Debt Discharged in Prior Chapter 7 Isn’t Counted in Later Chapter 13 Eligibility

On an issue where the courts are divided, Bankruptcy Judge Ann M. Nevins of New Haven, Conn., ruled that personal liability on a secured debt that was eliminated in a prior chapter 7 discharge is not counted toward the debt limits in a subsequent chapter 13 case.

The decision by Judge Nevins was informed in part by a decision from the Ninth Circuit Bankruptcy Appellate Panel on July 30. Washington v. Real Time Resolution Inc. (In re Washington), 18-1206, 2019 BL 284935, 2019 Bankr. Lexis 2389, 2019 WL 345052 (B.A.P. 9th Cir. July 30, 2019).

In a so-called chapter 20 case, the BAP held in Washington that personal liability extinguished in a prior chapter 7 discharge is not resurrected and is not a claim to be paid in the debtor’s subsequent chapter 13 case. To read ABI’s discussion of Washington, click here.

The Extinguished (?) Personal Liability

Judge Nevins was ruling on motions by the trustee to dismiss two chapter 13 cases. Together, the debtors in both cases had owned a business that went belly up. They had both personally guaranteed about $3 million in business debts and secured those debts with subordinate mortgages on their homes.

They had both filed chapter 7 petitions and received discharges in April 2013. The chapter 7 discharges standing alone meant that the debtors’ personal liabilities on the $3 million subordinate mortgages were no longer personal liabilities, although the chapter 7 discharges did not strip the mortgages from the homes. In legal parlance, the mortgages remained in rem liabilities encumbering the homes but not personal liabilities of the debtors themselves.

To strip down or strip off the subordinate mortgages from their homes, the debtors employed the so-called chapter 20 strategy by filing chapter 13 petitions in August 2018. Because the new filings were entered more than four years after their chapter 7 discharges, they were both theoretically eligible for discharges in the new chapter 13 cases.

One debtor owned a home worth $460,000 that had a first mortgage of about $500,000. Standing alone, Section 506(a)(1) would treat the $3 million subordinate mortgage as a wholly unsecured claim.

The second debtor owned a home worth $175,000 that was subject to a $140,000 first mortgage. Consequently, all but about $35,000 of the $3 million on the subordinate business mortgage would be treated as unsecured under Section 506(a)(1).

The debtors had incurred new unsecured and priority debts after receiving their chapter 7 discharges. They both filed chapter 13 plans proposing to pay $1,400 a month for 60 months, representing a 21% dividend for unsecured creditors.

If the chapter 20 strategy holds up, and if they were to complete all payments under their chapter 13 plans, the debtors planned on stripping off most or all of the subordinate mortgages from their homes while paying nothing on those business debts, because they were no longer personal liabilities as a consequence of the chapter 7 discharges.

Nonetheless, the chapter 13 trustee filed a motion to dismiss, contending that the debts exceeded the limits in Section 109(a). That section makes an individual eligible for chapter 13 if the debtor “owes . . . unsecured debts of less than [$394,725] and noncontingent, liquidated, secured debts of less than [$1,184,200].”

Differing with some bankruptcy judges in the Second Circuit, Judge Nevins denied the motions to dismiss in an opinion on August 16 and held that the debtors were eligible for chapter 13, assuming that a later valuation trial confirms the debtors’ valuations of their homes.

The Courts Are Split on ‘Eligibility’

If the $3 million in subordinate mortgages were counted as either secured or unsecured debts, the debtors would be ineligible for chapter 13 under Section 109(a). In that regard, Judge Nevins cited decisions from bankruptcy courts in the Second Circuit holding that unsecured portions of liens can make a debtor ineligible for chapter 13 relief even though personal liability had been extinguished in a prior chapter 7 case. However, Judge Nevins was headed in a different direction.

Judge Nevins pointed out a subtle but critical distinction in the statutory language. Section 109(a) makes a debtor ineligible for chapter 13 if the debtor “owes . . . unsecured debts” of more than $1,184,200. The statutory language is “debts,” not “claims.”

Judge Nevins said that a “debt is not the precise equivalent of a claim.” Consequently, she said that a “claim must be evaluated for enforceability . . . since, ‘not all claims are debts of the debtor,’” quoting the Collier treatise.

Therefore, Judge Nevins said the statute imposes a “debt limit, not a claim limit.” In her view, Congress could have used the word “claim” but chose “debt” instead. Because the previously discharged subordinate mortgage debts were no longer “claims” against the debtors, they should not count toward the chapter 13 debt limits.

There was another problem, however. In chapter 20 cases, some courts have required debtors to pay previously discharged personal liabilities on subordinate mortgages in their subsequent chapter 13 plans. However, Judge Nevins adopted the position of “[m]any courts” and the Collier treatise by holding that nonrecourse debts should not be counted toward chapter 13 eligibility.

Alluding to holdings by some courts, the trustee insinuated that the debtors must treat the previously discharged personal liabilities from the prior chapter 7 cases as unsecured claims in the subsequent chapter 13 plans.

“I disagree,” Judge Nevins said. “While many courts would resurrect in personam liability and require such treatment,” she found the rationale of the Ninth Circuit BAP in Washington “to be more persuasive.” Reviving the previously discharged debt, she said, “would be to impose liability on a chapter 13 estate when none exists for the chapter 13 debtor.”

Although Judge Nevins upheld the theory behind the debtors’ chapter 13 plans, she called for a valuation hearing to confirm that the subordinate mortgages would be allowed as secured claims in amounts not exceeding the chapter 13 limits.