Arizona Judge Grants Discharge Despite Default on Direct-Pay Mortgage

Adopting the minority interpretation, Bankruptcy Judge Madeleine C. Wanslee of Phoenix decided that failure to make all direct mortgage payments does not bar a chapter 13 debtor’s discharge if “there are no indicia of wrongdoing.”

The Facts

A couple filed a chapter 13 petition in 2013 and confirmed a 41-month plan. They cleared up almost $16,000 in arrears on their mortgage through payments to the trustee. Utilizing an option in Arizona’s mandatory model plan, the debtors elected to make ordinary monthly mortgage payments directly to the holder of the mortgage, thus avoiding the fees otherwise owing to the trustee.

During the 41-month life of the plan, the debtors made all required payments to the trustee plus those they made directly to the mortgagee. However, they stopped making direct mortgage payments three months after completing payments to the trustee.

The trustee moved to deny the couple’s discharges under Section 1328(a) and dismiss the case, contending the couple had not made “all payments under the plan.” In her 19-page opinion on March 28, Judge Wanslee disagreed with the trustee and granted the couple their discharges.

The Statute and Its Inconsistent Language

The governing statute, Section 1328(a), uses similar but different language in the same sentence. First, the section commands the judge to issue a discharge when the debtor has completed “all payments under the plan.” The subsection then says that the debtor receives a discharge “of all debts provided for by the plan.” Is the different phraseology a distinction without a difference?

Judge Wanslee found no controlling precedent in the Ninth Circuit. She noted how bankruptcy judges in Illinois disagree on the outcome.

The phrase “under the plan” is more narrow than “provided for by the plan,” Judge Wanslee said. She concluded that “under the plan” only refers to payments made to the trustee, because the phrase historically has “been understood to mean a debtor’s payments to a trustee.”

Rule 3002.1

Judge Wanslee went on to say that Bankruptcy Rule 3002.1 has been “misapplied by courts that deny discharges and dismiss cases based solely on direct pay post-petition mortgage defaults.” She explained that the rule “was designed to be a rule of creditor disclosure, not a procedure for denial of discharge.”

Furthermore, Judge Wanslee said that the only remedy in Rule 3002.1 is applied against “non-compliant creditors who fail to properly disclose mortgage payment changes.” There is no provision in the Code or rules, she said, requiring dismissal without discharge as a sanction for missing direct mortgage payments.

The Equities

Beyond the statute and rules, Judge Wanslee analyzed the equities. The debtors, she said, had made mortgage payments for almost four years, during the entire life of the plan. Moreover, the mortgagee had recovered almost $16,000 in arrears. 

Of course, the mortgage debt was automatically excepted from discharge by Section 1328(c), and default entitled the lender to foreclose. To deny discharge under these facts, Judge Wanslee said, “would be excessively harsh,” because the mortgage lender who received direct payments was “not materially affected by the chapter 13 discharge.”

Given that the debtor did not default on the mortgage until after completing payments to the trustee, Judge Wanslee said that denying discharge would be “a draconian and unfair result.”

In conclusion, Judge Wanslee added that denying discharge would be “nonsensical” because “Arizona is an anti-deficiency state” where the lender never would have been able to collect the mortgage debt as a personal obligation of the debtors. The lender, she said, could not have recovered more in bankruptcy or out, and “every other creditor received exactly what the Plan proposed to pay them through” the trustee.

Because she said there was no evidence “of gamesmanship, bad faith, or other mischief with respect to post-confirmation mortgage payments,” Judge Wanslee denied the motion to dismiss and ruled that the debtors were entitled to discharges.

Observations

Judge Wanslee’s opinion could be distinguished from cases with defaults on direct mortgage payments during the life of the plan. Her opinion also does not lay down a bright-line rule one way or the other, because she left the door open to denial of discharge if the mortgage default occurred earlier in the case or if the equities did not favor the debtor.

Bright-line rules are convenient, but they convert judges into robots and deprive them of the ability to be courts of equity. Perhaps direct-pay mortgage defaults are not amenable to bright-line rules, especially because mortgage debt is not discharged, and the lender is not prejudiced by the entry of discharge.

For some of ABI’s coverage of other cases on direct-pay mortgage defaults, click here, here, here, and here.