I rarely advocate That clients file Chapter 13′s because they take too long and keep them under the thumb of the bankruptcy court for (usually) five years.  So when does it make sense?

It makes sense when you want to keep your house but have junior unsecured liens stacked on top of the main mortgage.  In Chapter 7, if you want to keep your house, you have to keep the lenders current.  Not necessarily so in Chapter 13 when you have stacked loans secured by your home. Since 2006, the Heavy Question [see clever illustration below] has been:  Can you dump a mortgage loan in Chapter 13?  The short easy answer if you’ve ever read anything at all on my blog is that “it depends.”

First:  Is it “secured” solely by your primary residential real estate?  And by that I do not mean investment property or personal property.  (Pay attention here because the terms and definitions matter.)  That is, is the security agreement only applicable to your primary residence?  If so, you have passed the first test.

Second:  Is it WHOLLY unsecured?  By this is meant that there is no security for the loan at all after consideration of all senior debt.  Example:  House valued at $750,000 With a first deed of trust (“DOT”) for $690,000, a second DOT for $170,000, and  third DOT $75,000.  Now what?

Well, the first is wholly secured because the value exceeds the loan balance by $60,000 ($750,000 minus $690,000.)  Our hypothetical borrower can’t strip this lien because it is wholly secured.

The second is partially secured.  It is secured to the extent of the $60,00 left after accounting for the first DOT right?  $750,000 minus $690,00 leaves $60,000. Capiche?  So  because it is partially secured, you can’t strip it and the debtors will have to keep that lender current In order to keep the home.

But the third…Here’s where it gets interesting.  After accounting for the first and the second, there is no security value left for the third at all.  $690,000 plus $170,000 equals $860,000.  But the house is only worth $750,000.  Because the third is wholly unsecured, the borrower can “strip” this lien and shove the debt over to the unsecured column…Payable over the time of the Chapter 13 plan.

Why do we care? Because you can’t do this in Chapter 7.  It only works in Chapter 13.

This concept as described also only works in parts of the country, so don’t go charging into your bankruptcy lawyer’s office telling him or her all about how you read on the web that you can dump your HELOC. There’s a bit more to it than the above, but this sort of scenario and fact pattern is a good example of when a Chapter 13 might make sense.

 

As this dog-tired economy continues to drag on, with no relief in sight and no bounce-back in home prices appearing anywhere on the horizon, the single question I am asked most frequently is “Should I walk away from my mortgage, and if I choose to do that, what are my options?”

Usually it comes in the following form.  “We bought our house in 200_, for $_______.   It’s now worth less than what we paid, and less than the outstanding loan amount.  We’re considering our options, but are not sure what to do.”

Sometimes this question comes up because someone has lost a job, or is in the real estate business and hasn’t been able to generate much commission income in the past 2 to 4 years, although sometimes it’s just the economics themselves that trigger the inquiry.

The question about what to do, however, is less a legal decision than it is an economic decision.  Of course, once you decide to walk away, then the follow-through becomes a purely legal act, and should only be undertaken after consulting with legal counsel and obtaining a full understanding of what is likely to happen.

First, should you?  That all depends on where you think housing prices are going to go in the future, how long you’re willing to tough it out and what your other housing options look like.  Obviously, you have to live somewhere, so if you’re not going to own, then you have to have a good understanding of what your rental options are  Example:  A family of four, with two teenagers, living in a 1,500 square foot house in an expensive neighborhood is going to be looking at a very different set of concerns than a childless couple living in a 4,000 SF home in an affordable location.  That seems obvious, but to many folks it apparently isn’t.

So it’s not a straight dollars and cents analysis.  Just because your home is worth 20% less than the balance on your loan, no lawyer can advise you on whether you should keep the house and keep paying, or let it go and brave the consequences.  All a lawyer can do is tell you what is likely to happen under any particular course of action.

Next, if you do decide to walk away, what is going to happen?  Well, we all know that such a decision is going to cause significant credit problems.  It’s inevitable: If you walk away from a home loan, your credit is going to suffer.  But what else?Fortunately, we don’t have debtor’s prison, so despite the loss of the house to foreclosure–another inevitability although the timing may vary depending on circumstances–you may get sued.  Obviously that’s no fun, and is something that you should try to avoid, but whether that is likely to happen or not is a very good question to take up with a lawyer.  We’re lucky in California as there are very powerful anti-deficiency laws, about which I have already blogged rather extensively.  (See California anti-deficiency rules and statutes: When can a mortgage lender in California recover a deficiency after foreclosure?, California Mortgage Deficiencies: What is a Purchase Money Security Interest? and Second Mortgages in California: Deficiencies Not Usually an Issue for full treatment of the subject.)

Last, what about staying and trying to complete a mortgage modification?  I’m sorry to say that I’m a cynic on this subject.  The process seems capricious and arbitrary at best, and since my experience leads me to the unshakable and firm conviction that, as a class of people, consumer bankers are among the dumbest clowns wandering the planet, the percentage likelihood of any one homeowner or family successfully completing a mortgage modification is nearly microscopic.  This is especially true here in Northern California where incomes and home prices are among the highest in the country.  They’re not much interested in modifying mortgages for people with six figure incomes and seven figure home prices.  And of course, whether that is right or not is beside the point, but you need to understand the reality if you’re going to test the water.

Well, you know by now that the answer is:  It depends.

If you file Chapter 7, and either are current or get current with your mortgage(s), then you can most likely keep your home.  (Assuming you don’t have an equity interest that exceeds the homestead exemption.  As to which, see this blog post:  California Homestead Exemptions Increased as of January 1, 2010. Other California Bankruptcy Exemptions will increase on April 1, 2010.)

If however, you are in arrears, and are not able to bring the loan current, then–unless you can complete a mortgage modification that allows you to stay–you are likely lose the home.

On the other hand, if you file Chapter 13, and are able to successfully get a payment plan approved by the Court, then you may be able to stay.  This is because in a Chapter 13, you can take the outstanding mortgage arrearages, and pay them back through the Chapter 13 plan over the 3 to 5 year commitment.

But don’t try to do this analysis yourself. Talk to a bankruptcy lawyer before you get too excited. There are lots of nit-picky little rules that can torpedo an otherwise possible successful Chapter 13.  You need to do the analysis up front.

The New York Times recently reported on a movement by the California State Legislature to amend California Code of Civil Procedure (“CCP”) §580b.  (See “Battles in California over Mortgages.”) For those of you who’ve been following along, CCP §580b is the California statute that prohibits a mortgage lender from obtaining a deficiency judgment on any loan that was used to purchase or construct a residence.   Such loans are referred to in the law as “purchase money loans.”  I have posted about this a couple of times (See posts:  California anti-deficiency rules and statutes: When can a mortgage lender in California recover a deficiency after foreclosure? and Second Mortgages in California: Deficiencies Not Usually an Issue), and it is a very important statute for California homeowners.

On June 3, 2010, the California Senate passed, by a convincing margin of 30 to 4, Senate Bill 1178 which extends the protections of CCP §580b to any loan taken out to refinance a purchase money loan, up to the amount of the original purchase money loan which is refi’d.  Here’s how that works:  I take out a loan for $500,000 which I use to buy my home.  A few years later, I refinance that loan with a new loan for $700,000, $500k of which goes to take out the original purchase money loan, and the other $200k of which I use for other purposes.  Under existing law, because the new loan is no longer a “purchase money loan,” but is a refi of a purchase money loan, I would not be protected against possible personal recourse by the lender if it foreclosed and did not recover enough on the sale of the residence to pay off the whole loan.  Under the new law–if it passes the California State Assembly–I would still be protected on the refinance loan up to the amount of the original purchase money loan that was refinanced, or in my hypothetical, $50ok.  That would leave me exposed on the balance in excess of that refinanced amount.  In my hypothetical, up to $200k.

Do we care?  Well, maybe some day someone will, but I doubt it.

As usual, the press gets it all muddled up, and everyone jumps on the band wagon to shout about “consumer protections.”  It’s actually somewhat comical.  If you Google “SB 1178 California” you get a whole raft of folks nattering about the great “consumer protections” it offers.  But if you know anything at all about how the economics and law of foreclosure in California actually work in day-to-day reality, a little reflection shows that it doesn’t do anything of the sort.

As a Bay Area real estate and bankruptcy lawyer who lives on the front lines–representing both lenders and borrowers–in these sorts of disputes every day, I’ll go way out on a limb here, and say with confidence, and in my most stentorian tone of voice, that this is a bunch of hogwash.  More political window dressing in the face of a crippling inability to do anything meaningful at all.  It’s not going to solve a single one of the problems facing California’s real estate industry today, and in practice, its benefits–if any–will be limited to an extremely small group of people who have more money than brains. The investor who made a wrong bet, but who can still afford to pay their debts.  (Which, ironically, is the precise subset that everyone who’s anyone in this debacle–from Hank Paulson to Bernard Bernanke to George Bush to the Barrack Obama–has steadfastly maintained they have no desire to help.  But I digress.)  Legally and economically, this is a red herring brought to you by a band of legislators who are largely powerless to do much more than wave their arms in sturm und drang trying to demonstrate to an increasing angry constituency that they are doing something.

Here’s why this thing is meaningless:

First, in order for this hypothetical to be a real problem, the lender would have to file an action for judicial foreclosure, because under the provisions of CCP §580d, no deficiency is available to a lender who forecloses by trustees sale.  If the foreclosing lender has availed itself of the “power of sale clause” in the deed of trust, then no deficiency is allowed. Period, done finished, end of story. That’s what CCP §580d is all about.  It doesn’t matter what the money was used for, how it was obtained, from whom, etc.  No lawsuit, no deficiency.  (A trustee’s sale is when they sell the property by auction on the Courthouse steps, and a judicial foreclosure is when they file a lawsuit in Superior Court seeking a judicial decree of foreclosure and money judgment.)

Second, the California real estate market continues to slog along the bottom of the river, which means that there are very few loans where the bank is going to be interested enough in the borrower to actually spend the time and money to chase a debtor on one of these.  The costs of foreclosure are already sky-high, (found by a Joint US Congressional Economic Committee to approach an average of $80,000 (!!!), see Joint Congressional Economic Committee Report on Foreclosure Costs), and the added costs and uncertainties of trying to pursue a deficiency on a mortgage balance in a court only adds more time, expense and uncertainty. Banks–and the regulators who regulate them–hate time, expense and uncertainty when it has to do with a non-performing loan.

The fact is that most lenders are not going to spend the money to launch a judicial foreclosure on a generic breach of contract claim. Which is what this foofaraw is all about.  When a borrower defaults on a promissory note by not paying it back it is just a simple, no-brainer breach of contract claim. Mortgage lenders in this sort of hypothetical don’t sue for that. Why?  Because it’s a colossal, herculean, humongous and uncertain waste of time and money.  And why is that?  Because the person they’re chasing either doesn’t have the money to pay them back–which is why they’re not paying in the first place–which means that if they actually get a judgment it will be an uncollectible judgment, i.e., a meaningless wallpaper, and…And here’s the big one, a generic breach of contract claim on a promissory note is completely dischargeable in bankruptcy. The lender can chase the borrower all the way to judgment and the borrower can still squirt out by filing a simple $299 Chapter 7 petition.

The person that they will sue, however, is the scam artist who got the loan by fraudulent means, and there is nothing at all in the revised CCP §580b that is going to protect that scam artist from the consequences of their fraud.

So who is this new and improved law going to help?  Here’s the profile: He/she is a borrower who doesn’t want to pay the loan back even though he/she has the money to do so. Further, they’re willing to spend this money that he doesn’t want to spend to avoid the foreclosure to finance litigation. Oh yeah, and one more data point.  The National Consumer Law Center recently published a report on average hourly rates for experienced consumer law attorneys, experienced being defined as those with 20 to 30 years experience.  Me and my colleagues in other words. (See NCLC United States Consumer Law Attorney Fee Survey)  The result? $460 to $475 per hour. So this hypothetical borrower doesn’t want to pay his loan, but he’s willing to pay me or my colleagues $475 an hour to litigate this issue.  Total likely fees? $50,000 to $100,000 at those rates. Where is this idiot?

So the new and improved CCP 580b is a pointless public relations stunt, and any blogger, journalist, banker, lawyer, real estate agent or politician who tells you otherwise is a well-intended liar or, more likely, just doesn’t know what they’re talking about. I suspect what they’ll say in response to me, however, is that removing this threat removes a negotiating plank–the threat of a lawsuit–from the lenders’ arsenal.

Last, the new law, if it passes, is likely only to apply to loans made after June 1, 2011.

Stay tuned.

In a couple of other places in this blog I have discussed various components of California’s mortgage anti-deficiency laws. (See California Mortgage Deficiencies: What is a Purchase Money Security Interest? and Second Mortgages in California: Deficiencies Not Usually an Issue.)  This post will put it all in one place. At least the five basic rules.

I can’t warn readers enough, however, that these are very, very complex issues. I have–quite intentionally–over simplified them here, and I have done this to provide a precis on the big picture.  The case law interpreting the applicable statutes occupies volumes in California lawyers’ offices, and there are still many legal issues and questions that are unsettled.  So please go easy if I don’t answer your specific question here.  There is no way I can address all of the issues in one post, so if you have a specific question, please, post it in the comment section so everyone can see it, and I’ll do my best to answer it. But if you think you have a deficiency problem, or a possible exposure to a deficiency judgment, you really owe it to yourself to see an attorney who understands these issues. Also, bear in mind that the rules vary from state to state, so if you are reading this post with a real estate problem in any place other than California, you can be sure that the rules applicable to your situation are not the same.

First, what is a deficiency? Simply stated, a deficiency is what is left owed to a lender after the lenders forecloses and takes the real estate back. Example: If I owe $200,000, and the property is only worth $150,000 there is a so-called “deficiency” of $50,000. When can the lender come after the borrower for that “deficiency?”  That is the subject of this post. And, of course, in the current economy, a lot of people are trying to figure this out.

In California, there are four primary rules that apply. I discuss them below in no particular order.

1.  The One Action Rule. CCP §726(a).

The One Form of Action Rule basically says that the lender is required to chase the collateral first, and the debtor second…if it still can. A long, long time ago, a foreclosing lender could choose whether to foreclose on the collateral or go after the borrower personally for a money judgment. The one action rule of CCP §726(a) says that the lender must go after the collateral first, and, if it is legally possible, go after the borrower personally for any deficiency after that. Whether that is possible will depend on how the other rules set forth below kick in and apply to protect the borrower. But if you get sued on a promissory note and the lender is not a “sold out junior” nor taken hasn’t taken steps to foreclosure on the collateral, this rule would apply.

(I use the term “sold out junior quite a bit in this post. A sold out junior lienholder is the holder of a deed of trust that is junior to the first lienholder, and who has been denied a recovery due either to the foreclosure by the first lienholder, or because there isn’t enpugh value in the property to satisfy the junior debt after satisfaction of the senior debt. It is common for people to refer to such debts as “HELOCS,” but this isn’t technically accurate. A HELOC is simple a “home equity line of credit” that is secured by the subject property. It may be the most senior debt on the property or it may be a second, third…or tenth lien in order of its seniority. “HELOC” is a banking term; “sold out junior lienholder” is a legal term of art.)

2.   The Purchase Money Prohibition:  CCP §580b.

This is the best known rule and the one that applies more often than the others. If the loan that is being foreclosed on is a loan that was obtained for the purpose of purchasing the property, then no deficiency is allowed. It doesn’t matter if it’s a first, second or third.  It doesn’t matter if it’s classified as a “HELOC,” a “seller carry back,” or, ultimately, a “sold out junior.” Purchase money is purchase money. Example: Homeowner buys a house for $300,000, with a first for $200, and a second for $60,000, both put on the property at the time of acquisition. If the first forecloses, both lenders are barred from getting a deficiency because both loans are classified as “purchase money.” However, where the borrower has refinanced the original purchase money loan, or got a later home equity loan, that later loan is not a purchase money loan and could form the basis for a deficiency if the other anti-deficiency rules don’t otherwise apply.

But there is an exception to the exception: If the later loan was used to finance improvements to the property, then it can be a purchase money loan, and thus be a bar to a deficiency.

3.  The Non-Judicial Foreclosure, or “Private Sale Bar”:  CCP §580d.

This is the next most frequent rule. If the foreclosing lender has availed itself of the “power of sale clause” in the deed of trust, then no deficiency is allowed. Period. If they take the property back by means of a non-judicial foreclosure or trustee’s sale, then no deficiency. But unless one lender holds both loans, that only applies to the loan actually foreclosed on. Using the above hypothetical figures, though in this case making the second a non-purchase money loan, when the first forecloses, the holder of the first foreclosing loan is barred from seeking a deficiency both (1) Because it is purchase money, and (2) Because it has foreclosed by trustee’s sale. But the second, not being purchase money, and not being the one who foreclosed by non-judicial sale but having been wiped out by the foreclosure of the first, is not barred from pursuing a deficiency. In fact, in California, they have up to four years from the date of the breach of the contract to file a lawsuit seeking that deficiency.

And of course, as noted, there is an exception to the exception: If the holder of the first and the holder of the second are the same lender, and that entity forecloses on the first, it is also barred from seeking a deficiency on the second. This is important in California where lenders sometimes “stack” loans in order to get to a loan amount high enough to cover the high property values. It is also important to think about when the loans may have been sold to different lenders.

(On a historical note, CCP §580d was passed in light of the foreclosures and abusive deficiency judgments obtained by lenders during the Great Depression.  What we’re going through now is similar in many respects, though the ability of lenders to take the property and then chase the borrower who is already out of their home is limited by the passage of that statute. Small solace, to be sure, but it at least is doing what it was intended to do.)

4.  The fair Value Limitation: CCP 580aCCP §726(b).

This rule limits the amount of any possible deficiency to the amount by which the total debt exceeds the total fair value of the collateral. It only applies to deficiency judgments in judicial foreclosures, and, most importantly, it does not apply at all to sold out junior lienholders. Example: First mortgage of $450,000, and a second for $150,000, for total liens of $600,000. If the holder of the first forecloses and, it can be shown first at the time the first forecloses it can be shown that the property is only worth $400,000, then the foreclosing lienholder–on return to court seeking a deficiency–is limited to $50,000, regardless of what they sold the property for.  So if they pay a commission of 6% ($24,000, and additional closing costs of $5,000, that $29,000 is generally barred.  As for the holder of the $150,000 second? They can still come after the borrower for full payment, assuming, of course, such an action isn’t barred by one or the other of the above rules.

5.  The 3 Month Rule: CCP §580a.

This rule applies only in the case of judicial foreclosures. What’s that? Literally, it is a lawsuit in which the lender obtains a “decree of foreclosure” from a court–by definition not using the trustee’s sale procedure–and is unable to be made whole from the sale of the property. Example: Loan balance of $500,000. Lender obtains a “decree of foreclosure” from a court, after which it then goes out and sells the property for $400,000. In order to get a recourse judgment against the borrower for the $100,000 shortfall, that creditor must bring an action within 3 months of the sale date or it is barred.  An important carve out on this rule is that the 3-month limit does not apply to a sold out junior lienholder, the holder of the second in the above scenarios.

It is highly doubtful that you will have to deal with this rule without being fully aware of the issue steaming down the tracks towards you, simply because it can only happen in a judicial foreclosure. A lawsuit. As to whether or not you’ve been sued, well, you should know it. But check out my prior post Second Mortgages in California: Deficiencies Not Usually an Issue I referred to in my first paragraph above if you’re not sure.

As David Letterman would say, “please don’t try this at home,” by which I mean simply that if you are concerned that you may have a deficiency exposure, call a lawyer. A real estate lawyer, not a family lawyer, a personal injury lawyer or your Grandma Tilly’s trust and estates lawyer. This can be complicated stuff.

And last, of course, if the debt is discharged in bankruptcy, there is no deficiency at all. But that’s another post altogether.

Most of my clients know that I am not a fan of Chapter 13.  This is mostly because I think that it keeps people in the bankruptcy process far too long (3 to 5 years), and that as a result, makes that “fresh start” promised by Congress so elusive. Nonetheless, there are times when it is either advisable or flatly unavoidable.

So here, without fanfare or editorial, is what the federal government would like you to know about Chapter 13.  Like my prior post on Chapter 7, it is simply a reprint of the information found on the United States Bankruptcy Court’s website.

Continue reading »

The California Homestead exemption (found in CCP §704.730 for those keeping track) was increased as of January 1, 2010.

The Homestead Exemption is the amount of equity in excess of existing liens that the homeowner can protect from levy by creditors.  So if your home has a value of $500,000, your existing mortgage balance is $400,000 and you fall into the $75,000 homestead category, then $75,000 of the $100,000 equity cushion in your home is protected from creditors.  This works in bankruptcy and out.

Here are the new limits:

  • $75,000:  Basic homestead for single person
  • $100,000:  Head of household
  • $175,000:  Over 65 or physically disabled or under 55 with less than $15,000 in annual income ($20,000 if married).

The full text of the statute appears below.

The exact numbers of the California Bankruptcy Exemptions will be released by the Judicial Council on or about April 1, 2010, and published by the Administrative office of the Courts.  The actual published limits are harder than hens’ teeth to find on line, even if you know what you’re looking for.  But here is the current published list of  California “Current Dollar Amounts of Exemptions from the Enforcement of Judgments.”  You can check back here on my site for an update when they release the new numbers on April 1, 2010.

California Code of Civil Procedure ("CCP") §704.730

A question I am asked with increasing frequency is what happens to a mortgage modification negotiation when the borrower files bankruptcy.   Of course we all know by now that the answer is that “it depends.”

First, it helps to understand how most lenders staff these situations. There seems to be a common misconception that each loan and lender has a single, intelligent and rational professional banker assigned to it, who is charged with carefully weighing alternative courses of action, making intelligent decisions about each loan on an individual basis and maximizing the bank’s chances of earning the most return on its investment.  To that I say “fuggedaboutit.” Most lenders are in complete disarray and wouldn’t recognize a rational business decision on a loan-by-loan basis if it bit them on the nose. Remember, these are the same people that created this fiasco. It seems that the American banking industry has taken Will Rodgers seriously when he said, “If stupidity got us into this, why can’t it get us out of it.” I find it most useful to assume that there is no intelligent life on the other end of a telephone when I call a bank, an assumption which, while cynical, makes life easier by reducing my frustration when Forrest Gump answers.

The people tasked with analyzing and negotiating mortgage modifications are not the same people as those tasked with managing loans that fall into bankruptcy. So when you are negotiating for a possible loan mod and you file bankruptcy, in most cases the whole file gets transferred to someone else’s desk because the bank now has to take certain actions to protect itself that weren’t required pre-petition. They are going to shift into a different mode of “damage control.” That doesn’t mean that the loss mitigation folks can’t talk to you, but a bankruptcy filing is most definitely a game changer. (It is likely that, if you are able to actually negotiate a modification, court approval will be required, but that is a different subject and not within the scope of this post.)

Can you still negotiate a modification? Yes. There is no legal reason why a loan can’t be modified while the borrower is in bankruptcy. Will it happen? That depends on whether the bank keeps the loss mitigation representative involved in the game and talking to you (or your lawyer), and whether that person has a minimal level of motivation and intelligence, or whether they shut that process down.

In a situation I was recently involved in for a client, the lender had first denied the loan mod prepetition because the borrower’s income wasn’t high enough. When he resubmitted with different numbers, the loan mod was denied because he made too much.  After the bankruptcy petition was filed, and after the discharge was entered, the lender called me telling me that a loan mod had actually been approved. But when they sent me the documentation, all it was was a new, blank application intended to start the loan mod application process all over again.

Real chances of getting a loan mod are impacted by a lot of different factors, some logical and some which make no sense at all.  Bankruptcy may be a factor, but it doesn’t need to drive the end result.

I get a lot of questions about bankruptcy basics:  What’s the difference between Chapters 7, 11 and 13: What is a discharge? What can I keep?  What will I lose?

Here, without fanfare or embellishment, is how the federal government describes the process.  All in all, I think it’s a pretty good presentation, though of course, it lacks the “inside baseball” reality from the trenches that you can get from an attorney who spends a lot of time in the Bankruptcy Court.  For that, you’ll have to pick up a phone.

I do not claim authorship of the following:  It is extracted verbatim from the Federal Court’s website, and the link to the original is here.  I have omitted sections relating to Chapters 9 and 12 as they don’t apply to the vast majority of people.  If you have been told that they might apply to you, then check the link above.

Over the coming weeks I will also reprint some of the specific information on Chapters 7 and 13.

Article I, Section 8, of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies.” Under this grant of authority, Congress enacted the “Bankruptcy Code” in 1978. The Bankruptcy Code, which is codified as title 11 of the United States Code, has been amended several times since its enactment. It is the uniform federal law that governs all bankruptcy cases.

The procedural aspects of the bankruptcy process are governed by the Federal Rules of Bankruptcy Procedure (often called the “Bankruptcy Rules”) and local rules of each bankruptcy court. The Bankruptcy Rules contain a set of official forms for use in bankruptcy cases. The Bankruptcy Code and Bankruptcy Rules (and local rules) set forth the formal legal procedures for dealing with the debt problems of individuals and businesses.

There is a bankruptcy court for each judicial district in the country. Each state has one or more districts. There are 90 bankruptcy districts across the country. The bankruptcy courts generally have their own clerk’s offices.

The court official with decision-making power over federal bankruptcy cases is the United States bankruptcy judge, a judicial officer of the United States district court. The bankruptcy judge may decide any matter connected with a bankruptcy case, such as eligibility to file or whether a debtor should receive a discharge of debts. Much of the bankruptcy process is administrative, however, and is conducted away from the courthouse. In cases under chapters 7, 12, or 13, and sometimes in chapter 11 cases, this administrative process is carried out by a trustee who is appointed to oversee the case.

A debtor’s involvement with the bankruptcy judge is usually very limited. A typical chapter 7 debtor will not appear in court and will not see the bankruptcy judge unless an objection is raised in the case. A chapter 13 debtor may only have to appear before the bankruptcy judge at a plan confirmation hearing. Usually, the only formal proceeding at which a debtor must appear is the meeting of creditors, which is usually held at the offices of the U.S. trustee. This meeting is informally called a “341 meeting” because section 341 of the Bankruptcy Code requires that the debtor attend this meeting so that creditors can question the debtor about debts and property.

A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial “fresh start” from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision:

[I]t gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.

Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. This publication describes the bankruptcy discharge in a question and answer format, discussing the timing of the discharge, the scope of the discharge (what debts are discharged and what debts are not discharged), objections to discharge, and revocation of the discharge. It also describes what a debtor can do if a creditor attempts to collect a discharged debt after the bankruptcy case is concluded.

Six basic types of bankruptcy cases are provided for under the Bankruptcy Code, each of which is discussed in this publication. The cases are traditionally given the names of the chapters that describe them.

Chapter 7, entitled Liquidation, contemplates an orderly, court-supervised procedure by which a trustee takes over the assets of the debtor’s estate, reduces them to cash, and makes distributions to creditors, subject to the debtor’s right to retain certain exempt property and the rights of secured creditors. Because there is usually little or no nonexempt property in most chapter 7 cases, there may not be an actual liquidation of the debtor’s assets. These cases are called “no-asset cases.” A creditor holding an unsecured claim will get a distribution from the bankruptcy estate only if the case is an asset case and the creditor files a proof of claim with the bankruptcy court. In most chapter 7 cases, if the debtor is an individual, he or she receives a discharge that releases him or her from personal liability for certain dischargeable debts. The debtor normally receives a discharge just a few months after the petition is filed. Amendments to the Bankruptcy Code enacted in to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 require the application of a “means test” to determine whether individual consumer debtors qualify for relief under chapter 7. If such a debtor’s income is in excess of certain thresholds, the debtor may not be eligible for chapter 7 relief.

Chapter 13, entitled Adjustment of Debts of an Individual With Regular Income, is designed for an individual debtor who has a regular source of income. Chapter 13 is often preferable to chapter 7 because it enables the debtor to keep a valuable asset, such as a house, and because it allows the debtor to propose a “plan” to repay creditors over time – usually three to five years. Chapter 13 is also used by consumer debtors who do not qualify for chapter 7 relief under the means test. At a confirmation hearing, the court either approves or disapproves the debtor’s repayment plan, depending on whether it meets the Bankruptcy Code’s requirements for confirmation. Chapter 13 is very different from chapter 7 since the chapter 13 debtor usually remains in possession of the property of the estate and makes payments to creditors, through the trustee, based on the debtor’s anticipated income over the life of the plan. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received. The debtor is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. The discharge is also somewhat broader (i.e., more debts are eliminated) under chapter 13 than the discharge under chapter 7.

Chapter 11, entitled Reorganization, ordinarily is used by commercial enterprises that desire to continue operating a business and repay creditors concurrently through a court-approved plan of reorganization. The chapter 11 debtor usually has the exclusive right to file a plan of reorganization for the first 120 days after it files the case and must provide creditors with a disclosure statement containing information adequate to enable creditors to evaluate the plan. The court ultimately approves (confirms) or disapproves the plan of reorganization. Under the confirmed plan, the debtor can reduce its debts by repaying a portion of its obligations and discharging others. The debtor can also terminate burdensome contracts and leases, recover assets, and rescale its operations in order to return to profitability. Under chapter 11, the debtor normally goes through a period of consolidation and emerges with a reduced debt load and a reorganized business.

The bankruptcy process is complex and relies on legal concepts like the “automatic stay,” “discharge,” “exemptions,” and “assume.” Therefore, the final chapter of this publication is a glossary of Bankruptcy Terminology which explains, in layman’s terms, most of the legal concepts that apply in cases filed under the Bankruptcy Code.

The Wall Street Journal recently ran an article about how, when small businesses are forced to file for bankruptcy protection, the inevitable result is that it usually takes the owners down with it. This is extremely common, and far more frequently the rule than the exception.

Why does this happen? Why, if the proprietor has gone through the expense and trouble to create a corporation or a limited liability company (“LLC”) do these things wind up being just so much superfluous window dressing right at the moment when you really need them to step up and do their job?  (Their job being to protect your assets when things go sour.)  Because the corporation or limited liability company formed for the needs of the of the small business owner usually doesn’t have adequate assets or resources to give any comfort to creditors–bank lenders most commonly–and so the lender wants as much security for the loans as possible. Enter the concept of the personal guaranty.

If ABC Corp. wants to borrow $1 million for an operating loan but only has assets of $50k of office furniture, computers, fixtures, etc., the bank is going to want some other security. And if ABC Corp’s sole shareholder has a few hundred thousand dollars in equity in his home, then the bank is going to want a security interest in that. Plus whatever else the owner may own. So the bank demands a personal guaranty from owner, which are usually so broad in what they cover that they renders the entire concept of the LLC or the corporation almost completely useless. And it happens with such efficient thoroughness and with such frequency, that it’s probably safe to say that if a personal guaranty is involved, then don’t even bother with the corporation or LLC. (Except maybe for tax or accounting purposes but we won’t go into that here.)

Another place where this pops up is in the single purpose LLC formed for the purpose of owning real property. I have taken quite a few people through Chapter 7s recently who had a bunch of LLC’s (or the increasingly popular Delaware “Series LLC”) that had been formed to own real estate. The problem is that banks won’t lend money for investment real estate to an LLC on the same terms that then will lend for owner-occupied residential property. They usually want 30% to 40% down depending on the asset. Why? Because the bank wants the owner to have “skin” in the game so that he won’t walk away.

So here’s what happens.  (Or what was happening until things crashed in 2007.)

California resident finds great deal on 3br new construction home in Anytown, Utah (for example only). His real estate broker hooks him up with a loan broker to line up the financing. Owner has nothing to put down, and has read somewhere that investment real estate should be owned by an LLC to “protect his assets.” So Owner goes out and pays some lawyer $1,500 to form a fancy “Delaware Series LLC” for the purpose of owning the investment real estate in Utah. But here’s where the fancy plan derails: Bank won’t lend100% to an LLC, and the loan broker is usually too 1.) greedy 2.) stupid 3.) dishonest 4.) clueless to properly advise Owner. So Owner gets the stack of loan docs, all of which show that it is Owner as an individual, not Owner’s Delaware Series LLC that is the actual borrower on the loan.  Deal closes and Owner gets his house. At this point Owner may transfer title to the LLC in the misguided belief that he is actually using this fancy legal device that he paid the lawyer $1,500 to create for him. After that Owner installs tenant, hires management service, and sits back to starts to collect the rent.

Things go great until 2007 or 2008 when the when the world comes crashing down. The house that Owner bought for $265,000 is now worth about $200,000 or less, the tenants have moved out, and because of the crash in housing prices, Owner can’t rent the property for enough to cash flow the loan, taxes and other expenses. Owner is now officially upside down (or under water) and is having to send checks form California every month just to meet the expenses. So Owner goes to a new lawyer. In many cases, this is me.

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