Bankruptcy: A Fresh Start, But at What Cost?

Reverberations from the housing bubble collapse of 2008 are still being felt today – specifically in matters relating to bankruptcy filings by underwater homeowners. Two cases put these reverberations, and their accompanying confusions and uncertainty, into focus.

In question in both cases is the idea of “proof of claim,” a form used by the creditor to indicate the amount of the debt owed by the debtor on the date of the bankruptcy filing. The creditor must file the form with the clerk of the same bankruptcy court in which the bankruptcy case was filed.

What we’re seeing, recently, in such cases, is that courts are often finding for the creditor – a reversal of the tenor of previous judgments. Attorney Don Maurice wrote back in November of 2014 that “a U.S. Circuit Court decision this summer took an extraordinary step when it held that filing a proof of claim on time barred debt is conduct that violates the FDCPA. At the time, attorneys close to both bankruptcy and FDCPA proceedings warned that it would touch off a very real firestorm in that sector of the ARM industry. That has proven to be quite true.”

Up first is Bank of America v. Caulkett. Some background to start: When filing for bankruptcy, the defendant revealed that his property was subject to two mortgage liens, with the debt owed on the first mortgage exceeding the value of the property. This put the second mortgage, which Bank of America held, “underwater.” Caulkett’s argument to void Bank of America’s lien on the second mortgage focused on Section 506(d) of the Bankruptcy Code, which allows a debtor filing for bankruptcy to void a second mortgage when the debt owed on the first mortgage exceeded the value of the collateral property.

However, does the Bankruptcy Code allow for this kind of argument? The Supreme Court said no. In an essentially unanimous decision, the Court held that Section 506(d) of the Bankruptcy Code allows a debtor to void a mortgage “[t]o the extent that [the] lien secures a claim against the debtor that is not an allowed secured claim.” Justice Clarence Thomas wrote the opinion, re-asserting that primary residence mortgages can’t be modified in bankruptcy.

The other case worth examining is Donaldson v. LVNV Funding, LLC. Where Caulkett is based in Chapter 7 bankruptcy filings, Donaldson is concerned with Chapter 13. The case boils down to this: whether it is a violation of the Fair Debt Collection Practices Act (FDCPA) to file Proofs of Claim in a Chapter 13 proceeding on time-barred debt.

In Donaldson, the consumer plaintiff listed two debts owing to LVNV in his bankruptcy schedules. The creditor had filed proofs of claim for the same amounts listed by the debtor in the schedules. The court relied upon Indiana law regarding the status of a debt that is outside the statute of limitations. The court noted that under Indiana law the debt was not extinguished by the statute of limitations; instead, the debt is still owed, but the owner’s (e.g., the collection agency or debt buyer) remedies were limited.

The court held that the filing of the proof of claim 1) was not “false, deceptive or misleading”, 2) did not mischaracterize the legal status of the debt, 3) was not a “threat” to take action that could not be legally taken, and 4) was not an unconscionable or unfair means to collect the debt.

Finally, the court noted that the statute of limitations was an affirmative defense, and that the debtor had to object to/ raise the defense or it is waived. Donaldson had never objected to the filing of the proofs of claim in the bankruptcy proceeding.

Bankruptcy is supposed to give consumers a fresh start, and, on the surface, these recent rulings can appear to put a hold on those fresh starts for consumers. But, while bankruptcy can be a mechanism by which consumers try to correct their financial situation, it doesn’t mean that they get to do this funded, in effect, by erasing debt secured by their home, and then keeping all the potential appreciation in the property when markets recover.