If a creditor doesn’t cash a $230,000 distribution check on an allowed unsecured claim, is the chapter 7 debtor entitled to the funds 10 years later on the idea that the $230,000 represented a surplus estate under Section 726(a)(6)?
Answer: No, for reasons explained by Bankruptcy Judge Christopher M. Klein of Sacramento, Calif., in an opinion on August 11.
The debtor purchased a home in 2005, but the title company failed to record the mortgage in favor of the lender. The debtor filed a chapter 7 petition in 2009, scheduling the house as worth $320,000 subject to a $670,000 mortgage. The debtor did not claim an exemption in the home.
It was a “no-asset” case. The debtor received her discharge, and the case was closed later in 2009.
The trustee reopened the chapter 7 case in 2012, having learned that the mortgage was unrecorded. The trustee avoided the mortgage and sold the home “free and clear” for almost $300,000. The debtor still did not claim an exemption in the home.
Creditors were notified to file claims, and the servicer filed a claim for $670,000. There being no objection, the claim was allowed as an unsecured claim for $670,000.
The dividend to unsecured creditors was 34%. The trustee therefore sent a check to the mortgage lender for almost $230,000. The lender did not cash the check for fear of endangering its negligence claim against the title company.
In accordance with Section 347(a), the trustee stopped payment on the check and paid the $230,000 into the court later in 2012. Five years afterwards, the clerk of the court deposited the $230,000 with the U.S. Treasury under 28 U.S.C. § 2041.
In 2019, the debtor filed a motion asking Judge Klein to give her the $230,000 in allegedly “unclaimed” funds.
The servicer filed an objection and asked Judge Klein to have a $230,000 check made payable to the lender but delivered to it, as the servicer.
Although it’s unclear whether anyone aside from the U.S. Treasury will eventually end up with the money, Judge Klein said that the “debtor cannot help herself to the property of a creditor merely because the creditor has not been paying attention.”
Judge Klein distilled authorities under 28 U.S.C. §§ 2041-2042 to mean that funds in custodial escheat can be sent by the court to the “rightful owner” who is “entitled to” the money and can show “full proof of the right thereto.” He added precedent from the Ninth Circuit Bankruptcy Appellate Panel, saying there must be a “present entitlement” to the funds.
The debtor contended there was a surplus estate to which she was entitled under Section 726(a)(6). Judge Klein identified several flaws.
Judge Klein said that the debtor’s theory “assumes away” the allowance of the lender’s $670,000 unsecured claim. Furthermore, no one had moved to reconsider and disallow the claim. To the contrary, unless the “claim is either withdrawn or disallowed, it is impossible for the § 726 waterfall to yield a ‘surplus’ distribution to the debtor per § 726(a)(6).”
Judge Klein went on to say there can be no surplus for distribution to the debtor under Section 726(a)(6) when unsecured claims remain unpaid. “The fact that [the mortgage lender] may have been reclining on its rights for nearly a decade is mere self-inflicted economic harm not affecting the merits of its claim,” he said.
But what about the servicer? Why not send the $230,000 to the servicer in the form of a check payable to the lender, as the servicer had requested?
Judge Klein found two problems, either of which was a show-stopper. First, the servicer had not submitted a complete copy of the servicing agreement setting forth its right to receive the check, regardless of whomever the payee may have been. For that reason, the servicer had not shown “full proof” of right to the payment under Section 2042.
Second, Judge Klein surmised that the lender’s insurer or the title company may be subrogated to the claim for the $230,000 check. “Full proof” required by Section 2042 “requires demonstration that there is not a competing subrogation claim,” the judge said.
In short, Judge Klein denied the debtor’s request for the money with prejudice. He denied the servicer’s request without prejudice to a “demonstration that no insurer has competing rights.”
If a creditor doesn’t cash a $230,000 distribution check on an allowed unsecured claim, is the chapter 7 debtor entitled to the funds 10 years later on the idea that the $230,000 represented a surplus estate under Section 726(a)(6)?
Answer: No, for reasons explained by Bankruptcy Judge Christopher M. Klein of Sacramento, Calif., in an opinion on August 11.
The debtor purchased a home in 2005, but the title company failed to record the mortgage in favor of the lender. The debtor filed a chapter 7 petition in 2009, scheduling the house as worth $320,000 subject to a $670,000 mortgage. The debtor did not claim an exemption in the home.
It was a “no-asset” case. The debtor received her discharge, and the case was closed later in 2009.