A decision by a district judge in Madison, Wis., highlights a problem that Congress ought to fix: Chapter 13 debtors should have statutory power to file avoidance actions, because Section 544(b)(1) only bestows the power on trustees.
Perhaps a congressional fix isn’t necessary. As District Judge James D. Peterson said in his December 14 opinion, a chapter 13 debtor could seek derivative standing to sue in the name of the chapter 13 trustee. In the case before Judge Peterson, the chapter 13 debtor had not sought derivative standing.
The Unperfected Mortgage
A couple purchased a manufactured home and filed a chapter 13 petition two years later. The lender filed a secured proof of claim.
The debtors filed an avoidance action against the lender under Section 544(b)(1), contending that the lender had not properly perfected the security interest under state law. The bankruptcy court agreed with the debtors and avoided the security interest. In the process, the bankruptcy judge rejected the lender’s argument that the chapter 13 trustee alone had statutory power to initiate the avoidance action.
The lender appealed and won, perhaps because the debtors had not sought derivative standing in bankruptcy court.
Section 544(b)(1)
The pivotal statute is Section 544(b)(1), which says that “the trustee may avoid any transfer of an interest of the debtor in property . . . that is voidable under applicable law by a creditor holding an unsecured claim . . . .” [Emphasis added.]
Judge Peterson said that neither the Supreme Court nor the Seventh Circuit has “directly addressed the question of” whether a chapter 13 debtor may exercise powers under Section 544(b)(1).
In the absence of controlling authority, Judge Peterson said that the “text of § 544(b)(1) is unambiguous: avoidance rights belong to the trustee. No other party is identified in the statute as having the right to invoke § 544.”
Judge Peterson found support for his conclusion in other provisions of the Bankruptcy Code. For instance, Section 1107(a) gives the powers of a trustee to a chapter 11 debtor in possession but not to a chapter 13 debtor. Similarly, Section 522(h) gives a debtor certain powers of a trustee, but none relevant to the case at bar.
Judge Peterson saw Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000), as supporting his conclusion. In Hartford, an insurance company sought to recover the costs of preserving collateral under Section 506(c), but the Supreme Court ruled that the power only belongs to a trustee.
The debtors relied on three decisions from bankruptcy courts allowing chapter 13 debtors to bring avoidance suits. Judge Peterson was not persuaded. He said that all three were decided before Hartford.
Judge Peterson rejected the debtors’ argument that they were the “most appropriate party” to mount an avoidance action, because a trustee assuming the chore would incur expenses that might benefit only the debtors and not creditors. He responded by citing the Tenth Circuit Bankruptcy Appellate Panel for saying that avoidance actions are to benefit creditors, not debtors.
As a workaround, Judge Peterson alluded to the doctrine of derivative standing, where a court may allow a creditor or a creditors’ committee to sue in the place of a debtor or trustee. He noted that Hartford left open the question of derivative standing.
Judge Peterson said that the debtors had forfeited the idea of derivative standing because they had not raised the issue below.
Closing the opinion, Judge Peterson said that the court could not rely on “policy concerns” when the “unambiguous” statute gives power in Section 544 “only” to trustees.
Judge Peterson reversed and remanded, presumably for the bankruptcy court to dismiss the debtors’ avoidance suit.
Observations
To this writer, the opinion seems based in part on the assumption that avoiding the mortgage would benefit only the debtors and represent bad policy. This writer respectfully disagrees.
Were the debtors to avoid the mortgage, the economics of the chapter 13 case would change dramatically. Suddenly, the creditors would have a claim on the equity in the property above the homestead exemption. Furthermore, the avoided mortgage is not preserved for the benefit of the debtors.
“If the mortgage was avoided,” former Bankruptcy Judge Keith Lundin told ABI, “it would be preserved for the chapter 13 estate by Section 551 and then, things would get interesting. If debtors wanted to keep the property, they would have to pay the mortgage to the trustee or refinance or sell to pay the trustee and keep the excess under a modified plan.”
Indeed, Judge Lundin is correct. There might be little or no benefit to the debtors in avoiding the mortgage in chapter 13. Converting to chapter 7 could have a worse outcome, because the chapter 7 trustee might sell the house out from underneath the debtors.
Aiming to remain in chapter 13, the debtors would be obliged to raise enough cash to pay the creditors’ claims against the equity in the house. Raising the cash might entail selling the house or taking on a new mortgage. With rising rates, a new mortgage might be more costly than the avoided mortgage.
If the mortgage were avoided, Judge Lundin said, “It becomes ‘Let’s Make a Deal’ time with the chapter 13 trustee on one side and debtors scrambling on the other.”
Judge Lundin is one of the country’s leading commentators on chapter 13. See LundinOnChapter13.com.
A decision by a district judge in Madison, Wis., highlights a problem that Congress ought to fix: Chapter 13 debtors should have statutory power to file avoidance actions, because Section 544(b)(1) only bestows the power on trustees.
Perhaps a congressional fix isn’t necessary. As District Judge James D. Peterson said in his December 14 opinion, a chapter 13 debtor could seek derivative standing to sue in the name of the chapter 13 trustee. In the case before Judge Peterson, the chapter 13 debtor had not sought derivative standing.
A couple purchased a manufactured home and filed a chapter 13 petition two years later. The lender filed a secured proof of claim.
The debtors filed an avoidance action against the lender under Section 544(b)(1), contending that the lender had not properly perfected the security interest under state law. The bankruptcy court agreed with the debtors and avoided the security interest. In the process, the bankruptcy judge rejected the lender’s argument that the chapter 13 trustee alone had statutory power to initiate the avoidance action.