On the very same day, the Fifth Circuit and Bankruptcy Judge Keith L. Phillips of Richmond, Va., wrote opinions describing the limited circumstances under which a chapter 7 debtor may object to the claims of other creditors or object to the sale of estate assets.

The Fifth Circuit trotted out the three typical exceptions to the rule that a chapter 7 debtor may not object to claims. Judge Phillips created a fourth exception as a logical extension of the other three.

The Fifth Circuit’s General Rules on a Debtor’s Standing

In the Fifth Circuit, the individual debtor’s chapter 11 case had been converted to chapter 7. The debtor objected to the most significant claims filed in the chapter 7 case. Bankruptcy Judge Katharine M. Samson of Gulfport, Miss., overruled the debtor’s objections, finding that the debtor was not a party in interest and lacked standing. The district court affirmed on the same grounds.

The Fifth Circuit affirmed on October 11 in a nonprecedential, per curiam opinion.

Citing Section 502(a), the appeals court said that “only ‘parties in interest’ have standing to object to proofs of claim” in bankruptcy cases. Section 502(a) says that a claim is allowed “unless a party in interest, including a creditor of a general partner in a partnership that is a debtor in a case under chapter 7 of this title, objects.”

Although “party in interest” is not defined, the Fifth Circuit said that “a debtor generally cannot object to claims,” citing a decision by Bankruptcy Judge Robert L. Jones of the Western District of Texas. Citing one of its own per curiam decisions along with bankruptcy court opinions from New York and Louisiana, the appeals court described three exceptions to the general rule that debtors may not object to claims.

First, debtors may object to claims where there is the possibility of a surplus after the payment of claims. Second, a debtor may object when reducing claims may result in larger distributions to holders of nondischargeable claims. Third, a debtor may object when a trustee has unjustifiably failed to object.

In the case on appeal, only the third exception conceivably applied, but the Fifth Circuit said that the debtor had presented no evidence that the failure to object was unjustifiable.

The Fifth Circuit upheld dismissal of the appeal because the debtor lacked standing.

The Virginia Case

In the case before Judge Phillips, the individual debtor’s chapter 11 case also had been converted to chapter 7, where the debtor voluntarily waived discharge. The debtor scheduled assets worth about $250,000 and debts totaling almost $400,000. The mortgagee, with a claim of more than $200,000, had filed a motion to modify the automatic stay.

The chapter 7 trustee filed a motion to sell the mortgaged property for about $220,000. Rather than object to the sale, the mortgage-holder cut a deal with the trustee where the secured creditor would accept about $183,000 from the sale and allow the trustee to retain the remainder for distribution to unsecured creditors and others.

The debtor objected to the sale and claimed that he was entitled to be paid his $25,000 state homestead exemption. Judge Phillips first dealt with the debtor’s standing to object.

On standing, Judge Phillips was guided by Willemain v. Kivitz, 764 F.2d 1019 (4th Cir. 1985), where the Fourth Circuit held that a chapter 7 debtor had no standing to object to the sale of the debtor’s interest in a limited partnership. For a debtor to have standing, he quoted the appeals court as saying that “a debtor must ‘demonstrate that an alternative sale of the interest would return solvency to his estate.’” Id. at 1022.

Furthermore, the Fourth Circuit said, “[a] favorable appraisal without a corresponding actual purchaser cannot be allowed to stymie a bankruptcy court as it attempts to decide expeditiously matters before it.” Id. at 1023, n.7.

Even with the secured creditor’s carveout, there would be no distribution to the debtor and, thus, ordinarily no standing for an objection to the sale. Despite the insolvent estate, Judge Phillips explored whether there could be an exception to the general rule arising from the secured creditor’s carveout.

Judge Phillips on Carveouts

“Courts are divided,” Judge Phillips said, “on whether a debtor is entitled to assert his homestead exemption in a Trustee-negotiated carveout from a secured creditor’s lien.” On the issue, he cited a leading article by Prof. Ralph Brubaker, Short Sales, Mortgagee Give-up, and the Debtor’s Homestead Exemption: Taking Bankruptcy’s Priority Rules Seriously, 40 No. 11 Bankr. L. Letter NL 1 (2020), and a case from the Southern District of New York, In re Stark, 2020 WL 5778400 (Bankr. E.D.N.Y. 2020), rev’d Stark v. Pryor (In re Stark), 20-CV-4766(EK), 2022 WL 2316176 (E.D.N.Y. 2022). To read ABI’s report on the district court reversal, click here.

In Stark, the bankruptcy court had barred the debtor from asserting a homestead exemption against the carveout. Reversing under the New York exemption statute, the district court found that the carveout represented value of the property subject to the debtor’s homestead exemption. The district court held that the homestead exemption did apply to the carveout.

In view of the Supreme Court’s decisions in Jevic and Law v. Siegel, Judge Phillips decided that exemptions can be denied only on the statutory grounds contained in the Bankruptcy Code. He therefore concluded that he “must side with those courts that prioritize a debtor’s homestead exemptions.”

Judge Phillips held that the debtor had a “pecuniary interest” in the sale because “[t]here is nothing in the Bankruptcy Code that supports denying a debtor’s exemption in his homestead when a carveout agreement with a secured creditor is the source of unencumbered funds that are available to apply to the exemption.”

Judge Phillips found that the debtor had standing to object to the sale. However, it wasn’t a victory for the debtor.

Judge Phillips said that the record lacked sufficient evidence to establish whether there would be a “meaningful distribution” for unsecured creditors after paying costs of the sale and all secured claims. He scheduled a further hearing on the sale motion and the lender’s motion to modify the automatic stay.

The opinions are Okorie v. Citizens Bank (In re Okorie), 24-60255 (5th Cir. Oct. 11, 2024); and In re Atiyat, 21-32555 (E.D. Va. Oct. 11, 2024).