There is an issue that is growing in frequency in bankruptcy and real estate law affecting banks. The debtor files a Chapter 7 bankruptcy. The client has exempted the home from the bankruptcy estate under 11 U.S.C. § 522(d)(5). The client’s Chapter 7 bankruptcy is discharged. The client does not, however, reaffirm the promissory note on the primary residence prior to this date. The client continues to live at the home. The client also continues to make payments to the bank in the same amount and frequency as contracted for in the promissory note. The bank’s mortgage on the property is still in place as it was not discharged or removed in the Chapter 7 bankruptcy.
This is an unusual set of circumstances not generally seen until the past few years. There is not a valid promissory note between the debtor and the bank. In fact, the bank is prevented by federal law from even sending the client monthly statements on the discharged promissory note. The bank still holds the first mortgage on the residence, and the client still has legal title to the residence, yet continues to make payments on the discharged debt.
A thorough search for guidance was completed through several banking, legal, and bankruptcy organization websites (the Federal Deposit Insurance Corporation, Consumer Bankruptcy Association, American Bankruptcy Institute, American Bar Association, and others). There were no research articles or cases on point with the circumstances. There has not been case law to give direction as to how to treat the circumstance where the debtor continues to pay on the discharged debt and the bank accepts the payments. Specifically, how should the payments be applied, and once this occurs, and how should the bank act?
A portion of the banks and credit unions in the Ingham County, Michigan, area simply accept the payments as if the promissory note had been reaffirmed. Others simply give the debtor the choice of reaffirming the debt prior to the discharge or a foreclosure on the property is initiated post-discharge. Two attorneys surveyed on this issue stated they advise their banking clients to reaffirm the debt or foreclose on the mortgage. They also noted that the debtor can voluntarily make payments to the bank under 11 U.S.C. § 524(f); however, the bank cannot appear through its overt actions to be collecting on a discharged debt. Other debtor attorneys tell their clients never to reaffirm the debt, as this is contradictory to the intent and spirit of the Chapter 7 bankruptcy to give the debtor a fresh start.
There were, however, a handful of cases that were proximate but not on point. These primarily involved debtors not reaffirming the debt prior to the Chapter 7 bankruptcy discharge and afterward filing a motion to set aside the discharge (In re Smith & Blochberger, 467 B.R. 122, 2012 Bankr. LEXIS 1316 (Bankr. W.D. Mich. 2012); In re Golladay, 391 B.R. 417, 2008 Bankr. LEXIS 1985 (Bankr. C.D. Ill. 2008)) or a motion to reopen (In re Hodges, 2011 Bankr. LEXIS 5703 (Bankr. N.D. Ind., South Bend Div., 2011)). All these cases resulted in the motions being denied and the Chapter 7 bankruptcy discharge standing.
A slight twist to this was with the debtors intending to reaffirm the debt but not completing the task. The debtors in this case continued to make the payments to the bank, and the bank accepted them. The bank had the debtor sign a new note, citing the initial security agreement. The bank was later sued, and the court held that the bank violated the discharge injunction. In re Poindexter, 376 B.R. 732, 2007 Bankr. LEXIS 3160 (Bankr. W.D. Mo. 2007). To reaffirm the debt post-discharge, there has to be an extraordinary circumstance warranting this action. In re Huffman, 2007 WL 1856770, 2007 Bankr. LEXIS 2199 (Bankr. M.D.N.C., Winston-Salem Div., 2007). This was not found in any of the cases noted.
The intent of the Chapter 7 bankruptcy is to give the honest debtor a fresh start and liquidate the bankruptcy estate’s assets to pay the creditors. In the case at hand, however, there won’t be a liquidation (as there would be under 11 U.S.C. § 704(a)(1)), disposing of the proceeds (as with 11 U.S.C. § 725), or a distribution of the proceeds (per 11 U.S.C. § 726). There is no on-point section in the Bankruptcy Code addressing the circumstances at hand.
In this scenario, the debtor completed only half of the task to reaffirm the debt. The real property was exempted from the bankruptcy estate under 11 U.S.C. § 522(d)(5). However, the debtor did not reaffirm the debt in accordance with 11 U.S.C. § 524(c). As the debtor asserted he or she wished to keep the home, this would be filed with the bankruptcy court (11 U.S.C. § 524(c)(3)).
The broad concern with this issue is there is no case law or Bankruptcy Code section that specifically addresses it. However, the code and case law are clear that once the debt is discharged, this cannot be modified. For the bankruptcy court to consider this, there has to be a circumstance that would be highly unusual. This bar to later modify the residential is so stringent that the situation would have to be an anomaly. As evidence of this, the thorough journal and case law research indicated this had not occurred.
The debt would have to be modified prior to the Chapter 7 bankruptcy discharge. If the bank were to continue to collect on the debt and accept the payments post-discharge, there can be significant liability with this activity and the application of the payments to a void and discharged debt. Simply collecting the payments is ignoring the underlying problem and issue.
The best and most risk-averse guidance would be to have the client reaffirm the debt prior to the discharge or, if the client refuses, to foreclose on the real property.
Keywords: bankruptcy and insolvency litigation, Chapter 7, residential mortgage, promissory note, discharge