THE INTERACTION BETWEEN BANKRUPTCY AND FORECLOSURE LAW
by Jacinta Epting, ATG Law Clerk

Bankruptcies and foreclosures are often examined independently of one another. Foreclosures are the mechanism that mortgagees use to recover their money upon default. Bankruptcies are a way that debtors either eliminate their debts or establish a repayment plan for their debts and at the same time save their property. Frequently there are interactions between bankruptcies and foreclosures. The interaction normally occurs when a debtor commences a bankruptcy filing in the midst of the mortgagee's foreclosure proceedings. The law recognizes that both the debtor and mortgagee have legitimate interests to protect in the property. The question that arises is: "How might a bankruptcy action affect a foreclosure proceeding?" This article will answer that question primarily in the context of bankruptcy chapters 11 and 13. Additionally, this article will address the advantages of filing a particular chapter of bankruptcy, and briefly highlight the major tasks the debtor must complete when filing for bankruptcy within each of the chapters.

Bankruptcy refers to the judicial proceedings that debtors use when they are no longer able to pay creditors. Filing a bankruptcy petition suspends the normal operation of rights between the debtor and his or her creditors. The essence of filing bankruptcy is to rearrange rights and liabilities between debtor and creditor. As soon as the debtor files a bankruptcy petition, the court will impose an automatic stay. An automatic stay halts all actions against the debtor's property, real and personal, and remains in effect as long as the property is part of the bankruptcy estate. If the debtor files the petition knowing he or she cannot repay his or her creditors and hopes only to prolong the foreclosure proceedings it is likely that the court will dismiss the case. However, if it is likely that the debtor can reorganize and pay his or her debts the court will allow the bankruptcy case to proceed.

What Are the Advantages of Filing Chapter 11 Bankruptcy?

Filing chapter 11 bankruptcy is the logical and preferred choice for business entities in the commercial setting. Chapter 11 is essentially a compromise between the debtor and creditors. It allows the creditors to obtain repayment and allows the debtor to save his or her property and business while correcting debt problems. "Chapter 11 was designed by Congress to prevent waste and reduction in assets that result from unnecessary liquidation. Congress meant to encourage financial restructuring and to re-establish efficient business operations with the goals of permitting greater payments to creditors than could otherwise be made, while also preserving jobs and shareholders' interest." In re Schlangen, 91 Bankr 834, 837 (Bankr ND Ill 1988).

One of the biggest advantages of filing chapter 11 is that there are no dollar limits on the amount of indebtedness owed. 11 USC § 109(d) (2000)1 provides that a person eligible to file chapter 7 is also eligible to file chapter 11. Additionally, a debtor may conduct a chapter 11 case without the appointment of a trustee. This means that the debtor becomes a "debtor in possession" exercising, with some exceptions, the rights, powers, functions, and duties that a trustee would ordinarily exercise.

What Are the Requirements for Filing Chapter 11?

There are several tasks a debtor must complete when filing chapter 11 bankruptcy. A debtor commences a chapter 11 case by filing a petition, which also operates as an "order of relief." Section 362 provides that there is an automatic stay on foreclosure proceedings when the debtor files the petition for chapter 11, 13, or 7. A debtor will also need to file a "plan of reorganization." The debtor may file a plan with the petition. Unlike chapter 13 cases, the debtor has a considerable amount of time to file the plan. Section 1121(b) provides that the debtor has 120 days to file a plan after filing the petition. Additionally, during these 120 days the debtor has the exclusive right to file a plan. If the debtor has not filed within 120 days, any party in interest, including the debtor or trustee, may file a plan before 180 days following the date the petition was filed. § 1121(c)(3). The court may for cause reduce or increase the 120-day period on the 180-day period. § 1121(d). Section 1123 provides an extensive list of what a plan must include. A plan must, for example, specify any class of claims or interests that are impaired (those whose rights to payments are being modified by the plan) or not impaired under the plan. Additionally, the plan must provide for an adequate means of implementation.

The debtor must provide the shareholders and creditors with a disclosure statement and a copy of the plan. Each class of claims within the plan must accept the debtor's plan. A class of claims has accepted a plan when more than one half in number and at least two thirds in amount of the allowed claims actually voting on the plan approve the plan. § 1126(c). After each class has voted on the plan, a bankruptcy court must confirm the plan. The court may confirm a plan even if all the impaired classes did not accept the plan. Section 1129(b) provides that a plan will be confirmed by the court if at least one impaired class has accepted the plan, the plan does not discriminate unfairly, and the plan is fair and equitable. Additionally, the court will confirm the plan if it meets all the requirements of the statute including that it was proposed in good faith and not by any means forbidden by law. § 1129(a)(3).

Finally, there is always a possibility that the court will dismiss a case. Section 1112(b) provides that the court may dismiss a case or covert it to chapter 7 for cause when certain factors are present. Some of those factors include the following: (1) Continuing loss to or diminution of the estate and absence of a reasonable likelihood of rehabilitation; (2) an inability to effectuate a plan; (3) unreasonable delay by the debtor that is prejudicial to creditors; (4) failure to propose a plan in the applicable time; (5) inability to effectuate substantial consummation of a confirmed plan; and (6) material default by the debtor with respect to a confirmed plan. § 1112(b). Courts have concluded that the enumerated causes set forth promulgated in Section 1112(b) are not exclusive and no one factor is determinative. Additionally, courts have dismissed chapter 11 cases or converted these cases to chapter 7 when the debtor files the case in bad faith. "Although bad faith is not one of the ten grounds for dismissal promulgated in Section 1112(b), circuit courts have recognized and affirmed the power of bankruptcy courts to dismiss chapter 11 cases that meet a good faith standard." In re Park Place, 115 Bankr 940, 945 (Bankr ND Ill 1989).

How Might Filing a Chapter 11 Bankruptcy Affect Foreclosure Proceedings?

If any of the factors promulgated in Section 1112(b) are present in the debtor's case, the court may dismiss or convert the bankruptcy case and the foreclosure proceedings will go forward. Typically, mortgagees will argue that the debtor filed the case in bad faith. A clear example of bad faith filing occurs when the debtor files a case to save his property knowing that there is no chance of reorganization. In In the Matter of James Wilson and Associates, 965 F2d 160, 170 (7th Cir 1992), Judge Posner stated, "[t]he clearest case of bad faith filing is where the debtor enters chapter 11 knowing that there is no chance to reorganize his business and hoping merely to stave off the evil day when the creditors take control of the property." In In re Park Place Associates, 115 Bankr 940 (Bankr ND Ill 1989), the court held that the debtor's case was filed in bad faith and dismissed the case. In that case, the debtor, owner of a shopping mall, filed for chapter 11 bankruptcy in the midst of foreclosure proceedings. The court dismissed the case because the debtor did not show there was a chance for reorganization. The court pointed to the fact that the mall was being only marginally maintained. At the time of filing the chapter 11 case, the mall was only 46 percent occupied and by the time of the final hearing on the motion to dismiss, the mall was less than 41% occupied. Additionally, the mall had a history of leasing space to tenants that were delinquent in paying rent and who were placed in possession in order to increase the occupancy rate. Finally, the mall was the debtor's only asset and several liens had been placed on the property.

However, if there is a chance that the debtor can reorganize, the court will allow the bankruptcy case to go forward even if the debtor commenced the case in the midst of foreclosure proceedings. In In re Cadwell's Corner Partnership, 174 Bankr 744 (Bankr ND Ill 1994), the mortgagee argued that debtor's filing of chapter 11 in the midst of foreclosure proceedings was an act of bad faith. Specifically, the mortgagee argued that the debtor's motive in filing for bankruptcy was to forestall the foreclosure proceedings in order to defer adverse tax consequences to limited partners. The court disagreed and found that filing the petition was not an act of bad faith so long as there was a chance the debtor could reorganize. The court stated:

A property owner certainly has every right to engage in litigious actions to avoid foreclosure, and the debtor's adverse attempts to put off foreclosure are not proof of a bad faith filing. If there is a reasonable chance for an effective reorganization, a debtor has every right to file for bankruptcy in the midst of a foreclosure action. In fact, the very purpose of the automatic stay is to provide debtors with some breathing room from such foreclosure proceedings to enable them to make a fresh start. Id at 362.

What Are the Advantages of Filing Chapter 13 Bankruptcy?

Chapter 13 is a means by which an individual with regular and stable income can repay his or her creditors. "Congress added chapter 13 to the Bankruptcy Code in an effort to help debtors protect their assets from liquidation under chapter 7 and to insure that available bankruptcy proceedings would provide debtors with a fresh start after the bankruptcy process." Bank One, Chicago, NA v Flowers, 183 Bankr 509, 514 (Bankr ND Ill 1995). Many debtors find chapter 13 advantageous because the plan does not require creditor acceptance of a plan and there is no provision for creditor committees. Chapter 13 is also advantageous because it allows the borrower to cure any defaults under the mortgage and to maintain current payments while the case is pending. See §§ 1322(b)(3) and 1322(b)(5). This means that even if the home is sold at a foreclosure sale the borrower has the right to cure defaults until the court confirms the sale. In re Crawford, 217 Bankr 558 (Bankr ND Ill 1998).

What Are the Requirements for Filing Chapter 13 Bankruptcy?

Section 109(e) provides an individual with a regular income who owes on the date of filing the petition non-contingent, liquidated unsecured debts of less than $269,250 and non-contingent liquidated secured debts of less than $807,750 may be a debtor under chapter 13. Like chapter 11, a chapter 13 case begins with the filing of a bankruptcy petition and triggers the automatic stay provision of Section 362. Section 1321 provides that the debtor must file a plan and Section 1322 provides an exhaustive list of what the debtor's plan must include. Bankruptcy Rule 3015 provides that debtor must file the plan within 15 days of filing the petition, and that the court may only extend the time for cause. A plan may not provide for payments over a period of three years unless the court for cause approves a longer period not to exceed five years. § 1322(d). A court, rather than creditors, will vote on and confirm the plan. Section 1325 promulgates the necessary requirements for the court to confirm the plan and among other things requires that the debtor propose the plan in good faith.

Similar to chapter 11 cases, the court has the discretion to dismiss chapter 13 cases. Section 1307(c) lists the reasons why a court may for cause covert a chapter 13 case to chapter 7 or dismiss the case, whichever is in the best interests of creditors and the estate. Some of those reasons include the following: (1) unreasonable delay by the debtor that is prejudicial to creditors; (2) failure to file a plan timely under Section 1321; (3) material default by the debtor with respect to a term of a confirmed plan; and (4) failure to commence timely payments. Courts have also dismissed or converted cases to chapter 7 under Section 1307(c) if the debtor filed the case in bad faith. The court will use a totality of the circumstance test in deciding whether a case was filed in bad faith. Specifically, the court will examine: (1) whether debtor has stated his or her debts and expenses accurately; (2) whether the debtor has made any fraudulent representation to mislead the bankruptcy court; or (3) whether the debtor has unfairly manipulated Bankruptcy Code. In re Johnson, 228 Bankr 663, 668 (Bankr ND Ill 1999).

How Might Filing a Chapter 13 Case Affect Bankruptcy Proceedings?

If any of the factors promulgated in Section 1307(c) are present in the debtor's case, the court may dismiss or covert the case to chapter 7 and the foreclosure proceedings will go forward. For example, courts have stated that it is proper to dismiss a debtor's case for failing to file a plan within 15 days of filing the petition. See In re Nowak, 143 Bankr 154, 158 (Bankr ND Ill 1992). However, like chapter 11 cases, the mortgagee will typically argue that the debtor filed the case in bad faith. The court will not find that a chapter 13 case was filed in bad faith simply because it was filed in the midst of foreclosure proceedings. In In re Herrera, 194 Bankr 178, 187 (Bankr ND Ill 1996), the court stated, "[f]iling a bankruptcy petition to prevent foreclosure if undertaken pursuant to a legitimate effort at reorganization is not reprehensible and is in accord with the aim of the Bankruptcy Code." The court went on to state that a debtor files a chapter 13 case in bad faith if the purpose is only to delay foreclosure proceedings. "However, when a case has been filed only for the purpose of inhibiting or forestalling a foreclosure action on the debtor's assets without the intention of financial rehabilitation, the case should be dismissed as having been filed in bad faith." Id.

A Brief Note on Chapter 7 Bankruptcy

Debtors who have consumer debts typically file Chapter 7 bankruptcy. Chapter 7 is most advantageous when the debts exceed the dollar amount permitted by chapter 13. Additionally, chapter 7 if the preferred choice when the debtor lacks sufficient income to fund a plan.

Filing a petition under chapter 7 will impose an automatic stay on the foreclosure proceedings. However, debtors rarely use chapter 7 when seeking to preserve their property. This is because there is no opportunity to cure mortgage arrearages over time. However, if there is no equity in the property in which the trustee would have an interest, and the debtor can negotiate the terms of affirmation pursuant to Section 524(c), chapter 7 is beneficial. The benefit is the immediate discharge of non-reaffirmed debt and the avoidance of the budgetary restrictions that a chapter 13 plan imposes.

Reasons Why Filing Bankruptcy May Not Affect Foreclosure Proceedings

Even if the bankruptcy court allows the debtor's case to proceed, the mortgagee can still request relief from the automatic stay. Section 362(d)(2) provides that a court must grant relief from the automatic stay under the following conditions: (1) the debtor does not have any equity in such property; and (2) such property is not necessary to an effective reorganization. The party seeking relief has the burden to prove a lack of equity in the property. In re Cadwell's Corners Partnership, 174 Bankr 744, 759 (Bankr ND Ill 1994). To obtain relief from the stay, the mortgagee must file a motion with the court, and the court will have a hearing on the matter. If the court grants the mortgagee's motion, the mortgagee may proceed with the foreclosure sale. Some courts have found that the property remains part of the bankruptcy estate despite the relief from the stay until the property is removed by abandonment. See In re San Felipe, 115 Bankr 526, 528 (SD Tex 1990). Other courts have expressly permitted the mortgagee to proceed with the foreclosure sale when granting the mortgagee's request for relief, thus making abandonment unnecessary. See In re Thomas W Parks, 227 Bankr 20, 25 (WD NY 1998); In re Ellis, 60 Bankr 432, 433 (Cal 1985).

A debtor could find that despite filing for bankruptcy the foreclosure proceedings remain unaffected because of Section 305. Section 305 allows a bankruptcy court after a notice and hearing to dismiss a case or suspend all proceedings at any time if the interests of creditors and the debtor would be better served by such dismissal. It is unlikely that a mortgagee will convince a court to dismiss under this section since the court must first conclude that doing so would be in the best interests of all creditors. In In re Foundry of Barrington Partnership, 129 Bankr 550, 555 (Bankr ND Ill 1991), the court reiterated that other courts have refused to abstain where abstention would only serve the interest of one mortgagee seeking to obtain possession. Finally, Section 109(g) provides that no individual may be a debtor if the individual was the debtor in a case pending at any time in the preceding 180 days, and (1) the case was dismissed by the court for willful failure of the debtor to abide by the orders of the court, or to appear before the court in proper prosecution of the case; or (2) the debtor requested and obtained voluntary dismissal of the case following the filing and request for relief from the automatic stay provided by Section 362.

Conclusion

There are many reasons why a bankruptcy case may or may not halt foreclosure proceedings. While it is clear that bankruptcy courts will not dismiss or convert a debtor's case simply because the case was filed in the middle of foreclosure proceedings, it is also clear that courts may dismiss a case for many other reasons. It is important that both debtors and mortgagees realize that there are many reasons why a bankruptcy case may or may not affect foreclosure proceedings.

1. All statutory references are to the Bankruptcy Code unless otherwise noted.

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