Bankruptcy 101: Chapter 7 vs. Chapter 13
December 1, 2016
We have been asked on numerous occasions recently to provide guidance to our community association clients about the effects that bankruptcy has on their collections cases. The most common forms of bankruptcy by owners in the community association context are filed pursuant to either Chapter 7 or Chapter 13 of the United States Bankruptcy Code. Because of the confusion surrounding bankruptcy, many boards see bankruptcy as a negative for their community. Though the filing of bankruptcy certainly can have negative consequences, bankruptcies can actually be a good way for owners to restructure their debts and do not necessarily discharge all of the obligations owed to the community. That is, the bankruptcy may actually result in the association receiving more of the funds owed than they otherwise would have.
First, it is important to understand that, in both Chapter 7 and Chapter 13 bankruptcies, the operative date is the filing of the Voluntary Petition for Individuals Filing for Bankruptcy (the “Voluntary Petition”). This differs from an ordinary breach of contract lawsuit, in which the judgment date (once the court decides the case) is the significant date. In bankruptcy, as soon as the Voluntary Petition is filed, the delinquent owner’s account should be split into two groups: (1) amounts due pre-petition and (2) amounts due post-petition. Once the Voluntary Petition is filed, an automatic stay prohibiting all collection activities is in place during the pendency of the bankruptcy proceeding, meaning that the association and its attorney may not attempt to collect the debts in any of the ordinary fashions. If the bankruptcy is dismissed, however, it is as if the bankruptcy was never filed; the pre-petition and post-petition amounts should be merged back into one account, and the community may resume its collection activities.
Despite these similarities, there are important differences between the two main types of bankruptcies that affect how each case is handled. A Chapter 7 is known as “liquidation.” If the debtor meets the “means test,” meaning that their income is below a certain threshold, then the Chapter 7 Trustee will review all assets, sell any non-exempt assets to pay creditors, and then discharge the remaining creditors.
In the community association context, a Chapter 7 bankruptcy functions to discharge an owner’s personal obligation for delinquent pre-petition amounts only. The owner who filed bankruptcy is also responsible for the post-petition amounts that come due and owing after the filing of the bankruptcy.
There are three important details to keep in mind regarding a Chapter 7 bankruptcy. First, the bankruptcy stay only applies to the owner who filed the bankruptcy. Therefore, the community may still pursue collections against any co-debtor on the same property who did not file bankruptcy. Second, although the owner no longer has a personal obligation to pay, the liens filed against the property survive the bankruptcy. Accordingly, once the personal debt is discharged and the bankruptcy stay is no longer in effect, the community should still receive payment of the pre-petition amounts, secured by liens, in the event that the property is transferred or refinanced. The community also retains the ability to foreclose those pre-petition liens despite the discharge of the personal debt. Third, the Chapter 7 does not affect the post-petition amounts; all assessments that come due after the filing of the Voluntary Petition remain the obligation of the owner.
A Chapter 13 bankruptcy functions as a restructuring of the owner’s debt. Much like the Chapter 7 bankruptcy, there is a collections stay in place during the pendency of the bankruptcy. However, in a Chapter 13 bankruptcy, the debt is restructured and a payment plan on the pre-petition amounts is created and approved by the bankruptcy court. As a secured creditor (meaning the community has liens against the property) and after filing the requisite proof of claim, the community will often receive full payment on the pre-petition amounts through the Chapter 13 payment plan, which typically allocate payments over sixty (60) months. In other instances, the debtor may choose to deal with the association’s debt outside of the plan. If the community is unsecured (does not have liens against the property), the community typically receives payment of only a fraction of its claim, which is another reason why it is so vital for collections accounts to be turned over promptly and for the association’s attorney to file liens against the property.
Owners who wish to keep their property are responsible for payment of the assessments and related fees that come due after the filing of the Voluntary Petition. If these post-petition amounts are not paid, the association may file a motion to lift the bankruptcy stay and utilize ordinary collections procedures. A limited exception exists for owners who “surrender” their property in the Chapter 13; there is a split in the decisions among federal courts as to whether owners are responsible for post-petition amounts in this instance. The inconsistent rulings do not provide clear guidance and require advice on a case-by-case basis on whether the post-petition amount should be pursued by the Association.
Unlike a Chapter 7 bankruptcy, however, a Chapter 13 bankruptcy creates a stay for collection activities against the co-debtors, even if the co-debtor did not file bankruptcy. Additionally, liens against the property may be stripped in certain situations, thus making the community an unsecured creditor. For instance, courts will typically allow owners to strip the association lien if a senior lien (most commonly a mortgage or deed of trust) exceeds the value of the property. Bankruptcy courts conduct a global review of all of the debtor’s assets and debts in the bankruptcy; because there is no value or equity in the property supporting the community’s claim as a secured creditor, courts allow the junior liens to be “stripped” off the property, and the community’s claim becomes unsecured. Deciding whether to challenge an owner’s attempt to strip a lien involves many factors and should be reviewed by an attorney on a case-by-case basis.
It is also important to note that revoking privileges for nonpayment of assessments (such as parking permits, voting rights, and pool privileges) is considered a violation of the bankruptcy stay. Therefore, if an owner files bankruptcy and the stay has not been lifted, the community must reinstate the previously revoked privileges during the pendency of the bankruptcy stay.
The objective of this letter is to provide general guidance in the event an owner files bankruptcy. Because each case is different, however, we stand ready to assist to answer questions about your individual cases.