A recent case shows the potential for interplay between the law of mortgages and bankruptcy.
In that case, Piedmont Capital Mgmt. v. McElfish, No. B316372 (Cal. Ct. App. Aug. 24, 2023), the borrower purchased a home in 2006, acquiring a first deed of trust from one lender, and a home equity line of credit (HELOC) from a second. For convenience, in mortgage parlance, the first loan constitutes the first (or senior) mortgage, while the HELOC constitutes a second mortgage. The HELOC had a 30-year maturity (2036). It also gave the lender the option to accelerate the loan and ask for all past due amounts, which was renewed as each successive month’s payment became due.
The buyer began to experience financial difficulty a few years later, and in or around 2011 and 2012, he stopped paying on the first mortgage and the HELOC, respectively. The holder of the first mortgage foreclosed in 2012, apparently by trustee’s sale. The HELOC was unsatisfied by the sale.
Had the homeowner chosen to file Chapter 7 bankruptcy after the first lender foreclosed, the debt owed to the HELOC lender likely could have been discharged. Again, this is because the collateral was gone. The HELOC was a classic unsecured debt. The homeowner could still likely do so, even after the Court of Appeal’s intervention, because bankruptcy is federal law, and is a different statutory scheme which answers to a different sovereign, i.e., the Federal government.
Instead, the homeowner embarked on four years of litigation, which included the Court of Appeal. The trial court held that 1) the four-year statute of limitations for written contracts applied, 2) that the homeowner had made his last payment in or about 2012, and that therefore, 3) the 2019 lawsuit was time-barred.
Enter the Court of Appeal, which reviewed the HELOC agreement. That Court decided that each monthly payment that came due constituted not only an opportunity to pay the regular monthly amount, but each successive monthly failure to pay gave the HELOC lender the option to accelerate the loan (the “acceleration clause”) and ask for all past due amounts. Because the contract called for monthly payments until 2036, and each successive month gave the HELOC lender the option to invoke the acceleration clause, the lender’s time to seek all past due payment was not even close to running out. There was no bar of the statute of limitations, for amounts that could be demanded up until 2036.
Consumer bankruptcy (“Chapter 7”) has as its goal the liquidation of unsecured debt. The moment that the borrower’s home was foreclosed and taken by the holder of the first mortgage, the security (collateral) for the HELOC was gone. The HELOC became an unsecured debt. A Chapter 7 could have discharged (cancelled) the debt.
As of the time of the Court of Appeal’s decision, the homeowner still owed the HELOC payments. Effective bankruptcy counsel could, however, show him another option that could protect his remaining estate.
THIS POST DOES NOT CONSTITUTE LEGAL ADVICE, NOR CREATE AN ATTORNEY-CLIENT RELATIONSHIP. PLEASE CONSULT AN ATTORNEY.
In 2019, Congress passed the Small Business Reorganization Act of 2019 (“SBRA”), whose Subchapter V specifically allowed small businesses to reorganize, discharge certain debts, and pay back a portion of other debts over a 3- or 5-year period. This latter aspect is similar to the standard Chapter 11 employed for large organizations, such as General Motors, the Los Angeles Dodgers baseball club, or the recent reorganizations of cryptocurrency firms Voyager, Celsius, and FTX.
In the Subchapter V bankruptcy, the debtor proposes the plan of reorganization, and the court has the option to cram it down the creditors’ throats (assuming that the Court believes that the plan is objectively fair). This is called a “non-consensual plan of reorganization” in Subchapter V.
In an interesting twist, however, where the court approves the small business’s nonconsensual plan of reorganization, the SBRA allows small enterprises to discharge their debts, even where the creditor alleges debts that stem from fraud, breach of fiduciary duty, tax fraud, malicious conduct, or any other exception to discharge stated under 11 USC Sec. 523(a).
In other words, the exceptions to discharge (debts that cannot be cancelled) stated in 11 USC Sec. 523 (a) do not apply to small business, where the court approves the nonconsensual plan of reorganization.
This may lead to harsh results. For example, in a recent case, the creditor who claimed she was injured by the company’s malicious conduct found her claim to barred, or “discharged.” As a result of the explicit language of the SBRA, her claim was effectively cancelled. The court explained that, if Congress had intended a different result in such a case, it would have said so in the law.
In re Off-Spec Solutions, LLC (Kristina Jayn Lafferty v. Off-Spec Solutions LLC, et al)
BAP ID-23-1020-GCB; Adv. No. 22-06020-NGH (Ninth Circuit Court of Appeals, Bankruptcy Appellate Panel; Appeal from the Bankruptcy Court for the District of Idaho; Filed July 6, 2023)
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In 2010, a California property developer, Momentum, signed a contract to have an oil well drilled on its real estate. About 2 years into the drilling, in 2012, Momentum, transferred the property to a related but separate entity, Pyramid, for 55¢, without notifying the drilling company. The drilling company apparently did not strike oil, because Momentum sued for breach of contract in 2014, even though it no longer owned the land (an obvious legal contradiction).
Momentum lost at trial (possibly for lack of standing, i.e., it no longer owned the land, and hence, the contract), and a judgment for the drilling company was entered in May 2018 (less than seven years after the 55¢ transfer).
Momentum promptly (June 2018) filed for Chapter 7 (liquidation) bankruptcy, saying that it had no assets.
The bankruptcy put the 55¢ sale in the spotlight. A “fraudulent transfer” is defined as a conveyance intentionally done to deprive creditors of the asset, or a transfer for less than reasonable value, which is made when the debtor is insolvent, or which transfer renders the debtor insolvent. 11 US Code Sec. 548 (a)(1)(A)-(B); Uniform Voidable Transactions Act, § 4(a), at 19.
The bankruptcy Trustee (Diane Weil) discovered the relationship between Momentum and Pyramid, and sued to undo the land deal, as a transfer intended to frustrate creditors. This is an interesting argument, because Momentum sued the drilling company, and not the other way around. The Trustee could have reasoned that the common ownership and management of Pyramid and Momentum was suspicious, and the 2012 transfer could render a countersuit against Momentum meaningless.
The bankruptcy court allowed the Trustee’s suit. California’s Universal Voidable Transactions Act (Civil Code Sec. 3439.09) has a 7-year statute of repose (the maximum time to sue for a wrongful act, even where the other party has not been harmed), and Bankruptcy Code Sec. 546 extends for 2 years the Trustee’s ability to sue on any fraud claim that exists at the time the bankruptcy is filed.
In this case,
1) Momentum in 2012 sold the property to its sister entity, Pyramid, for 55 cents without notifying the oil driller;
2) Momentum became liable for the fraudulent transfer in May 2018, when it lost the Superior Court case against the driller;
3) Momentum filed for Chapter 7 bankruptcy in June 2018;
4) Because California’s 7-year statute of repose for the fraudulent transfer had not expired when Momentum filed for bankruptcy in 2018, the bankruptcy Trustee had an additional 2 years (a maximum of 7 + 2 years) to begin fraud proceedings in the bankruptcy court, with intent to undo the sale and take control of the property, under 11 USC Sec. 546.
The Trustee began her fraudulent transfer proceedings against Momentum and Pyramid in 2019, pursuant to California law. The bankruptcy court held that the Trustee’s action was timely, and the Bankruptcy Appellate Panel affirmed.
WEIL v. PYRAMID CENTER, INC. (IN RE MOMENTUM DEV. LLC), 649 B.R. 33 (9th Circuit Bankruptcy Appellate Panel; Filed March 2, 2023)
WARNING: THIS POST DOES NOT CONSTITUTE LEGAL ADVICE; PLEASE CONSULT AN ATTORNEY ! ! !
Bankruptcy Appellate Panel held that the discharge of a company in a Chapter 11, Subchapter V case did not release the person who owned the LLC from the same debt. Essentially, the owner (the only member of the LLC) was a co-debtor, and co-debtors do not receive the benefit of the bankruptcy debtor’s discharge. 11 USC Sec. 524 (e).
As a result, state-court litigation against the LLC owner by a creditor could continue for that same debt, because under the applicable state law (Delaware), “alter ego” liability was derivative. The owner was liable derivatively; the allegation in the complaint was not that the owner and the company were the same entity. The state court litigation did not violate the discharge injunction of 11 USC Sec. 524 (a).
In re RS Air (BAP No. NC-23-1008-FSG), filed June 2, 2023.
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Where debtors claimed “100% Fair Market Value” of their home as protected by the Homestead Exemption, and there was no timely objection by the US Trustee, then the claim of exemption protected the full amount of money generated by the sale of the home, after payment to the mortgage lender, even though the “FMV” number claimed was over the allowable limit.
In re Masingale (9th Circuit Bankruptcy Appellate Panel) 644 B.R. 530, Opinion of Farris J.
Filed November 2, 2022.
The Ninth Circuit Court of Appeal applied the “snapshot rule,” and applied the Homestead Exemption that applied to the debtor’s residence on the date the bankruptcy petition was filed ($600,000), and not the amount of the exemption in existence on the date the creditor’s $477,000 judgment was entered (which was 4 years before the bankruptcy petition was filed). Because the total of debtor’s 1) homestead exemption ($600K) + 2) the balance of 2 outstanding mortgages ($551K) + 3) the creditor’s judgment ($477K), was greater that the value of the debtor’s home ($1.1 million), the entire judgment was uncollectible (the debtor avoided the judgment).
The Court of Appeal cited to 11 USC Sec. 522(f) [debtor’s avoidance of liens]; Owen v. Owen, 500 U.S. 305, 308, 111 S.Ct. 1833, 114 L.Ed.2d 350 (1991) and White v. Stump, 266 U.S. 310, 313, 45 S.Ct. 103, 69 L.Ed. 301 (1924) (describing the “snapshot rule”).
Barclay v. Boskoski, 52 F.4th 1172, United States Court of Appeals, Ninth Circuit.
Argued and Submitted September 23, 2022 Pasadena, California.
Court’s Opinion Filed November 14, 2022.