ABA Section of Business Law

ABA Section of Business Law
Business Law Today
September/October 1998

When Debt Comes Crashing Down

Are 'reaffirmation agreements' a good thing?

Williams is the managing shareholder of Williams & Prochaska, P.C., in Nashville, Tenn. and chair of the Section's Consumer Bankruptcy Committee.

Most people generally agree that the U.S. bankruptcy system offers a better approach to the discharge of debt than its historic English predecessor, debtor's prison. It clearly provides a more humane recourse for overextended debtors. With more than 1.3 million bankruptcy filings in 1997 alone, the Bankruptcy Code may be one of the greatest social relief acts of the 20th century.

Essential to each bankruptcy filing is the ability to discharge debt. In Chapter 7, discharge is generally invisible to the eyes of the debtor. In this process, the overextended consumer will generally attend one creditors' meeting but will never see the inside of a courtroom. An alternative to discharging debt is to reaffirm certain debt obligations. Typically, a Chapter 7 debtor may want to reaffirm his car or house note in order to avoid foreclosure of property critical to the debtor's way of life. With a timely filed reaffirmation agreement, the reaffirmed debt is unaffected by bankruptcy although no court hearing is generally required and the Bankruptcy Trustee is not a party to the reaffirmation agreement.

Recently, a new concept has emerged. With nine of 11 circuit courts reporting, the five to four majority rule is that a Chapter 7 debtor, current on his or her monthly payments, can keep the creditor's collateral and obtain a bankruptcy discharge. There is little the creditor can do about it. This leaves the creditor with rights only against the collateral but no recourse against the debtor. On the other hand, if the debtor is current and intends to remain current, why should a court force a bankrupt debtor, already financially troubled, to reaffirm an obligation only to find out later that she has become over extended?

The very subject of reaffirmation agreements has disturbed drafters of the Bankruptcy Code from the beginning. On the one hand, does it erode the "fresh start" policy of the code to allow certain debts to survive bankruptcy? On the other, isn't bankruptcy's essential purpose to fully administer the debtor's bankruptcy estate by making disposition of each debt and each asset?

Joe Consumer and his wife Cynthia had a love affair with their credit cards. They had 12 cards in all. Each came with a 5.9 percent "tickler" rate. One by one, Joe and Cynthia ran each card to the limit, then started making the minimum monthly payment. Joe had been promoted four times in the last two years. With each increased monthly payment, Joe and Cynthia managed to come up with a commensurate amount of additional income. One day, they had a financial hiccup. They owned two cars, a boat, a new house and, since it was interest-free for one year, they even financed their new furniture. Since getting married almost 10 years ago, Joe and Cynthia never had a family budget.

Joe and Cynthia live in a state where state law exemptions allowed them to keep enough property that it was in their best interest to file a Chapter 7 bankruptcy. When they filled out their bankruptcy schedules, they came across a form called the statement of intentions. The form asked them to indicate whether they wanted to surrender or redeem collateral or reaffirm the debt secured by their property. They meant to ask their lawyer what this all meant, but forgot.

Joe and Cynthia started getting something called "reaffirmation agreements" from their creditors. These included offers of additional credit from credit card companies, if the consumers would agree to reaffirm. The total monthly payment if Joe and Cynthia had signed every reaffirmation agreement would have exceeded their current monthly disposable income.

One creditor filed a motion to compel them to redeem, surrender or reaffirm under Section 521 of the Bankruptcy Code. Their home mortgagor filed a motion for relief from the automatic stay to foreclose their new home. Joe and Cynthia were current on their house payment, both car payments and their furniture payment.

At least one reason Joe and Cynthia filed for protection under the Bankruptcy Code was that Joe's company was downsizing. Joe's salary had already been cut once and rumors abounded that Joe's job might be axed entirely. Joe and Cynthia weren't sure they could continue making their monthly payments to creditors and wanted to wait until the other shoe dropped, if at all.

Because of Joe's good credit, XYZ Finance had extended Joe long-term financing on his vehicle. During the later years of the contract, the value of the collateral would be greatly exceeded by the payoff amount. Because the car was presently worth a little more than the debt, XYZ wanted either to get the car back or have Joe reaffirm the debt.

Home office counsel for XYZ found his memo on the subject and quickly ascertained that "ride through" is available to debtors in the First, Second, Fourth, Ninth and Tenth circuits, while it is unavailable in the Fifth, Sixth, Seventh and Eleventh circuits. Joe and Cynthia lived in the First Circuit.

The judicially created "ride through" option emerged after Section 521(2) was added to the Bankruptcy Code as part of the "1984 Consumer Credit Amendments." That section requires the debtor (within 30 days after filing but not later than the meeting of creditors) to file a statement indicating the debtor's intent to redeem or surrender property securing consumer debts: "... if applicable, the statement must specify that the property is claimed as exempt, that the debtor intends to redeem such property or that the debtor intends to reaffirm debts secured by such property." The debtor then has 45 days to perform her intentions.

While some courts have held that the debtor is required to state and then exercise his or her intentions, other courts have focused on the words "if applicable" to hold that the debtor is not limited to just these three options. These courts have fashioned a fourth choice: Remain current on the obligation and "ride through" the Bankruptcy Case retaining the property/collateral. What should concern creditors and debtors alike is what happens after the bankruptcy case is over.

First, the Sixth Circuit in General Motors Acceptance Corp. v. Bell, 700 F.2d 1053 held that there were but two exclusive methods for a debtor to retain collateral - redemption or reaffirmation. Moreover, the court found that "redemption," as set forth in the Bankruptcy Code, required a lump sum payment equal to the value of the collateral. The court also found that the bankruptcy default provision appearing in the debtor's retail installment sale agreement was valid and immediately exercisable at the moment the trustee abandoned the collateral. In 1989, the Tenth Circuit was the first to approve "ride through" in Lowry Federal Credit Union v. West, 882 F.2d 1543. In Lowry, the court held that the Bankruptcy Code nowhere limited the debtor's choices to just redemption or reaffirmation. As the case is in equity involving injunctive relief, the court found that Lowry must show some damage by virtue of the debtor retaining the collateral in spite of its bankruptcy default clause. Since Lowry failed to show that the value of the collateral was decreasing faster that the debt was diminishing, the court allowed the debtor to "ride through." Four other circuits, however, have gone farther, finding that the "ride through" option is implicitly incorporated in the Bankruptcy Code by virtue of the words "if applicable" appearing in Section 521(2)(A).

In "ride through" circuits, the creditor is left with only in rem rights against the property securing the debt. When the debtor receives a discharge, the debt is extinguished as a personal liability of the debtor. Chapter 7 discharge does not, however, extinguish the creditor's security interest in collateral. Thus, after discharge, while the debt becomes nonrecourse to the debtor, the security interest survives.

Creditors like XYZ Finance in Joe and Cynthia's case argue that the collateral may be depreciating faster than the principal is being paid down. If Joe defaults in the later years of Joe's contract with XYZ, the creditor will be able to repossess and dispose of Joe's vehicle only at a significant loss.

On the other hand, were the creditor to be substantially under-secured, the debtor would have to continue making payments well after the debtor had paid the value of the collateral to the secured creditor. If the debtor failed to pay the entire obligation, the creditor could still foreclose the collateral notwithstanding the fact that the value of the collateral was paid a long ago. While it may be expedient for courts to allow debtors to "ride through," this process may be inequitable to both debtors and creditors. Thus, either way you look at it, "ride through" either flies in the face of bankruptcy's "fresh start" principal or results in creditors' loss of substantive property rights.

What options do debtor and creditor have after the debtor receives a discharge in a "ride through" case? It would seem that the creditor has the right to foreclose the collateral if the debtor defaults. Equally, the debtor may have the obligation to make payments well after he has paid the value of his 1969 Plymouth Fury.

Some creditors have taken the position that they can agree with the debtor to "redeem the collateral in installments" rather than foreclose. After all, most creditors would rather have the payments than the collateral. Section 524 of the Bankruptcy Code, however, creates a permanent injunction against creditors' collection of discharged debts. As one might guess, how to negotiate an installment redemption agreement with a discharged debtor may be tricky.

In re Latanowich, 207 B.R. 326, the now-infamous Sears reaffirmation case, while exceptional, illustrates some of the dangers of post-discharge debtor agreements. Admittedly, the facts in Latanowich were horrible. It was alleged that Sears coerced Latanowich into signing a reaffirmation agreement promising to keep his line of credit open and even promising to extend additional credit. The bankruptcy court found that the new credit was never extended and Latanowich was given the impression that he had in fact reaffirmed his obligation to Sears. The reaffirmation agreement was never filed with or approved by the court as is strictly required under section 524 of the Bankruptcy Code.

Sears admitted not only that it had failed to file the reaffirmation agreements, but that its policy was not to file reaffirmation agreements with the court. Bad facts notwithstanding, Latanowich - and a number of comments made by the court - create the impression, if not the holding, that creditors may be under a duty to return payments made voluntarily by a "ride through" or "pay as you go" debtor. The Latanowich court stated: "No transaction that leaves a debtor ... believing that he or she is obligated to pay any part of a discharged debt can be characterized as a voluntary repayment within the meaning of §524(f)."

Thus, the problems with "ride through" become obvious:

• Can the secured creditor send monthly statements to the debtor indicating the amount of debt on the creditor's books?
• What can the monthly statements say? Can they include the monthly payment amount or the payoff amount of the now-discharged loan? Must the statement indicate that the debtor really doesn't owe the creditor any money but must (Whoops! I mean may "voluntarily.") pay the regular monthly payment in order to keep the car?
• Must the creditor return to the debtor any payments that exceed the value of the collateral? Must the creditor return any payments made by the debtor when she was under the mistaken impression that she had to pay?
• Can the debtor "redeem" the collateral by agreement with the creditor to paying the value of the collateral over time?
• If the creditor enters into a redemption agreement with the debtor post discharge, is a new debt created so that the creditor's remedies include demand for the debt rather than just foreclosure of the collateral?
• If the debtor's only option is to pay the value of the collateral over time, what cost-effective process can be used to appraise the collateral? Do the debtor and creditor always have to agree?

Like the automatic stay that protects the not-yet-discharged debtor during the bankruptcy case, Section 524 protects the debtor against any efforts to collect a debt after a discharge is granted. Section 524 also provides the exclusive method of reaffirming debt, and nothing in the Bankruptcy Code prevents a debtor from voluntarily repaying. Several bankruptcy cases have held that any post-discharge agreement that serves to either reaffirm or create an obligation of the debtor to pay more than the value of the collateral may be tantamount to an illegal reaffirmation agreement.

The legislative history of the original Section 524 indicates a strict prohibition against the reaffirmation of dischargeable debt without compliance with the procedures set forth in Bankruptcy Code Section 524(c). The drafters of the Bankruptcy Code wanted to make certain that the debtor both understood the reaffirmation process and had every opportunity to back out.

As Section 524(c) reads today, each reaffirmation agreement must clearly and conspicuously advise the debtor that the agreement is not required either under bankruptcy or nonbankruptcy law and cannot be required by contract with a creditor (or any one else). Each reaffirmation must be executed and filed with the court before a discharge is granted and must clearly and conspicuously advise the debtor that the agreement may be rescinded any time up to 60 days after it is filed with the court or a discharge is granted, whichever is later.

If the debtor is represented by counsel, debtor's lawyer must provide an affidavit that he or she has advised the debtor of all of the consequences and voluntary nature of reaffirmation; and that reaffirmation doesn't impose an undue hardship. If the debtor doesn't have a lawyer, the court has to conduct a hearing and determine that the reaffirmation doesn't impose an undue hardship and that it is in the best interests of the debtor.

In spite of all these precautions, some say the Bankruptcy Code doesn't go far enough. Like Joe and Cynthia, a surprising number of debtors are provided with reaffirmation agreements creating monthly obligations that exceed the debtors' pre-petition payments - the very payments that drove the debtors to file bankruptcy in the first place.

Almost never has a reaffirmation agreement reaffirmed only the value of the collateral. Reaffirmation contemplates reaffirming debt. Chapter 13, for instance, contemplates paying the value of collateral over time. Since reaffirmation is of an entire obligation, reaffirmation agreements are not required to consider that collateral value may be less than the total amount owed to the creditor. While creditors might fare much better by allowing the debtor to reaffirm an amount greater than they would get in foreclosure, but less than the payoff, this rarely happens.

The Bankruptcy Review Commission in its report to Congress in October 1997 recommended that reaffirmation agreements be limited to the value of the underlying collateral and recommended that unsecured debt not be subject to reaffirmation at all.

There is no requirement in the Bankruptcy Code that the Chapter 7 trustee sign off on a reaffirmation agreement or even that he knows about it. In fact, if the debtor has counsel, the reaffirmation agreement is filed with the court clerk and reviewed by no one. Unless the trustee abandons the collateral, or the debtor can successfully claim it as exempt, the trustee can sell the property if there is equity over the amount of the secured claim available to the bankruptcy estate and its creditors. If this happens, the whole purpose of the debtor's reaffirmation (for example, having a car to go to work) is defeated.

A BLS Section Committee steps forward

In a recent survey by the ABA Section of Business Law Consumer Bankruptcy Committee, it became clear that few agree on to how to solve the apparent difficulties with reaffirmation agreements. As a legal matter, reaffirmation is reinstatement of a debt, not an obligation to pay the value of collateral. Paying the value of collateral over time is nothing more that redemption in installments. Redemption in installments is not a concept contemplated either by the Bankruptcy Code or by the Uniform Commercial Code. Thus, were a debtor able to redeem in installments, the notion of redemption (under bankruptcy law, paying the value of the collateral in one lump sum) would disappear.

Further, as a practical matter, limiting reaffirmation only to secured debts could be devastating to anyone who needed a line of credit after discharge. While even a newly discharged debtor might find a credit card in 1998, that may not always be true. It certainly hasn't been true in the past and consumer credit will surely become less available in the next economic downturn.As a lawyer, I travel often. Have you ever tried to buy a plane ticket, rent a car or reserve a hotel room without a credit card?

There is one thing in our Consumer Bankruptcy Committee survey that most respondents agreed on: The Bankruptcy Code should provide certainty. While not unanimous, those polled indicated that debtors should be limited to the three choices of redeeming the collateral, surrendering the collateral or reaffirming the debt. Allowing a fourth choice of keeping up the payments is fraught with difficulties, which may arise only after the bankruptcy court's jurisdiction is long forgotten.

But let's look at the three choices for a moment. Suppose the debtors refuse to sign a reaffirmation agreement with an undersecured creditor because, like Joe and Cynthia, they are unsure they can continue to pay. Perhaps they counter offer that they would be more than happy to agree to a higher collateral value and will agree to pay this amount over time. Thus, an agreement is reached, essentially to redeem in installments. While the debtors are not obligated to pay the full debt, the creditor receives considerably more than it would if it had to foreclose. All this could happen with court approval in a supervised setting and with the advice of the debtor's counsel.

As to the role of counsel, what if, instead of reaffirmation agreements being submitted to the court at any time during the pendency of the case, all reaffirmation agreements had to be submitted at once? It might work like this: No reaffirmation agreements could be provided to the debtor by creditors more than 30 days following the date first set for the meeting of creditors. At that time the debtor's counsel would have 30 days to discuss the merits of all reaffirmation agreements with the debtor. The debtor and his lawyer could sit down and consider the wisdom of reaffirmation as a whole and determine whether the debtor is financially able to pay all of the reaffirmed debt. The lawyer's affidavit would simply indicate that the total of reaffirmed monthly payments does not exceed the amounts available when you subtract the debtor's monthly income from his or her expenses set forth in the schedules already filed with the court.

When it has been decided which debts to reaffirm, or collateral to redeem in installments, debtor's counsel would submit all reaffirmation and redemption agreements to the court, along with a motion to approve them. The motion would be served on the trustee with opportunity for the trustee to object. If the motion is granted, the trustee will be deemed to have abandoned the estate's interest in the collateral underlying the approved reaffirmation and redemption agreements.

This framework would further the goal of the bankruptcy laws that debtors should be able to make a fresh start in their financial affairs, while preserving the better features of the judicial "ride-through." So far, there is no legislation before Congress that balances these varying interests. Little agreement exists as to the correct approach. Although we have seen no statistics, it would appear that billions of dollars are involved in bankruptcy "ride-through," with many consumers potentially suffering at least the uncertainty of not knowing whether they can really keep their car or home.