We are often asked the question: can a loan be modified after a Chapter 7 Bankruptcy Discharge? While we are not Bankruptcy attorneys, after much research and inquiry wih BK attorneys, the simple answer appears to be “Yes” … if both the lender and borrower agree to do so. However, the more important questions that need to be answered are: 1) whether modifying an otherwise discharged loan would make you liable again for the debt; and 2) whether any such modification would be legally enforceable. In this Article, we’ll address those questions.
Nature of Real Estate Secured Debt
A real property loan has two parts: 1) The Promissory Note which establishes your personal liability to repay the debt; and 2) the Security Instrument (Deed of Trust or Mortgage) which gives the lender a security interest in the real property. If the borrower defaults in payment under the Note, the Security agreement gives the lender a power to foreclose and sell the property. In most States, including California, this foreclosure action must be taken before a lender could seek to get a money judgment against the borrower.
The Role of Bankruptcy
Sometimes a person may be so in debt that they cannot pay everything. A Bankruptcy is a legal proceeding designed to give the debtor a “fresh start” either by extinguishing personal liability for their debts (Chapter 7) or creating a reorganization plan to pay some and extinguish the rest (Chapter 13). While Bankruptcy can eliminate liability, it does not transfer real estate that may be securing those debts. In a Chapter 7 Bankruptcy Petition, Exhibit B-8 is the Debtor’s Statement of Intention wherein they state what they intend to do with the property. One of those choices is to Reaffirm the Debt. If the borrower elects “Reaffirm”, the debt is not discharged in the Bankruptcy and the personal liability remains. However, concerning real estate secured debt, this usually is not advised.
When the loan is not reaffirmed, the Bankruptcy discharge extinguishes the personal liability under the Note. However, the Bankruptcy does not extinguish the lender’s Security against the property. Thus, after discharge the borrower could keep on paying the loan and keep the property even though they have no personal liability. If they later default in payment, the only thing the lender could do is foreclose on the Security but they cannot get a deficiency judgment against the borrower. …. unless the borrower has somehow later “reaffirmed” the debt. And that is the worry about post-Bankruptcy loan modification.
Impact of Post-Bankruptcy Loan Modification
Since the Bankruptcy discharge eliminated the borrowers “obligations” under the Note, there is no obligation left to modify. If, however, the borrower and lender enter a Modification Agreement, the terms would likely express either a reaffirmation of the debt or, alternatively, a new promise to pay. On paper at least, this post-Bankruptcy agreement would create a new enforceable “obligation” and thus impose personal liability against the borrower for the modified debt. In short, the Modification could arguably reaffirm the previously discharged debt. Whether this would be actually enforceable is another issue.
Post-Bankruptcy Loan Modification Might Not Be Enforceable
Bankruptcy Courts are very reluctant to allow Reaffirmation Agreements within a Bankruptcy since that eliminates the “fresh start” that the Bankruptcy was intended to provide. In essence, such agreements are the antithesis of the purpose of bankruptcy; a reaffirmation gives up the very thing the debtor sought by the filing. Accordingly, judges go out of their way to find reaffirmation agreements improper. Unless reaffirmed, not only is the loan liability extinguished, but any further action to collect upon the discharged debt is prohibited. So, after the Chapter 7 discharge, the focus changes from entering into improper reaffirmation agreements to acts in violation of this discharge injunction. The discharge order makes clear that lenders cannot take any action to collect a debt as a personal obligation of the borrower. However, they can run afoul of this prohibition in a variety of ways.
All loss mitigation efforts (e.g., loan modifications, forbearance and repayment plans, short sales, etc) involve communications with the debtor which could reasonably be construed as debt collection actions even if the lenders include language that states that they are only acting against the property. That may not be enough. If the loan is secured by real property where the value of the property is less than the amount owed on the loan, any requirement that payments be made essentially could be construed as a requirement that the borrower remain personally liable. Accordingly, a payment plan, loan modification or short sale where there is no equity in the property could be found to be a violation of the discharge injunction.
Courts are concerned about the attempt of creditors to avoid the Chapter 7 discharge and are increasingly likely to find that attempted reaffirmations are invalid. In addition, courts are increasingly likely to find that any action that might be construed as a threat of personal liability against the debtor is violative of the discharge injunction. Finally, courts are very willing to assess significant damages against lenders who violate the discharge injunction including allowing recoveries in class action law suits. Section 524 of the Bankruptcy Code provides that an order discharging a debt in a bankruptcy case “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 such debt as a personal liability of the debtor . . . .” 11 U.S.C. § 524(a)(2). The discharge injunction is broad and prohibits any act taken to collect a discharged debt as a personal liability of the debtor.
If any party knowingly violates the discharge injunction, the court may properly hold that party in civil contempt. For example, in a recent case out of Texas, Bank of America had hired collection agencies to pursue debtors even though they knew that the debt had been fully discharged in Bankruptcy. In that case, the Court awarded the debtors: 1) $2,500 in actual damages; 2) $79,839 in attorneys fees; and 3) imposed sanctions against BofA and its collection agency totaling $150,000. (McClure v. Bank of America, Adv. No. 08-4000 (Bankr. N.D. Tex. 11/23/09).
Based upon the foregoing, these conclusions appear accurate:
1. A borrower and a lender can enter into a post-Bankruptcy Loan Modification Agreement. This may be desirable if the borrower is trying to keep the property;
2. The Loan Modification Agreement may create a reaffirmation of the debt that had been extinguished by the Bankruptcy making the borrower once again personally liable for the debt; and,
3. Any such Loan Modification Agreement may be deemed by the Bankruptcy Court as an illegal violation of the Bankruptcy discharge which could result in voiding the Modification and raising damage claims against the lenders.?
The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If your real estate is upside-down and if you are negotiating a Loan Modification – especially if you have filed and been discharged in Bankruptcy – get competent legal advice in your State immediately so that you can determine your best options.