By David Swedelson, Esq. and Alyssa Klausner, Esq.
It should be no surprise to anyone that the Great Recession has caused a significant amount of people to fall into serious debt, and many have filed bankruptcy. This is having a significant impact on many community associations’ efforts to collect delinquent assessments.
Just how big of an issue is bankruptcy in California? The Central District of California (CDC) is among the busiest bankruptcy courts in the U.S. The CDC serves over 18 million people in southern and central California, the largest federal judicial district by population. The CDC’s mission statement is “To provide, efficiently, justice to all parties affected by bankruptcy in the most populous and diverse district in the country.” A whopping 142,407 bankruptcy cases were filed in the CDC In 2010 (a 31% increase from 2009), greatly outnumbering the 14,330 bankruptcy cases filed in the Southern District of New York in 2010. The percentage of bankruptcy filings increased nationally by 13.8% from 2009-2010. It is no wonder we are seeing so many requests from our clients seeking assistance with a bankruptcy matter of a delinquent owner and to obtain relief from the bankruptcy automatic stay so that the collection process can continue, something we were rarely asked to do before the recession. Because the recession is not really over for California community associations, as there is still a significant amount of homes that are or will be in foreclosure for some time to come, it is important that board members and association management understand the basics of what bankruptcy is all about.
Personal bankruptcy is a legal way to give people with overwhelming debt a fresh financial start. Many people do not realize that there are five types of bankruptcy options available under the U.S. Bankruptcy Code; however, for most consumers, there are really only two viable options; Chapter 7 and Chapter 13 bankruptcy, although many middle-class homeowners are being forced out of the comparatively simple Chapter 13 process into a Chapter 11 bankruptcy simply because they have too much debt and the Chapter 11 rules work poorly for individuals (more on that later).
Chapter 7 bankruptcy is entitled, “Liquidation”. In a Chapter 7 bankruptcy, a court-supervised procedure occurs during which a court-appointed Trustee determines whether the debtor has any assets that can be liquidated in order to pay the debtor’s creditors while allowing the debtor to retain certain exempt property, which is commonly the debtor’s residence. Generally, in a Chapter 7 case, there is little or no non-exempt property that can be liquidated, and therefore most Chapter 7 cases are no-asset cases, which means that there are no assets that can be liquidated for the benefit of creditors. In the unusual case where the Chapter 7 is an asset case, the associations need to take steps in order to protect their rights and ensure that they are one of the creditors who will receive a distribution. For example, in a Chapter 7 asset case, the association would have to submit a Proof of Claim before the claim deadline. Moreover, if the association recorded a lien on the Unit prior to the delinquent owner’s bankruptcy, then the association is a secured creditor who is entitled to a higher priority in the distribution process (i.e. in many instances, only the secured creditors receive a distribution, and unsecured creditors often do not receive anything). Additionally, the bankruptcy case does not eliminate the association’s lien recorded on the property prior to the delinquent owner’s bankruptcy, and therefore the association retains the right to foreclose on the unit even after the delinquent owner’s bankruptcy is over. This is why it is so important for community associations to record assessment liens as soon as possible so the association is considered a secured creditor, which would allow the association to continue the collection process and foreclose on the unit, home or lot. In almost all Chapter 7 bankruptcies, the debtor will be granted a discharge that releases them of personal liability for most unsecured and dischargeable debts. The entire process normally takes just about 6 – 8 months from the time the bankruptcy petition is filed.
Chapter 13 bankruptcy is entitled, “Adjustment of Debts of an Individual with Regular Income”, which basically means repayment. Chapter 13 bankruptcy is traditionally used for people who have a regular source of income or a full-time job, and therefore they may not qualify for Chapter 7 (since the rules were adjusted in 2005). For many people, Chapter 13 is preferable to Chapter 7 because it allows the debtor to keep some assets. A Chapter 13 bankruptcy allows the debtor to repay creditors (through the bankruptcy trustee) over time, while retaining their possessions and property and making payments to creditors. This time traditionally varies from three to five years. In a Chapter 13 case, the debtor proposes a Chapter 13 Plan with regard to the repayment of the debtor’s pre-bankruptcy petition debts. This type of repayment proposal takes place at a confirmation hearing, at which time the court will either approve or disapprove the Plan. If the debtor owes money to the association prior to the bankruptcy filing, it is important to determine whether the debtor has included the association in the debtor’s Chapter 13 Plan, and if the amounts included are correct. If the association recorded a lien prior to the debtor’s bankruptcy, then the association is a secured creditor that should be included in the Plan. However, if the association is not included, it is up to the association to take the necessary steps to protect itself, including the filing of a Proof of Claim and filing an Objection to the Plan prior to the Confirmation of the Plan.
Unlike Chapter 7 bankruptcy, the debtor does not receive an immediate discharge of their debts. Under Chapter 13 bankruptcy, the debtor must complete the repayment plan before the discharge is granted; however, while the bankruptcy is pending, the debtor is protected from lawsuits, garnishments, and other creditor action while the plan is in effect (due to the automatic stay).
In Chapter 13 bankruptcies, the debtor may end up paying back 50% or more of their current debts, and 100% of secured debts, which again confirms just how important it is for associations to get liens recorded against delinquent owners’ property. Additionally, if the debtor misses a regularly scheduled payment at any time during their Chapter 13 bankruptcy repayment plan, they could end up in violation of the court and have their bankruptcy case dismissed such that they would have to repay all their debts!
Unfortunately, it is a fact that in most cases, debtors do not complete their Chapter 13 bankruptcy repayment plans. Most people filing Chapter 13 bankruptcies think they will be able to complete their repayment plan; however, only about a third of them actually do.
Since the economic downturn, many property owners are being forced out of the comparatively simple Chapter 13 process simply because they have too much debt. The Chapter 11 Bankruptcy (like a Chapter 13 Bankruptcy but for individuals with higher net worth and/or higher amount of debt) rules work poorly for individuals, and many of the lawyers who represent consumer debtors don’t understand those rules. Under current limits, pegged to the consumer price index, a debtor cannot use Chapter 13 if he or she has more than $1,081,400 in secured debt, such as a mortgage, which is not that unusual in Southern California. Even more typical is a debtor with a second mortgage, which no longer is backed by any real value in the property. Bankruptcy courts classify that second mortgage as unsecured, which can easily push the debtor over Chapter 13’s limit on unsecured debt of $360,475.
Many people do not realize that if they own a home with a sizable amount of equity, have a fair amount of assets to protect, or have co-signers on a loan, they most likely will not be able to file Chapter 7 bankruptcy under current law. With recent changes in bankruptcy law, it will be even more difficult to file for bankruptcy. But many still are, and many of them seem to live at the community associations we represent.
If you require additional information on the subject of bankruptcy and how your association can deal with this process as part of assessment collection, please contact Alyssa Klausner, Esq. at firstname.lastname@example.org.