Illinois Bankruptcy Lawyer Blog

Yes Virginia, it is possible to both discharge unsecured debts forever (Chapter 7) and strip down secondary mortgages (Chapter 13). The result is a so-called "Chapter 20." But should Debtors file two cases when it's hard enough to put themselves through one? Read on and find out.

When Is Chapter 20 a Good Idea?

There are situations that fairly cry out for Chapter 20 treatment:

Situation #1: Debtor is burdened with priority unsecured obligations like IRS debt, that must be completely retired in Chapter 13. But that would yield unsustainably high monthly payments. By contrast, once the Debtor's unsecured obligations are discharged, the resulting Chapter 13 plan payments become downright manageable. Chapter 20 is the solution.

Situation #2: Debtor's mortgage exceeds the value of the Debtor's home (i.e. the property is "underwater"). Chapter 7 cannot help the Debtor ameliorate their high payments or deal with their delinquent second mortgage. All Chapter 7 can do is give the Debtor an opportunity to reaffirm the mortgage(s) on the same outrageous terms. Chapter 20 is the solution because it permits the Debtor to treat its second mortgage like an unsecured debt and pay only pennies on the dollar to retire it.

How Does Chapter 20 Help, Exactly?
Chapter 20 works by reducing the overall amount of debt to be paid, then stretches that smaller sum over as many as 60 months. Practically speaking, Chapter 13 plan payments are determined by 2 factors:

• The Means Test imposed by the 2005 BAPCPA Amendment to the Code; and
• The amount of secured claims, arrears, and priority debts the Debtor must pay
  

This is where Chapter 13 Debtors may take advantage of the lien strip - an option not available in Chapter 7 - that allows them to treat secured loans on owner-occupied property as unsecured, and pay down those loans at far less than face value.

What is Lien Stripping, Again?

Lien stripping is the process of treating some "secured" loans as unsecured: it applies only when the property in question is "underwater" - i.e. its market value is exceeded by the face value of the primary mortgage. In that case the 2nd mortgage or home equity line of credit (HELoC) is really unsecured and may be paid under the plan of reorganization at the same rate as other unsecured debt - $.10 on the dollar, $.50 on the dollar, etc. And Boom! goes the dynamite.

Are People Using Chapter 20 Successfully?

In re Davis, 4^th Cir., slip opinion 12-1184 (2013), the latest case to discuss the legitimacy of Chapter 20 lien strips, points out that Chapter 7 eliminates personal liability but leaves in rem interests like mortgage liens undisturbed. It goes on to point out that an interest is "secured" only to the extent of the creditor's interest in the underlying real estate. See Code §506. Thus, if a house is worth less than its primary mortgage then 2nd and 3rd liens are unsecured by definition. And since §1322  of the Code permits the modification of the rights of unsecured creditors, a lien strip is both warranted by the facts and supported by the law. Finally, the Davis Court points out that while not every circuit has explicitly ruled on lien stripping, the 2nd, 3rd, 4th, 5th, 6th, 9th, and 11th Circuits have, and all have permitted it. (Id. at 7). 

Last But Not Least...

The only remaining question is whether a Debtor must receive a discharge at the end of its Chapter 13 case in order to complete a lien strip; or if the mere completion of its plan of reorganization is sufficient. The issue arises here because the BAPCPA mandates that once  a discharge is received in a Chapter 7 case the Debtor must wait 4 years to file Chapter 13 and obtain another discharge. Realistically however, a Debtor that has received a Chapter 7 discharge does not need a Chapter 13 discharge on top of it. Unfortunately, there is no consensus in this area.  Even in the Northern District of Illinois the answer may depend on your Judge (cf In re Fenn, 428 B.R. 494 (Bankr. ND Ill. 2010) with In re Anderson, 10-B-45294 (unreported)).

Conclusion

Bankruptcy discharges affect only personal ("in personam") liability: a discharge does not simply cause liens on property to disappear. As set forth in Sec.1322(b)(2) of the Bankruptcy Code, a plan of reorganization may only modify the rights of unsecured creditors. A lien strip exposes the wholly-unsecured lien on real property and, under the auspices of Code Section 506, allows the Debtor to pay off that "secured" interest for pennies on the dollar, as if it were merely an unsecured interest (which it really is).

In the 7th Circuit Case of In re Porayko, appealed from the Bankruptcy Court for the Northern District of Illinois, a Citation to Discover Assets was served on a year before the Debtor filed bankruptcy, while a 3rd Party Citation was served on his bank the month he filed. The creditor moved for relief from the Automatic Stay to seize the $10,000 in the Debtor's bank account and the Trustee objected on the basis that the initial citation had not created a lien, while the 3rd Party Citation was avoidable pursuant to 11 USC 547.

The Law
Citations to Discover Assets are addressed in Illinois Statutes, Section 5/2-1402. According to Sec. 1402(m) a Citation to Discover Assets creates a lien on all

"nonexempt personal property including money, choses in action and effects of judgment debtor" as well as "personal property belonging to the judgment debtor in the possession or control of the judgment debtor or which may thereafter be acquired or come due..."

Illinois cases support the concept that a checking account is personal property to which a lien may attach. See Chicago v. Air Auto Leasing Co., 297 Ill. App. 3d 873, 878 (1st Dist. 1998), a problem for the Trustee.

The Argument
The Trustee in Porayko tried to distinguish Air Auto Leasing by pointing out that other Illinois Courts treated bank accounts as mere promises to pay rather than items of personal property that could be subject to a lien. The leading case of its kind, Citizens Bank of Maryland v. Strumpf, 515 US 16 (1995), dealt with whether a bank could offset a payment while the Debtor was in Bankruptcy. But the Porayko Court found the situation before it to be quite different, and concluded that the creditor's citation had created a secured interest in the checking account, so the relief from the Automatic Stay granted by the Bankruptcy Court was proper. 

Surprisingly, this meant that under the proper circumstances the lien of a pre-filing creditor could trump the interest of a Bankruptcy Trustee: a notion that would appear to stand the law of insolvency on its head.

The Takeaway
The takeaway from the Porayko case is that Debtors are wise to address debts before their creditors secure judgments that turn into liens. At a minimum, a Debtors ought to file soon enough so that creditors cannot perfect their judgment liens and trump the case Trustee.

Everything Was Going Fine Until...

Your customer or borrower has been paying like clockwork and you, the creditor or vendor, have been dispensing goods and services as promised. Then your customer starts to pay a little later, then later still. Why not? Times are tough. So you do the decent thing and take their payments without complaining. Next thing you know, your customer seeks bankruptcy protection, leaving you holding the bag for thousands, tens of thousands, even hundreds of thousands of dollars worth of goods and services. Money you'll never see again. 

The Worst Part Is (Not) Over

You're out a lot of material, and now you'll never get paid. Sure that's tough to take, but at least the worst part is over, right? Wrong.

All sums paid by customers or clients in the 90 days before a bankruptcy is filed are de facto preferences. In other words, sums paid in the 3 months before a bankruptcy case is filed can be recouped by the Bankruptcy Estate without a guaranty of ever getting that money, or any portion of it, back.

Most creditors think that once a payment is received, all is good and they can move on. This is not the case if a customer filed bankruptcy. Sections 547 and 550 of the Bankruptcy Code allow a Trustee (in Chapter 7 cases) or Debtor in Possession (DIP) in Chapter 13 or 11 cases to recover preferential transfers. 

Will you have this problem? Was your customer's payment a preferential transfer? Short answer: "Yes it was" if

• payment was for the creditor's benefit    See 547(b)(1)
• on account of antecedent debt   (i.e. bought on credit)
• for goods or services that were received  See 547(b)(2)
• while a Debtor was insolvent as defined  See 547(b)(3)
• within 90 days before a bankruptcy filing See 547(b)(4)

Note: It is immaterial whether the vendor or creditor knew, had reason to know, or suspected a borrower or customer was about to file for bankruptcy or was insolvent. Once the case is filed the 90-day look-back is automatic. See 547(f)

Taken literally these rules mean creditors ought to stop lending, and vendors stop selling, if there is any concern about the financial health of the borrower or customer. Of course if that happened creditors and vendors could fail themselves. So what should creditors really do? While there is no one-size-fits-all answer, here is a list of 3 Don'ts and 1 Do If a Customer or Borrower Files Bankruptcy:

Don't 

• Volunteer to return sums paid by your Customer or Borrower. The case Trustee or DIP must first calculate what is due, decide whether to attempt to recoup it, and file a motion with the Court. 

• Contact your customer and raise hell - that will only make things worse.

• Represent your own interests in Bankruptcy Court. You wouldn't perform brain surgery on yourself, would you?

Do 

• HIRE A LAWYER 

Why only a single "Do?" And why put it in all caps? Because Bankruptcy Courts already favor the Trustee or DIP. Failing to hire a good lawyer to argue on your behalf if like bringing a knife to a gunfight, partner.

Defenses to a Preference Action

All doom and gloom aside, there are defenses that creditors can use when confronted with a motion to recover preferential transfers.The 2 most common defenses are 

• Contemporaneous Exchange for Value; and 
• Payment in the Ordinary Course of Business

A so-called Contemporaneous Exchange is essentially a COD arrangement. The creditor will supply goods and is paid on delivery or within a few days thereafter - functionally at the same time. These payments can be defended as non-preferential transfers.

The Ordinary Course of Business defense is more subjective: it relies on the way the parties treat each other. For instance if a vendor supplies goods to the buyer on a standard basis like Net-30, and the buyer pays as envisioned, then the payments made according to those terms can be defended as non-preferential transfers.

The Limits of the Ordinary Course Defense

Several recent cases have weighed in on the Ordinary Course of Business defense and shed light on the limits of this theory. 

In In re Universal Marketing, 481 B.R. 318 (Penn. E.D. 2012) the Chapter 7 Trustee sought to recover two $25,000 payments made to the Debtor's financial advisor. An Engagement Letter had been executed before the bankruptcy providing for 7 months worth of service at the rate of $25,000. The Debtor had made its monthly payments, but some had been late: opening the door for for the claim that no ordinary course defense existed. The Court disagreed, and found that the subject payments were made in the ordinary course of business. In its Opinion, the Universal Marketing Court considered the following facts:

• the existence of an agreement (the engagement letter)
• the services offered were of the type the debtor needed
• the creditor was in the business of providing such services
• length of time during which the arrangement was in place
• that the payments were typical for such an arrangement
• that the creditor did not exert undue influence to get paid.

The Court found the payments under consideration to be consistent and proportional to fees charged by the creditor for like services to other customers. This only left the occasional late payment. But the Court noted that this amounted to just a few days: too small of a divergence to transform them into preferential transfers. 

In re Mainline Contracting, 2012 WL 5247173 (N.C. BK 2012) was a Chapter 7 case involving not only late payments by the Debtor but lax collection tactics by the vendor. To begin with, Invoices clearly labeled "Net 30" had seldom been paid within 30 days by the Debtor. What's more, in the year leading up to the bankruptcy filing the Debtor took an average of 79 days to pay, with the number creeping up as the Debtor neared its bankruptcy filing date. Then there was testimony that the Debtor actually never paid before 90 days, unless the creditor called or emailed to inquire. There had also been a number of instances in which the Creditor put the Debtor on a COD basis due to its poor payment history, the Debtor would catch up, and the whole process started over. Eventually the Debtor filed for bankruptcy and the Trustee sought to recover certain payments.

The Marine Contracting Court found that the payments in question were not preferences, and thus not avoidable. In reaching its decision the Court noted that

• although the invoices read "Net 30," that was not the practice of the parties
• the creditor would continue to supply materials on credit even when not paid
• it was only after invoices were 60+ days overdue the creditor demanded payment
• it was only after invoices were 90+ days overdue that the creditor switched to COD
• such behavior was consistent over both the baseline period and the preference period 

The weightiest factor in the Court's analysis was the behavior of the parties during and before the the 90-day preference period.The consistency of that treatment indicated that these were truly payments made in the ordinary course of business.

Take-Away:What Does It All Mean?

The takeaway from this discussion is that creditors should strive to be consistent in the way they treat customers. Talk to cistp,ers about past-due payments. Follow up consistently and in a timely fashion. If payment terms are "Net 30" for instance, send reminders at 45 and 60 days. And if a customer is a bad payer consider COD or a prepayment arrangement. After all, if credit is not extended there can be no preference action.

Okay nobody dies, but the case does address the long-overdue question:

What happens when the property taxes of a Chapter 13 Debtor, protected by the Automatic Stay, are sold at auction? 

Here the Bankruptcy Court for the Northern District of Illinois, Eastern Division, had to decide whether a Chapter 13 Plan of Reorganization affects the deadline for the Debtor to redeem sold taxes. 

The answer is, Yes. Who says tax sales + bankruptcy doesn't = fun?

The main issue was as follows: 11 USC 108(b)(2) provides that if a time frame established under applicable non-bankruptcy law determines when and where the debtor can cure a default, then that date is extended by 60 days from the entry of an order for bankruptcy relief. At the same time however, 11 USC 1322(b)(2) provides that a Chapter 13 debtor may take up to 60 months to pay liabilities such as past due real estate taxes. The question was, which section ought to prevail under the circumstances of the case?

As of the initiation of the case, there was a split within the Northern District of Illinois as to which section of the Code ought to win the day. Older opinions tended to take a rigid view of Section 108 and held that 60 days was it: no Plan of Reorganization could change that. See In re Murray, 276 BR 869 (Bankr. N.D.Ill 2002), and Smith v. Pheonix Bond, 288 BR 793 (N.D.Ill 2002). But newer cases had taken a more holistic view and concluded that since a primary driver of the decision to file Chapter 13 case is the debtor's determination to keep their primary residence and cure mortgage deficiencies over the life of the Plan of Reorganization, it was only natural to extend that logic to real estate taxes and other debts that affect how ownership. This line of reasoning is well demonstrated by Judge Wedoff's opinion in the matter of In re Bates, 270 BR 455 (Bankr. N.D.Ill 2007), as well as Judge Hollis' opinion in In re Kasco, 378 BR 207 (Bankr. N.D.Ill 2007).

A "tax buyer," i.e. one who purchases unpaid property taxes from the County, has no legal claim against a debtor but, rather, an in rem interest against the debtor's real property. So, as with any other party holding an in rem interest, the tax buyer can - and according to the opinion, should - file a claim in the debtor's Chapter 13 case. In bankruptcy, creditor's claims are often modified by the debtor's plan. Payment terms can be extended, interest rates can be modified, and in the case of a plan of reorganization in Chapter 13 or 11, claims can be paid off at a fraction of their face value. In other words, debtors who face this problem and file Chapter 13 as a means to deal with it are not counting on the ability to extend a non-bankruptcy deadline (by 60 days for instance), but rather the ability to pay off the underling debt within 60 months. 

If the above reasoning is correct, then as long as the tax buyer/creditor's claim is honored in the debtor's plan of reorganization, the creditor's interest is preserved throughout the case; and if the debtor fails to successfully complete the plan, the creditor can snap back into action. This is no different than the situation of a mortgagee that must refrain from taking action to foreclose so long as the debtor is making the payments the Trustee and Court consider reasonable. Those "reasonable" payments, combined with the underlying secured claim, constitute adequate protection Adequate for what, you ask? Adequate to assure the tax buyer/creditor that they are getting their money's worth, or at least that they are receiving no less than others of the same stature (secured creditors).

Put these pieces together and here is what they mean: so long as any creditor is adequately protected, they have no grounds to lift, modify, or annul the Automatic Stay and are effectively forced to wait out the debtor's plan like everyone else. As always, the lynchpin of this system is for debtors to complete their plan payments and earn the removal of the tax buyer's in rem interest in their property.

As an aside, the poor innocent tax buyer might think - Hey what about me, I only have a year to obtain a tax deed once the redemption period has expired. If the Debtor's plan goes for 5 years, I could blow the statute and never be able to collect. Illinois law provides for this. Under 35 ILCS 200/22-85, if the tax buyer is prohibited by court injunction from obtaining the deed, the one year period is tolled during this time. Since the automatic stay is an injunction, tax buyers are protected.

Guest Post By Jonathan Trent
Edited by M. Hedayat, Esq.

It's that time of year again! As January winds down business owners are contemplating new projects, new ideas, and New Year's resolutions. Putting together resolutions can be an eye opening experience... or a chore. Sure, you want to continue improving what works, weed out what doesn't, and learn from the past to avoid making the same mistakes in the future. But when the rubber meets the road, how do you make that call?

Here's a simple method that has been used by small businesses for year.

(1) Review the significant business events of the past year - marketing, financial, etc.

(2) Ask yourself "What worked? What didn't? Could we have avoided that problem?"

(3) This is critical: repeat the process until you have turned over all events in detail

(4) Prepare these 3 distinct lists (be prepared to write and rewrite them as needed)

Things I Should Do Again: these worked and should be part of your workflow

Things Never To Do Again: these didn't work, or they hurt more than helped

Tweak and Try Again: With changes, these practices could work

Sounds easy, right? Too bad it's one of the hardest things you have to do as a business person. Not only is the self-reflection challenging, but the act of turning objective facts into recommendations and then seeing those recommendations through is... well, it's what distinguishes good businesses from great ones.

Until you really complete your own business evaluation and give yourself a business-practices audit (a more formal term for this process), here are 5 New Year's resolutions being put into effect by businesses right now!

Be More Earth-Friendly

There are several ways a business can go green. Using less power and less paper is a good start. Buy recycled materials. Install energy efficient lighting, heating, and cooling. This not only helps the environment but your business costs as well. You may be surprised how much a company can save after one year of saving energy and cutting costs.

Improve Communications

Install a new office communications network. Office phone systems can be built to suit your needs. Connect all your employees like never before. Get high-tech with voice activated phones, 3-way calling, and messaging services. Information is relayed quicker and clearer when all departments are better connected. Messaging and conference calls can help to bring in new clients and seal important deals.

Reevaluate Company Policies

Send out a new list of rules and standards and make sure all personnel know what is expected of them in any situation. What is the company's policy of on social media? What are the consequences if it is misused during work hours? What should employees do if there is an emergency, power outage, or natural disaster? Making everyone aware of what is expected of them leaves no gray areas or confusion.

Offer Achievement Incentives

Gather and showcase the best employees based on sales figures, leadership, or morale. You could also send top employees to leadership or group training seminars. It's amazing what this can do for your company. You may see a great change in your staff. Plan and implement team meetings, pep talks, or even parties. A lively, encouraged team will want to excel and work in a fun environment.

Financially Prepare for Next Year

Create a nest egg and be financially secure. You never know if certain laws may be passed and it means drastic company changes. You need to prepare long term. Be ready for possible problems that could result in company losses. Owning a business can be tough and you many need to take extra care to avoid paying more taxes, fees, or business owner penalties. Get business taxes done by a professional and keep perfect records.

And Finally...

Don't forget to secure a Legal Audit to ensure compliance with applicable laws, regulations, and industry best-practices. How? That's easy: contact M. Hedayat & Associates, P.C. for your Free Legal Audit. With over 18 years of legal experience under his belt, a string of start up companies to his credit, and an MBA in addition to his law degree Mazy Hedayat is ready to roll up his sleeves and tell you where your business stands from a legal perspective.

About the Author: Jonathan Trent is a web marketing specialist with NextUC, a provider of audio, video and web conferencing solutions. He is a sports fanatic that enjoys writing about the internet and modern technology. He has written several articles about the advancements and future of communication and technology.

How does a company with $69.8 million in assets and only $9.2 million in liabilities end up filing for Chapter 11 bankruptcy protection? The answer is crime doesn't pay, especially when you get caught hiring a hit man to make someone "stop breathing."

An Offer A Creditor Can't Refuse...Unless Someone's Wearing a Wire.
Daniel Dvorkin, a local developer who was formerly in charge of Dvorkin Holdings LLC, was arrested in July after telling a federal informant that he would pay $100,000 for the informant to find a hit man that would make sure one of his creditors would sleep with the fishes. The cooperating witness was wearing an audio and video recording device for several of the conversations with Dvorkin. The target was an attorney who owned a corporation that had recently won an $8.2 million judgment against Dvorkin.

As the allegations against Dvorkin spread, Dvorkin Holdings filed for Chapter 11 bankruptcy protection in August. Despite the apparently strong balance sheet indicators (almost 70 million in assets against just 9 million in liabilities), the venture's debts will almost surely rise as unsecured creditors will file foreclosure suits demanding what they are owed amidst Dvorkin's legal mess.

Dvorkin Holdings owns stakes in properties across Chicagoland, including a large medical office building in Palos Heights and a commercial building in Lakeview. One of the venture's largest projects, a 250-unit condominium building, was repossessed in 2010.

Back to (Bankruptcy) School
Chapter 11 bankruptcy protection is most commonly used by businesses, though individuals can also seek it under certain circumstances. A Chapter 11 is more advantageous than a Chapter 7 bankruptcy because the debtor can still operate the business under the supervision of the Bankruptcy Court, just with a reorganized payment plan to its creditors. Under the Bankruptcy Code, a trustee, normally the debtor, executes the Chapter 11 plan under the guidance of the Court. A Chapter 7 bankruptcy is a total liquidation of assets and means the business stops operating.

For Dvorkin Holdings LLC, the Chapter 11 buys the company time while Dvorkin's legal proceedings play out. The Court may allow the debtor company to cancel certain contracts, or most importantly litigation against the company can be put on hold. For Dvorkin Holdings, this is a considerable advantage as many unsecured creditors are demanding payment for what they are owed. The creditors are obviously concerned that Dvorkin's criminal proceedings will undermine the future of the LLC.

The Creditor Strikes Back
The company's creditors are not simply rolling over for the Chapter 11 however. One of the creditors, Ohio-based FirstMerit Corporation, is seeking a separate and independent trustee for Dvorkin Holdings. Alluding to Dvorkin's criminal charges, FirstMerit raised these concerns in their court appearance in conjunction with the Chapter 11. Under the Bankruptcy Code, all creditors are allowed to have their day in court to challenge the Chapter 11 plan.

A separate and independent trustee is someone who was not previously associated with the company. Considering the dastardly allegations against Dvorkin, FirstMerit has little faith that the company would act rationally if it were its own trustee, "(the creditors cannot) possibly be expected to have any confidence that (Dvorkin Holdings) is acting in their interests in light of these drastic allegations." Dvorkin Holdings is owned by Daniel Dvorkin, his wife Francine, and their children. Under the Bankruptcy Code, a separate and independent trustee can be appointed if a creditor shows cause, which is legalese for strong rationale that the debtor will not operate the business rationally if it is its own trustee.

Crime Doesn't Pay
While Daniel Dvorkin awaits trial, the future of Dvorkin Holdings and its Chapter 11 plan is murky. The Bankruptcy Court will have a challenge on its hands handling aggressive creditors hoping to get their money back before Dvorkin himself potentially heads to jail. Furthermore, whether Dvorkin is convicted or not, it would difficult to imagine the company's reputation and business prospects will not be unsullied by the ordeal. On top of those headaches, Dvorkin Holdings will try to gain the best deal possible in part by arguing that Dvorkin is still innocent until proven guilty. Dvorkin's lawyer has repeatedly stated his client's innocence.

Is your business struggling? Are you staying above water but simply need extra time for business to pick up? Contact M. Hedayat & Associates today-we have been Chicago experts in all forms of bankruptcy as well as real estate and business law for nearly two decades.

These are dark times in the galaxy....

Unemployment is stubbornly high. The recovery has nearly stalled. People's savings are low. The housing market's so-called rebound has been uneven. Since June 2011 almost a million and a half people have sought bankruptcy protection. The number of filers keeps growing (so much for the salutary effect of BAPCPA).  Is there hope? 

A New Hope

One effective feature of Bankruptcy is the lien strip. Traditionally Chapter 7 debtors could not take advantage of a lien strip, which permits a debtor to treat unsecured mortgages and lines of credit the same way as other unsecured debts such as credit cards. If they could, those debts - previously treated as a "secured loan" or "mortgage" would really be discharged at the end of the case like a credit card debt. 

Instead, Courts have permitted lien strips to be employed only in connection with Chapter 13 reorganizations. Ironically this meant that the Chapter 7 debtors least able to keep their 2nd mortgage or HELOC could not get relief. And Courts have adhered to the Chapter 7 v. Chapter 13 distinction right up to the present - even as real estate values have plummeted.

But in a recent decision the 11th Circuit Appellate Court held that a Chapter 7 debtor could avoid a junior lien, in essence giving millions of Americans a new hope.

The Empire Strikes Back

So what makes Chapter 13 and 7 so different when it comes to the treatment of unsecured mortgages and home equity loans? Why let the Chapter 13 debtor to pursue a lien strip but deny it to the Chapter 7 debtor?

Chapter 7 of course is reserved for those who make less than the median income in their State or can demonstrate that letting them liquidate despite having an above the median income isn't an abuse of the Code. Chapter 7 cases move quickly- assets are liquidated or abandoned by the case Trustee within a short time-frame. 

Chapter 13 by contrast is the adjustment of debts by those with regular income who can meet their living expenses, but have fallen behind. The theory is they just need to catch up. Chapter 13 debtors are even their own trustees or Debtor in Possession and their repayment plans take up to 5 years to administer. 

But are those really fair characterizations of Chapter 7 and 13 debtors?  These days a sudden job loss, illness, drop in property value, or plain old economic malaise can transform a wage earner into a deadbeat. So why not offer the same benefit to both types of debtors? Why not permit Chapter 7 lien strips?

Return of the Jedi

Speaking of lien strips, what is a lien exactly? Answer: it's a security interest in real property given or taken in return for value. Typically, a bank lends the money to buy your house and in return you grant a lien in the property. But not all liens are created equal, since only some are perfected. Holders of perfected liens get paid before the holders of unperfected liens. 

That's where McNeal v. GMAC Mortgage comes into play. In McNeal the 11th Circuit Court of Appeals concluded that Chapter 7 debtors had as much right as Chapter 13 debtors to strip unsecured junior liens. The Court's reasoning rested largely on a linguistic choice - "stripping down" versus "stripping off." In fact, policy considerations drove the decision and reversed a long line of precedent.

The facts were these: McNeal, a Chapter 7 debtor, had two mortgages. The amount due as to the first mortgage was $176,413, the amount due as to the second loan was $44,444 and the debtor's house was wroth only $141,416. This would have qualified the debtor to perform a lien strip in Chapter 13. But this was a Chapter 7. 

The Bankruptcy Court cited a long line of precedent, including a Supreme Court case, all of which pointed in a single direction: Chapter 7 debtors could not 'strip down' junior liens. But the 11th Circuit went a different way. It applied the U.S. Supreme Court case of Dewsnup v. Timm which concluded that a Chapter 7 debtor could "strip down" a partially unsecured lien even though the debtor could not 'strip it off' altogether. The result was essentially the same - the debtor got out of paying the entire value of the lien.

Boom goes the dynamite!

Epilogue: Yes, There is Hope

Okay, was the 11th Circuit really persuaded by the distinction between a "stripping down" and "stripping off?" Probably not. But for years consumer groups had called for a vehicle by which debtors could strip liens in Chapter 7 and escape crushing debt without losing their house and home. Many of the Circuits criticized Dewsnup too because it seemed to declare once and for all that only Chapter 13 debtors could employ lien strips then stopped just short of overturning the practice altogether. 

So is this an unconditional victory for Chapter 7 debtors? Not exactly. The rest of the Federal Circuits, including the 7th Circuit, have recently reaffirmed their allegiance to Dewsnup and the narrow reading of the practice of lien stripping. But the circuit split means the Supreme Court may yet have to address the issue in its next term. But until then, all bets are once again off.

Want to learn more about qualifying for a lien strip? Read about it on our website and feel free to reach us at 630-378-2200 or at mhedayat@mha-law.com.

444 North Northwest Hwy. LLC and Northbrook Bank & Trust were embroiled in a foreclosure action in the Illinois courts when 444 filed for Chapter 11 protection and became the Debtor in Possession.

The parties faced off over numerous issues in Bankruptcy Court; so the Judge consolidated the issues for trial. 3 days before the trial date however, the Debtor in Possession brought a motion to disqualify the lawyers for the bank, Much Shelist, based on "conflicts" arising from contact between a lawyer at Much Shelist and the principal of 444 North, John Heintz.

Of course neither the lawyer that spoke with Heintz, nor Much Shelist itself, had represented the Debtor. In fact, Heinz once stated on the record that he did not recognize that firm name. His memory had apparently failed right up until he swore out the affidavit days before trial.

In the Bankruptcy context Attorney disqualification means a lawyer or law firm can no longer serve the Client, period. The 444 Court described disqualification as "a drastic measure to be taken" only when "absolutely necessary." Meanwhile, tactically a motion to disqualify can be useful whether or not it succeeds. Either it throws off the opponent's momentum or it sows a seed of suspicion between the opposing party and it's lawyers 

But the Debtor in Possession argued that Much Shelist should be disqualified under the plain meaning of the Illinois rules of professional conduct. No dirty tricks - just the law. The Court did not agree. First, it went out of its way to note that the Federal District Court's local rules applied, not the Illinois rules. Then, it went on to apply Local Rules 83.51(9)(a) and 83.51.10.

Local Rule 83.51(9)(a) holds that a lawyer who previously represented a client may not represent another party in the same or substantially related matter in which that party's interest is adverse to that of the former client - without written consent.

Local Rule 83.51.10 is a follow-up: it holds that a lawyer who becomes aware that another lawyer from that firm is barred from taking a case due to 83.51.9(a) cannot avoid the conflict by stepping in and taking the case instead. 

At first blush the Local Rules mean Much Shelist is in hot water. There was no doubt a Much Shelist lawyer had discussed aspects of the foreclosure with the Debtor but now represented one of 444's creditors in the bankruptcy or that the rapidly approaching trial was substantially related to that advice. It looked like a case of foul play. 

Ultimately the Court emphasized the delay between Much Shelist's entry into the case for the bank and the Debtor's last-minute revelations. It then came down on the side of logic by holding that the Debtor waited too long to reveal its bombshell.The result left little or no time for the bank to find new lawyers and clearly the Debtor was gaming the system.

The Court classified the delay as extraordinary and noted that, considering the pace of the trial, the bank would probably not be able to find new counsel at all; let alone counsel that could prepare in time. Finally, the Court noted that granting the motion would unduly reward an obvious ploy and prejudiced the bank. 

The Court's Opinion never establishes whether the Debtor knowingly refrained from objecting to Much Shelist's involvement until the last minute. But reading between the lines, the Court didn't believe the Debtor.Once more the outcome was the logical one: that a business facing foreclosure doesn't suddenly forget the law firms and lawyers that it consults. Furthermore, it looks like the timing of the Debtor's revelation suggested a more nefarious intent.

Whether or not you believed the Debtor there were lessons here. Most importantly, it seems like a good idea to keep track of all lawyers and law firms contacted, even if via something as simple and informal as an e-mail or voice mail. A simple record of communications can repair even the most implausible story and satisfy the Court.

M. Hedayat & Associates, P.C.represents debtors in Chapter 11 and conducts trials in both State and Federal Court, including Bankruptcy Court. We represent small businesses as well as entrepreneurs. Call us at 630-378-2200 or reach us at mhedayat@mha-law.com for a no cost consultation.

Before the weekend, take a look at the link below. It's a concise, simple, and accurate explanation and criticism of the Department of Justice's argument in the E-Book battle.

AppleAmicusBrief.pdf

Alan J. Mandel Law Offices had been representing a Debtor in Possession (DIP) in Chapter 11 and sought final payment for Attorneys' fees as well as expenses. Ultimately Mandel received only part of the requested compensation due to its overly broad reading of the Bankruptcy Code and the resulting attempt to fit a square peg into a round hole.

Officially "No" ... Unofficially "Yes"
Multiut, an Illinois Corporation, filed a Chapter 11 Petition on May 14, 2009 due largely to litigation between it and Dynegy Marketing and Trade. Mandel, who was eventually retained with Court approval, served as outside general counsel to Multiut during the litigation and even acted as Bankruptcy Counsel. But Mandel was not hired by Multuit until January 22, 2010 and was not "officially" retained until February 1, 2010; at which point it sought payment for fees and costs retroactive to the Petition Date via a legal technique known as nunc pro tunc (Latin for 'now, for then').

But as a creditor of Multuit's with a stake in the outcome of its Chapter 11 reorganization, Dynegy fought back by voicing its displeasure at the apparent conflict of interest between Mandel the litigator and Mandel the bankruptcy attorney. Due in part to those objections, Multiut's Plan of Reorganization failed and the case was converted to a Chapter 7 liquidation - ensuring that almost nobody got anything.

It's the Latin, Stupid
In its ruling, the Court noted that under Sec.330 of the Bankruptcy Code, as well as case law on the subject from the 7th Circuit, an Attorney not retained in accordance with the Code is ineligible for compensation regardless of whether its work benefited the bankruptcy estate. In other words, the Bankruptcy Court would not go out of its way to avoid stiffing a lawyer: if an Attorney failed to plan it looked like they might as well have planned to fail. As for the nunc pro tunc argument, the Mandel Court noted that other courts had considered it and concluded that nunc pro tunc retention ought to be permitted only in "extraordinary circumstances," whatever that meant. That said, the Court granted Mandel compensation in this case. So all's well that ends well, right? Well not exactly ...

Game of Counsels
The decision to grant some fees and costs to Mandel was not the end of the inquiry. After looking into the facts, the Court noted that many of the services recorded by Mandel were compensable only under Sec. 327(a) of the Bankruptcy Code: not Sec. 327(e). The latter section, which was the basis of the Mandel Application for Compensation, was narrower in scope and did not include the same activities.

So, did Mandel go too far? To the Court there was no question in this case. "General Chapter 11 Administrative" services were not within the purview of 327(e), which explicitly states that services must be for a specific purpose other than the Bankruptcy case itself. The kinds of "day to day activities" recorded by Mandel were clearly connected with the Bankruptcy case and thus not payable under 327(e). What's more, the Debtor had already obtained 327(a) Counsel to handle the Bankruptcy case, so Mandel should have known it could not take on "day to day" activities and expect to be paid.

A Man's Got to Know His Limitations
The upshot of the Mandel decision is simple: respect the Bankruptcy Code or face the consequences. Get compensated the right way, or expect to go back to the office at least partially empty-handed.

If you enjoyed this post feel free to contact M. Hedayat & Associates today. The firm has been expertly handling Bankruptcy cases of all kinds for nearly twenty years.

IN RE MULTIUT CORPORATION, Bankr. Court, ND Illinois 2012

While Bernie Madoff serves out his 150-year sentence, the fight over how to satisfy his creditors rages on. Now, an infamous 2011 ruling by the Supreme Court limiting the power of bankruptcy courts may have a bizarre and unintended affect: many of the investors that recovered money when Madoff was first exposed may lose it (again) because the Bankruptcy Court may have overstepped its bounds by giving it to them in the first place. Confused yet?

Collateral Damage

Here's the problem. Irving Picard, Trustee in the Madoff Bankruptcy, is now attempting to recoup funds lost to Madoff's Ponzi schemes by means of fraudulent transfer suits. A Ponzi scheme is an illegal investment scheme that involves investors getting returns on their investment not based on profits but by subsequent investors. The enticement for new investors is usually short-term investments that offer an unnaturally high rate of return. Because it is not based on actual profits, it is destined for collapse. Madoff, on his way to becoming the largest financial fraud in U.S. history, created a Ponzi scheme that defrauded investors of billions of dollars. A fraudulent transfer suit is when in an effort to mislead creditors, the debtor transfers assets he knows he does not have. This is a fraudulent conveyance. The "suit" part is when a creditor, or a Bankruptcy Trustee, sues the recipients of the fraudulent conveyances demanding the funds back. In the case of Madoff and his Bankruptcy Trustee Picard, Picard is trying to augment the bankruptcy estate by suing people who originally invested in Madoff's Ponzi scheme and received a "return" on that investment from Madoff. Picard wants the investors' funds back, despite it being Madoff who created the fraudulent scheme in the first place. So if you are one of those investors, what do you do?

On June 12, defendants in the fraudulent transfer proceedings filed a brief arguing that the bankruptcy judge cannot rule or recommend rulings on fraudulent transfer suits by Picard, the liquidator of Madoff's brokerage. The defendants, many of whom after receiving original returns from Madoff invested again only to eventually see that investment vanish, argued that attempts to "augment" a bankrupt estate are based on common law and must be heard in district court. In May, US District Judge Jed S. Rakoff ruled bankruptcy courts could not issue final rulings on claims of fraudulent transfers or unjust enrichment, but they could make recommendations or reports to federal district judges, citing the recent Supreme Court decision Stern v. Marshall. The defendants argued such recommendations by bankruptcy judges are not allowed, as Congress has "considered and rejected bankruptcy judges serving as magistrates, who would issues reports and recommendations."

TMZ Meets the Supreme Court

Oddly enough, the fate of the fraudulent transfer suits and the collateral damage of Bernie Madoff rest with the fortunes of an ill-fated and questionably famous starlet, whose case ended at the doorstep of the supreme law of the land. The case of Stern v. Marshall, decided June 23, 2011, involved the estate of the late Anna Nicole Smith and her late husband. Her husband's estate, worth a modest 1.6 billion, resulted in a protracted legal battle. The case, which outlived many of the original players, was in 2006 compared to "a Harlequin romance novel. It's part Knots Landing, and part Shakespearean filial betrayal...the protagonists, shall we say, are not without flaws." Ouch.

The Supreme Court's ruling issued a stern warning to Congress not to leave judicial duties to anyone other than the judicial branch. With Chief Justice John Roberts writing the majority opinion, the court held unanimously that under a 1984 law, Congress had given the bankruptcy court the power to issue a final ruling in the debtor's claim, but ruled 5-4 that Congress violated Article III by creating such power in the bankruptcy courts, thus shutting out Smith. The infamous, flaw-filled celebrity diva went home empty-handed. Tragic.

Roberts argued Congress had grossly overstepped its authority by creating such power in the bankruptcy courts. The ruling states bankruptcy judges cannot constitutionally decide debtor's claims that are based solely on state law. Bankruptcy judges can still decide cases that are based on federal law or related to a federal regulatory scheme. According to the Court, issuing such decisions from a non-Article III court threatens the entire separation of powers, "...Article III would be transformed from the guardian of individual liberty and separation of powers we have long recognized into mere wishful thinking." But why do the Madoff victims care about this?

Fight (in Bankruptcy Court) or Flight (out of Bankruptcy Court)

In response, hundreds of former Madoff investors, many of whom were unaware of Madoff's unapologetic fraud, and facing fraudulent transfer suits in bankruptcy court, are trying to get their case before a federal judge and not a bankruptcy judge, arguing their claim is based solely on state law. Unclear in Stern v. Marshall is whether or not a bankruptcy court can issue recommendations to the relevant federal judges as Rakoff argued in May. Rakoff argued that the specialized expertise of bankruptcy court judges make them better suited to handle such claims and thus should issue recommendations to less experienced federal judges.

If you are concerned that you are a victim of a Ponzi scheme, or could be facing a fraudulent transfer suit, contact the offices of M. Hedayat & Associates. The firm has been expertly handling Bankruptcy proceedings of all kinds for nearly twenty years.

The SEC filed a complaint. The court appointed a receiver to handle defendants' assets for distribution among victims of the $31 million fraud. Assets included oil and gas leases. SonCo filed a claim. The parties came to terms; the court entered an agreed order that required SonCo to pay $580,000 for assignment of the leases. The wells were unproductive, because of freeze orders entered to prevent dissipation of assets; the lease operator, ALCO, had posted a $250,000 bond with the Texas Railroad Commission. The bond was, in part, from defrauded investors. SonCo was ordered to replace ALCO as operator and to obtain a bond. More than a year later, SonCo had not posted the bond or obtained Commission authorization to operate the wells, but had paid for the assignment. The judge held SonCo in contempt and ordered it to return the leases, allowing the receiver to keep $600,000 that SonCo had paid. SonCo returned the leases. The Seventh Circuit affirmed that SonCo willfully violated the order, but vacated the sanction. The judge on remand may: reimpose the sanction, upon demonstrating that it is a compensatory remedy for civil contempt; impose a different, or no sanction; or proceed under rules governing criminal contempt.

Download the Opinion in .pdf format.

7th Circuit Opinion Summaries courtesy of Justia.com

United States v. Rogan

Bankruptcy, Criminal Law, Government, White Collar Crime

River Road Hotel Partners, LLC v. Amalgamated Bank

Bankruptcy

Bloomfield State Bank v. United States

Bankruptcy, Real Estate & Property Law, Tax Law

Costello v. Grundon

Bankruptcy, Commercial Law, Securities Law

CDX Liquidating Trust v. Venrock Assocs., et al

Bankruptcy, Business Law, Securities Law

Reedsburg Util. Comm'n v. Grede Foundries, Inc.

Bankruptcy, Utilities Law

Kimbrell v. Brown

Bankruptcy, Injury Law