entirely by the actual value of the home. By doing so, there is a strong argument that the sale constitutes adequate consideration to support a new debt obligation and a corresponding new mortgage. A central advantage of this type of arrangement is the return to a normal lending and security interest relationship between the lender and the borrower.
There are a number of issues to keep in mind should the lender opt for this alternative. First, the lender’s title work should be updated to assure first position and to confirm that no junior encumbrances appear of record that would otherwise compromise the “new” first mortgage to be recorded against the property. Second, the lender should be mindful of its due diligence and underwriting criteria for this type of loan secured by real estate. Given that the lender will be dealing with borrowers that filed for relief under the Bankruptcy Code, the newly documented transaction may be a classified loan as soon as it is signed. This is an internal banking decision that needs to be addressed on the part of the lender.
This type of arrangement is relatively untested in the Bankruptcy Courts; however, it is based on sound legal principals. The major risk to the lender is that a court will find this an unenforceable arrangement based on a discharged debt, causing the new note and mortgage to be unenforceable. Like Post-Discharge Agreements, the likelihood of enforceability here is a sliding-scale. The more a lender can show that the consideration for the sale of the home back to the borrower is based solely on the actual value of the home, the more likely it is that the new note and mortgage will be found enforceable. Conversely, the more it appears that the sale back to the borrower is really just an attempt re-document the previously discharged note and mortgage, the less likely it is that the new note and mortgage will be found enforceable.
Option 4: Foreclosure
The purpose of this article was specifically to discuss some options that would allow the borrower to stay in the home and the lender to continue collecting payments from the borrower. However, it is important to note that the lender always retains the option to simply foreclose the lien of the mortgage or deed of trust, as the borrower’s bankruptcy has no effect on the lender’s lien. In many circumstances, this may be the best result for the lender.