Bankruptcy Reform Act: The Fundamental Changes for Lenders
By: RYAN T. MURPHY
December 2005
The President signed the Bankruptcy Abuse Prevention and Consumer Protection Act (the “Reform Act”) on April 20, 2005. Most of its provisions apply to bankruptcy cases filed after October 17, 2005.
Following Katrina, a few members of Congress presented bills to stay the implementation of the Reform Act as to the country as a whole or states directly affected by the hurricane. Those bills were not passed. But the United States Trustee has stated that Katrina may constitute “special circumstances” that would not require an individual Chapter 7 (liquidation) debtor that earns more than the state median income to devote a portion of her future income to creditors. Special circumstances will likely be restricted to those displaced by Katrina.
As a whole, the Reform Act tilts the balance of power toward creditors, including banks. The principal change requires debtors to repay at least a portion of their debts over 5 years if they earn more than the state median income. Below is a summary of the most salient provisions affecting lenders. The changes alter the legal rights of debtors or creditors; therefore, banks should consult with an attorney when a bankruptcy case is commenced.
Rollback of the Automatic Stay
A debtor will often file a series of bankruptcy cases to invoke the automatic stay (a bar that precludes a creditor from taking any action against debtors or their property) to halt proceedings including foreclosures. The Reform Act significantly undercuts the debtor’s ability to stay the proceedings through serial filings. It provides that the stay shall automatically terminate after 30 days if a second bankruptcy case was filed within one year of the prior case. If a third repeat filing occurs within that one-year period, the automatic stay does not arise.
In cases involving transfers of real property without the consent of the secured creditor or Court approval, or multiple bankruptcy filings involving the same real property, the Court may order relief from the stay. That order, if properly recorded, is binding on all owners of the property for 2 years. When a non-approved transfer of real property or a number of cases are filed with respect to the same property, the bank may seek relief from the stay.
Restrictions on Exemptions
The Reform Act hampers the debtor’s ability to change her domicile to utilize more advantageous exemptions of another state. Under the Reform Act, the debtor’s domicile is where she lived for the 2 years prior to filing. If the debtor did not live in a single state for that period, the debtor is considered to be domiciled in the state in which she lived between 2 and 2½ years before the filing. A trustee will typically investigate this issue.
The use of the homestead exemption as a pre-bankruptcy planning tool for debtors is also curtailed. Any value in excess of $125,000 that is added to a homestead during the approximately 3½ years before the bankruptcy filing may not be exempted unless it was transferred from another homestead in the same state or the homestead is the principal residence of a family farmer. This cap may make more assets available for distribution to creditors.
Reaffirmation and Redemption
The Reform Act requires that the debtor receive an extensive set of disclosures before entering into a reaffirmation agreement – an agreement to pay a debt that would otherwise be discharged in bankruptcy. When a debtor indicates she would like to reaffirm a debt (typically, a home mortgage), disclosures and agreements must be properly documented.
The Reform Act now makes clear that redemption requires full payment of the secured claim at the time of redemption. Under prior law, the value of collateral for purposes of redemption was measured by what the creditor would receive upon repossession. Under the Reform Act, the value of personal property securing a claim in a case of an individual debtor in Chapter 7 or 13 (debt repayment) is the cost to the debtor of replacing the property, which typically should be greater than the repossession value for a secured creditor. If the property was acquired for personal, family or household purposes, the replacement cost is the retail price for similar property.
The Reform Act eliminates an option that a Chapter 7 debtor might have had to retain collateral without redeeming or reaffirming, by simply maintaining current payments on the secured debt. This is accomplished by two provisions. First, a debtor cannot retain any personal property that is subject to a purchase money security interest unless the debtor within 45 days after the first meeting of creditors redeems the property or enters into a reaffirmation agreement. Second, the automatic stay is also terminated with respect to personal property that is collateral for any secured claim where the debtor fails to file a statement of intent as to whether he will retain or surrender the property. If it is to be retained, the debtor has 30 days after the meeting of creditors to enter into a reaffirmation of the debt. Thus, a secured creditor must be informed within 30 to 45 days whether the debtor will seek to retain the collateral. If not, the secured creditor can begin to proceed with repossessing the collateral after ensuring that the automatic stay no longer applies.
Chapter 11 Reorganizations
The Reform Act does not directly alter the rights of a lender in relation to a business debtor that files a Chapter 11 reorganization. It does expand and raise the priority of claims of other classes of creditors. None of these claims take priority over a lender’s security interest in collateral; however, the expanded and elevated rights will indirectly affect the lender vis-à-vis the debtor. The new and elevated rights will require the debtor to expend additional funds at the outset of the case and at confirmation of the plan of reorganization. This may make liquidation or a sale, either outside or in bankruptcy, the only option for some debtors. Thus, a commercial lender should remain cognizant of the expanded rights of other creditors because they place additional financial burdens upon the debtor.