The Housing Bubble and Consumer Bankruptcy (Parts III and IV).

• Author: Carlson, David Gray

Table of Contents PART III. Chapter 13 (Continued) A. The Price of the House B. The Creditors' Right to Surplus Disposable Income C. Court Approval of Sale D. Time Limits on Modification E. Projected Disposable Income F. Unrealized Gains G. Calculating Capital Gain PART IV. Converted Chapter 7 Cases A. When the Debtor Still Possesses the House B. Valuation of the House C. Mortgage Paydowns D. Mortgages Out of the Money E. House Proceeds F. Bad Faith Conversions CONCLUSION PART III. Chapter 13 (Continued)

1. The Price of the House (1)

   Chapter 13 invites a debtor (D) to buy her house back from the bankruptcy estate in exchange for postpetition income. What is the price D must pay to buy the house along with the rest of the chapter 13 estate? There is a bipartite answer to this. First, D must pay the creditors at least what they would have received in a hypothetical chapter 7 liquidation. (2) This requirement goes under the name of "best interest of the creditors" test.

   In making this purchase, D is granted some "scrip." D may offset the price owed for the house by the amount of any monetary exemption (ME) that D may claim. Judge Jeffrey Hughes put this colorfully (with respect to cars):

   Exempting property from the bankruptcy estate is in some ways like shopping at a warehouse outlet. For example, the debtor might want to purchase (i.e., exempt) his car from the warehouse (i.e., bankruptcy estate). If the trustee refuses to accept the exemption tendered and the court agrees, then the car stays in the warehouse. On the other hand, if the trustee accepts the tender, or if the trustee refuses but the court compels acceptance, then the debtor is allowed to drive the car home. (3) Thus ME on the car is "funny money" which the chapter 13 trustee (T13) is obliged to accept against the price of the car.

   Once ME is applied and the amount of the home mortgage lien (ML) is accounted for, there may still be a surplus value in the house. D must pay sufficient future income such that the present value of the eventual payout equals the appraised amount of surplus. (4) That future payments must be reduced to present value follows from the appearance of the word "value" in [section] 1325(a)(4):

   the value, as of the effective date of the plan, of property to be distributed under the plan on account of each allowed unsecured claim is not less than the amount that would be paid on such claim if the estate of the debtor were liquidated under chapter 7 of this title on such date. (5) This is the first part of our bipartite answer as to the price D must pay for the house. The answer requires that we know the value of the house.

   There is a second answer to the question of price. This second answer has nothing to do with the value of the house. (6) If Tor any creditor objects to the plan, D must contribute all disposable income (7)--gross income minus expenses. The disposable income rule requires there to be a five-year plan for above-median debtors and a three-year plan if the debtor is below the state median for income. (8) The plan may be shorter if the creditors are paid in full in that shorter time. (9) For expositional convenience, we shall assume five years is the applicable commitment period.

   Confirmation usually stands for the fact that D has "bought" the house on unsecured credit via the plan. Accordingly, D owns appreciation value, so long as that value is not cashed out by a sale. But if D sells, prior to the end of the five-year term, the sales proceeds should be (in part) considered disposable income. This means capital gain above a basis, which is set by the ME, plus capital improvements to the house, plus payments made under the plan to buy back debtor equity above ML+ME, plus payments made to reduce ML's secured claim.

   The realization of a capital gain does not mean the creditors automatically get it. The creditors are bound by the plan, (10) and the plan continues in force as written, so long as D makes the required plan payments. The plan stipulates the disposable income that D must pay, and so far the plan makes no reference to the fortuitous capital gain.

   The unsecured creditors or T may move to modify the plan if D has received surplus disposable income over the stated plan amount. (11) We shall defer for a moment the calculation of the extent to which cash proceeds from the house constitute income. For the moment, we observe that not all the proceeds are income. From the proceeds there must be deducted a basis.

   The concept of basis has not been worked out in the case law. But the existence of basis in determining income is implied. Consider this simple example. Suppose D's house is valued at $100,000, where ML claims $80,000. D's equity is $20,000. This D buys back from the chapter estate for a monetary exemption of $15,000 and future disposable income with a present value of $5,000. Suppose D is invited to live with her parents for free. (12) She sells the house for $20,000. The basic chapter 13 bargain is that Dis not required to liquidate her prepetition property. (13) She is only required to pay disposable income. Therefore, she may keep the $20,000. It is not income. It is proceeds of property she is validly buying back (on credit) from the creditors. As long as D continues to make plan payments, she is not required to contribute former property of the chapter 13 estate to the creditors. Her duty is to pay disposable income from postpetition income. (14)

2. The Creditors' Right to Surplus Disposable Income

   The unsecured creditors can move to modify a chapter 13 plan to capture surplus disposable income above the amount stated in the plan. (15) This presupposes that the creditors find out about the house sale. How can they find this out?

   D does have a duty to file an annual report about income, (16) but this reporting requirement may miss the house, where the sale is, say, a month after the report is submitted.

   Some courts impose upon D additional reporting requirements. In Standiferd v United States (In re Standiferd) (17) a confirmation order imposed on D the obligation to "keep the trustee apprised of their postpetition financial condition." (18) Although the case did not involve the sale of a house, a sale would have to be reported, according to the terms of the confirmation order. In Standiferd, D's chapter 13 case was dismissed for failing to obey a court order. In the converted chapter 7 case, failure to follow the disclosure order then became grounds to deny C a discharge. (19)

   In Cole v. Coastal Fed. Credit Union, (20) the confirmation order provided D "shall not transfer any interest in real property without prior approval of the court." (21) The district court ruled that the court order was justified by Bankruptcy Code [section] 105(a), since the anti-alienation order aided T to recapture house proceeds pursuant to [section] 1329(a).

   Is it legitimate for a court to supplement the Bankruptcy Code with court-made reporting requirements? Sections 1327(b) and (c) do seem to invite supplementing the plan with court orders involving vestment of assets in D (22) or the avoidance of creditor interests to property conveyed to D. This might be done over the opposition of D. After all, if D does not like these supplemental orders, D can use her right to convert the case to chapter 7 at will. (23) "To effectuate a conversion, a debtor need only file a notice with the bankruptcy court. No motion or court order is needed to render the conversion effective." (24) In the chapter 7 case, any property acquired by D after commencement of the case belongs to D, not to the chapter 7 trustee, (25) at least where D converts the case in good faith. (26) But [section] 1327(b) or (c) say nothing about adding reporting requirements. Reportage is not mentioned in [section] 1325(a) as a requirement for plan confirmation.

   The Seventh Circuit, in Petro v. Mishler., (27) ruled that reporting requirements (and by implication anti-alienation orders) may not be added to a confirmation order. The court reasoned that the bankruptcy court was obliged to confirm a plan that complied with [section] 1325(a). Since [section] 1325(a) says nothing about extra reporting, a bankruptcy court could not add such requirements to the confirmation order. (28)

3. Court Approval of Sale

   Another way for creditors to find out about the impending sale and the accrual of disposable income is if D seeks court permission to sell the house. If D must have court permission to sell, D must notify the chapter 13 trustee in the motion pursuant to [section] 363(b). Tis then in a position to countermove to modify the plan and capture the income. (29)

   But does D need court permission in order to sell? Prior to confirmation of the plan, D must clearly seek court approval to sell the house. According to Bankruptcy Code [section] 1303, D has the power to sell out of the ordinary course under [section] 363(b), but this requires court permission.

   Once the plan is confirmed, however, D has bought the house. The house is no longer property of the estate. (30) According to [section] 1327(b): "Except as otherwise provided in the plan or order confirming the plan, the confirmation of a plan vests all of the property of the estate in the debtor." (31) "Vest" is not a defined term. It is best interpreted as "transfer." (32) Thus, a plan transfers to D all of the estate's property (except the income that D gives back to the chapter 13 trustee). The bankruptcy estate has come to an end (except for the income actually paid to and in possession of T). (33) D no longer is licensee of the bankruptcy estate with regard to the house. Dis the owner--a freeholder no longer in tutelage to the bankruptcy court. After confirmation, D can sell without court permission. (34) And if that is true, the creditors are hard pressed to find out about the impending sale.

   Yet Bankruptcy Code [section] 1322(b)(9) invites the plan to delay vesting in the debtor. (35) Section 1327(b)...