One of the most challenging aspects of loan servicing is handling loans involved in bankruptcy proceedings. These loans require special expertise and can be costly to administer. Many servicers have become increasingly sophisticated in dealing efficiently with some of the special problems of bankruptcies, including the automatic stay, reorganization, plan confirmation or objection and the cramdown. But the bankruptcy law entails many more issues, some of which may impose significant liability on servicers and their investors if not correctly addressed. In particular, many servicers do not understand the legal ramifications of a discharge of the debt in a Chapter 7 bankruptcy and how common servicing practices may run afoul of the laws that concern discharge.

Chapter 7 In a Nutshell

In Chapter 7, the debtor turns over to the Chapter 7 trustee all of his nonexempt assets which the trustee then sells distributing the proceeds to creditors under a fairly complex statutory scheme. In return, the debtor obtains a discharge approximately six months after the filing of the case.

The discharge provides that the debtor is no longer personally liable for the debt. The discharge order also enjoins creditors from asserting any personal liability over the debtor. Attempts to collect the debt which appear to be attempts to make the debtor personally liable after the discharge order may subject the creditor to significant liability. Servicers generally do not focus on this part of the discharge order because the discharge does not appear to immediately affect them. The mortgage lien on the secured property remains after discharge. Further, the discharge terminates the stay against foreclosing on the property. Therefore, the discharge order is often merely viewed as a mechanism to get relief from stay to allow foreclosure.

Servicers need to be made aware that the discharge order has many more ramifications than simply terminating the stay as to the debtor and that effective servicing after the discharge order is fraught with problems. As is more fully noted below, the Chapter 7 discharge has a big place in the hearts of bankruptcy judges. It essentially provides the debtor with a fresh start free from prior liability.

There are ways for the debtor and creditor to negotiate away the fresh start by agreeing that the debtor will continue to be personally liable for the debt even after discharge. However, courts are very reluctant to approve these reaffirmations of the debt and go out of their way to find such agreements invalid.

The Chapter 7 Discharge

To understand these problems, one must first understand what a discharge does and does not do. First, as noted above, the discharge order terminates the stay with respect to the foreclosure on the debtor’s secured property. However, this is only an ancillary part of discharge. The major function of "discharge" is to end the personal liability under the loan. In short, after discharge the lender can still foreclose and recover the property, but there is no right to obtain a deficiency judgment.

Many servicers seem confused by this concept. Contrary to popular belief, a bankruptcy discharge does not terminate the loan. Instead, upon discharge the loan becomes what is commonly known as a "nonrecourse" loan. This concept should not be troubling to servicers. Many loans being serviced today are nonrecourse loans from the start, i.e. they are nonrecourse even without a bankruptcy discharge. For example, most purchase money mortgage loans in California are nonrecourse loans. Accordingly, a lender can foreclose a California nonrecourse purchase money loan, but the lender cannot obtain a deficiency judgment. Similarly, loans that have been discharged in bankruptcy are nonrecourse loans. All the terms of the note apply (e.g., the borrower still must make payments; the servicer can assess late charges and impound the loan, etc) but the sole remedy in the event of default is to foreclose; there is no right to obtain a deficiency judgment.

Reaffirmation Agreements

The Bankruptcy Code provides a variety of ways to avoid the loss of personal liability caused by the discharge order. The most common method is known as a reaffirmation agreement. Here the debtor and lender may agree to continue the personal liability under the note provided five exacting conditions are met: (1) the agreement must be made prior to discharge; (2) the agreement must advise the debtor that the reaffirmation may be rescinded up to sixty days after it is filed; (3) the agreement must be filed with the court; (4) the debtor cannot already have rescinded the agreement within the proper time frame; and (5) the agreement must be in the best interest of the debtor. A reaffirmation agreement, which does not comply fully with these provisions, is void and unenforceable.

Reaffirmation agreements are greatly disfavored by bankruptcy judges. 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. Many judges have developed their own special rules, many of which are unpublished, to assure that reaffirmation agreements are discouraged. Thus, following the Bankruptcy Code does not ensure that a reaffirmation agreement is valid. In addition, any attempt to assert personal liability over the debtor without a proper reaffirmation agreement is considered a flagrant violation of the injunction contained in the discharge order resulting in severe damages.

The Problem

Today, those few servicers who go beyond the simple relief from stay issues relevant to the discharge order seem narrowly focused on the loss of deficiency rights caused by the Chapter 7 discharge. Accordingly, they limit their actions to seeking reaffirmation agreements to maintain those deficiency rights. This approach is fraught with problems and misses the mark. The real liability to servicers results from an improper assertion of personal liability after discharge where there is no reaffirmation agreement or there has been an improper reaffirmation agreement. This liability most often arises from improper actions taken after discharge in collection, foreclosure and loss mitigation. The loss of deficiency rights is insignificant in comparison to the liability that Servicers subject themselves to by improperly servicing a loan subject to a Chapter 7 discharge.

The Sears Cases

Sears has recently paid over $125 million in damages as a class action settlement for failure to properly service its credit card debt in various Chapter 7 proceedings. Its problem is a lesson to us all.

Upon receipt of the notice of commencement of a case, it was Sears’ practice to attempt loss mitigation. As is common in our field, Sears would send to debtors a proposed workout. This agreement was accompanied by a letter giving the debtor the option to sign the agreement, redeem the merchandise or return the product to Sears. As an additional inducement to signing the agreement, Sears agreed to increase the debtor’s credit limit.

Unfortunately, the documents sent to the debtors were misleading. They included language alleging that the debt was nondischargable where there were no facts to support nondischargeability. In a series of cases, the courts found the workouts to be improper reaffirmation agreements and all funds collected under the agreement a violation of the discharge injunction. The courts also found that Sears should have known that the agreements were improper reaffirmation agreements and it should have taken steps to correct the problem including: (1) informing the debtor the agreement was not filed and therefore ineffective; (2) discontinuing billing the account; or (3) refunding the payments made by the debtor. The Federal Trade Commission also filed an action asserting Bankruptcy Code and mail fraud violations. The Sears cases are only one example of the imposition of liability, which has been experienced by numerous credit issuers.

The lesson from these cases is "be aggressive, but don’t be Sears." Obviously, workout agreements that attempt to assert personal liability after the discharge order need to comply with the exacting requirements of reaffirmation agreements. Not only do such agreements need to be filed with the court, they must be clear and fair.

Mortgage Servicing And Reaffirmation Agreements

Some mortgage servicers are under the mistaken impression that reaffirmation agreements should be sought in every case. There are two main rationales for this belief: (1) that it is important to preserve a lender’s deficiency rights; and (2) that it allows for the effective servicing of the loan after discharge. Both rationales fail because in the final analysis the risks of doing reaffirmation agreements far outweigh the practical benefits of the results sought.

It is true that a properly drafted reaffirmation agreement that meets the statutory requirements can preserve a lender’s deficiency rights. However, how often are those rights truly exercised? In other words, how often do servicers actually recover from deficiencies and how much do they recover? The numbers are surprisingly small. And in states where there are no deficiency rights to assert (such as most purchase money loans in California), it makes no sense to reaffirm for this reason.

Conversely, seeking reaffirmation of the loan to avoid the problems associated with post discharge servicing appears at first look to be beneficial. Once a loan has been discharged, a servicer can no longer assert any person liability against the borrower. Accordingly, many of the standard letters, collection practices and loss mitigation solutions have to be approached in a different manner after the discharge to ensure that there is no attempt to assert personal liability. A proper reaffirmation agreement does avoid these problems.

While sound in concept, in practice this approach fails. It is impossible to obtain reaffirmation agreements on all loans. First, there is no way a servicer can force a borrower to enter into a reaffirmation agreement. And even if the borrower agrees, in certain instances a court can reject the agreement. To make matters worse, most servicing systems do not have a method for determining which loans have been reaffirmed and which have not. And even the most sophisticated systems that can track reaffirmation agreements rely on data from servicing acquisitions where reaffirmations are not tracked. Finally, there is legal authority to support the contention that where a lender refinances its own loan that had previously been discharged, the newly refinanced loan is also subject to the discharge injunction.

Loss Mitigation And Reaffirmation Agreements

During a Chapter 7 proceeding, loss mitigation actions carry great risk to the servicers. A pre-discharge workout that requires the debtor to make any sort of payment will likely be construed by a court as an improper attempt to obtain a reaffirmation agreement. Obviously, servicers do not follow the statutory procedures for a reaffirmation agreement when negotiating workout agreements. Therefore, like the Sears cases, a servicer that enforces a pre-discharge workout agreement after discharge will likely be found to violate the discharge injunction. (Pre-discharge workout agreements also may be found to violate the automatic stay.)

Mortgage Servicing and Chapter 7- Post-Discharge

After the Chapter 7 discharge, the focus changes from entering into improper reaffirmation agreements to acts in violation of the discharge injunction. The discharge order makes clear that servicers cannot take any action to collect a debt as a personal obligation of the borrower. Servicers run afoul of this prohibition in a variety of ways.

Standard Collection/Foreclosure Letters

Many servicers use standard collection and foreclosure letters that threaten personal action against the borrower if payment is not made. These letters violate the discharge injunction and could result in significant liability. The trick here is wording. A servicer can properly threaten foreclosure of the property without violating the discharge injunction. The key is to threaten action against the property as opposed to action against the borrower.

This language, in combination with your counsel’s care in not seeking personal judgment against the discharged borrower, should help to avoid any claim that you are seeking to violate the discharge injunction.

The Fair Debt Warning

Another tricky problem with servicing after the Chapter 7 discharge relates to the Fair Debt Warning. Most servicers wisely service all of their loans as if they were subject to the Fair Debt Collection Practices Act and include language in their documents and on their voice mail providing essentially as follows:

Servicer is a debt collector attempting to collect a debt. Any information you provide can and will be used for that purpose.

While this language comports to the requirements of the Fair Debt Collection Practices Act, it may run afoul of the Chapter 7 discharge injunction. The Fair Debt language can be construed as an attempt to assert personal liability against the borrower. To avoid this interpretation, it is recommended that above language making clear that you are asserting no personal liability be added to your documents and to your voice mail after the Fair Debt warning.

Loss Mitigation Workouts

Finally, all loss mitigation workouts (e.g., loan modifications, forbearance and repayment plans, short sales, etc) should also include the above language. But that alone may not be sufficient. If there is no equity to support the workout agreement, the mere statement that you have limited your rights to the property may be meaningless to the court.

An example puts this into perspective. If you have a completely unsecured note, and you do a workout requiring payment after the Chapter 7 discharge, a statement that you are not asserting personal liability is meaningless. In such a case, and despite your language, there is no equity to recover. The only recovery is from the borrower. Similarly, if you have a loan that is secured by real property where the value of the property is less than the amount owed on the loan, the requirement that payments be made essentially is 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 despite your statements to the contrary.

Summary

Servicing a Chapter 7 loan is complex and can result in significant liability where the servicer fails to properly reaffirm the debt and asserts personal liability against the debtor in violation of the discharge injunction. Courts are increasing 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. For all of these reasons, servicers should take another look at their practices in Chapter 7 cases and ensure that all of their communications make it clear that there is no attempt to assert personal liability after a Chapter 7 discharge.