Ch. 13 Debtor Can't Pay His Attorney Before Mortgage

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By Diane Davis

April 11 — A debtor's Chapter 13 plan improperly prioritized paying the debtor's attorney in full before paying a secured lender holding an interest in the debtor's home, a district court in Michigan held April 7.

Judge Thomas L. Ludington of the U.S. District Court for the Eastern District of Michigan reversed the decision of the bankruptcy court approving the debtor's Chapter 13 plan and remanded the case.

This case addresses the tension between Bankruptcy Code Section 1322(b)(2), which won't allow a Chapter 13 plan to modify the rights of “a claim secured only by a security interest in real property that is the debtor's principal residence,” and Section 1326(b)(1), which gives priority to administrative fees, including the debtor's attorneys' fees.

Unwarranted Intrusion

The district court's ruling “is an unwarranted intrusion in the bankruptcy court’s ability to administer its cases,” Matthew Mason told Bloomberg BNA April 11. Mason is a Detroit bankruptcy attorney and member of the National Association of Consumer Bankruptcy Attorneys and the National Consumer Bankruptcy Rights Center.

“Once one accepts that there is an automatic post petition, pre-confirmation default due to the time lag between filing and commencement of payments after confirmation, then it should be left to the sound discretion of the court as to the timing and extent of the curing of that default,” Mason told Bloomberg BNA. “Section 1326(b (1) gives the court discretion to order payment of administrative expenses first. Contrary to the District Court’s view, there is nothing sacred about a mortgagee’s right to receive a monthly payment such that the timing cannot be affected,” he said.

“If the bankruptcy court determines that in order to administer its Chapter 13 docket, it needs promptly paid competent bankruptcy counsel to shepherd the cases to a successful conclusion for both the debtor and creditors, then that exercise of discretion should not be second guessed,” Mason told Bloomberg BNA. “Chapter 13 plans have to be viewed in their entirety, not just at one moment in time. Mortgage creditors lose nothing by payment of the attorney fees in full. They still receive all of their monthly payments plus interest,” he said.

The court's decision “elevating form over substance just creates one more disincentive for competent counsel to handle Chapter 13 cases, a result that no stakeholder in the bankruptcy system should applaud,” Mason told Bloomberg BNA.

Limited Disruption to Existing Practice

The bankruptcy court said it was following the Eastern District of Michigan's “long tradition” of allowing debtors' counsel to receive full priority payment before other creditors and allowing a debtor to cure non-payment of post-petition monthly “gap payments” to all other creditors. The district court took issue with this, however, and said that although it might be disruptive to the Eastern District of Michigan model Chapter 13 plan, its decision had limited consequences in that it applied only where there is a homestead mortgagee and when the plan has insufficient funds to pay both the debtor's attorney and the creditor.

Debtor Craig Maike obtained a loan from appellant United Financial Credit Union (UFCU) for $62,000. Under their agreement, the debtor would make monthly payments of $454, and if he failed to make such payments, he would be in default.

Debtor's Proposed Ch. 13 Plan

Subsequently, the debtor fell behind on the mortgage and filed a Chapter 13 bankruptcy petition. Chapter 13 allows individuals receiving regular income to obtain debt relief while retaining their property. To do so, the debtor must propose a plan that uses future income to repay a portion of his debts over a three to five year period.

The debtor's Chapter 13 plan proposed paying his attorneys' fees of $2,910 in full, before beginning $510 in monthly payments to UFCU.

UFCU objected, arguing that the plan altered its rights to receive payments each month during the pendency of the plan under Section 1322(b)(2) and 1322(b)(5). The debtor and the trustee both argued that the debtor's attorneys' fees should be paid as a priority administrative expense.

Plan Confirmed

After an initial confirmation hearing, the bankruptcy court adjourned the hearing for a few months until the trustee had enough funds to pay the debtor's attorney in full and begin monthly payments to UFCU. A few months later, the bankruptcy court confirmed the debtor's plan, concluding that UFCU would receive its contractual payment of $503 each month, and that its post-petition arrearage of $3,522 would take 28 months to cure, and its prepetition arrearage of $2,515 would take an additional 20 months to cure. The total arrearage owed to UFCU would be cured within the 60 months required under Chapter 13.

On appeal to the district court, UFCU argued that the plan impermissibly modifies its rights under the mortgage agreement. According to UFCU, the plan can't create a post-petition default by requiring all of the post-petition income to be applied against the debtor's attorneys' fees exclusively. The debtor contended that the mortgage payment gap is permissible under Section 1322(b)(5), which allows for the maintenance and cure of post-petition default.

Not a Sword to Delay Payment

The district court focused on the fact that in this case, the post-petition default was created by the plan's requirement that all of the debtor's post-petition income be allotted to attorneys' fees. Although Section 1322(b)(5) may allow cure of post-petition default over a reasonable time period, it doesn't “contemplate or authorize a post-petition default created by the plan itself to accumulate cash for a preferred creditor — the debtor's attorney,” the court said. “The opportunity to cure a default is a shield by which a debtor can heal a delinquent debt. It is not a sword which the debtor can use to further delay payment while the attorney collects a fee,” the court said.

Section 1322(b)(5) “exists as a mechanism to cure defaults and maintain payments while a bankruptcy case is pending — it doesn't exist to allow the plan itself to create defaults at the expense of the homestead mortgagee in order to prioritize payment to debtor's counsel, exclusively,” the court said.

Encourages Competent Representation?

The court rejected the debtor's argument that payment to counsel at the outset of the plan encourages competent representation. There is no language in the Code to codify such a policy, the court said. “Concern for debtor's attorneys cannot override the express language of § 1322(b)(2) and § 1322(b)(5),” the court said.

In Michigan, “a number of attorneys already restrict their practice to Chapter 7 because of the often difficult road to confirmation, the many and varied objections to confirmation and the complexity of the work,” Mason told Bloomberg BNA. He explained that “[i]f you factor in ever greater uncertainty of being paid, given that the upfront time investment in a Chapter 13 can be significant, that would accelerate the trend toward Chapter 7 and attorneys only being willing to do the simplest, most likely to succeed Chapter 13's.”

Jennifer H. Doyle, Saginaw, Mich., and Michael M. Hall, Anagnost, Hall, Saginaw, Mich., represented appellee/debtor Craig Maike; Karl L. Wenzloff, Wenzloff & Wenzloff, P.L.C., Bay City, Mich., represented appellant United Financial Credit Union; Gaetan E. Gerville-Reache, Warner, Norcross, Grand Rapids, Mich., represented amici Michigan Bankers Association, Michigan Credit Union League, Chemical Bank, Mercantile Bank of Michigan; Charles J. Schneider, Charles J. Schneider Assoc., Livonia, Mich., represented amicus Northeastern Michigan Bankruptcy Bar Association; Melissa A. Caouette, Office of the Chapter 13 Trustee Carl L. Bekofske, Flint, Mich., represented amicus Chapter 13 Trustees for the Eastern District of Michigan.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com