Dealing with the Post-Discharge Debtor

A borrower or personal guarantor (herein, the "debtor") who has been discharged in a bankruptcy case sometimes wants to extend a loan or to receive forbearance from the bank. Otherwise, for example, the debtor might face losing property to foreclosure. The bank might also prefer to extend or forbear on the loan. This scenario puts the bank at risk of violating the debtor's bankruptcy discharge, which can have serious consequences. In this article, I highlight two fairly recent cases that illustrate the risk and the consequences. I also discuss some steps a bank may wish to take to minimize the risk.

Notably, as the cases show, the risk can be well hidden and may not rear its head for years. After all, the debtor wants the renewal or forbearance, and it may be in his best interest, so there might appear to be no harm in providing it. However, years into the future, the debtor's circumstances may change and, for example, the debtor may no longer fear a foreclosure. Under those changed circumstances, and after consultation with a lawyer, the debtor might decide to assail his deal with the bank as a violation of his bankruptcy discharge and to pursue a claim against the bank.

Case #1: Prior to filing bankruptcy, the debtor personally guarantees company loans, and after bankruptcy he signs a forbearance agreement that includes a new personal guaranty.

In the first case,^[1] the debtor was a doctor who personally guaranteed equipment finance agreements entered into by his medical practice. The debtor then filed Chapter 7 bankruptcy, in which he scheduled his guaranty obligation, and received a discharge. Subsequently, the lender entered into a forbearance agreement with the medical practice - which lowered the practice's monthly payments and extended the payment terms - that included a personal guaranty signed by the debtor. Two years later, the lender filed an action in the debtor's bankruptcy case requesting a declaration that the forbearance agreement did not violate the debtor's bankruptcy discharge and was not a reaffirmation agreement. The debtor countersued, arguing exactly the opposite and requesting damages.

The case presented two key questions:

1. Was the forbearance agreement effectively a reaffirmation of the debtor's pre-bankruptcy debt?
2. Did the forbearance agreement constitute a "voluntary" repayment?

The lender argued that the forbearance agreement was a post-bankruptcy agreement supported by "new and independent consideration" - new payment terms and the lender's agreement to forbear from exercising its rights - not a reaffirmation of the pre-bankruptcy debt. The lender cited an old line of bankruptcy court decisions to support its position that post-bankruptcy agreements supported by new and independent consideration are enforceable. The court, however, noted that those decisions have been questioned and found that the relevant question is not whether there is any new and independent consideration but, rather, whether a promise by the debtor to repay the original debt is any part of the consideration. If so, then the agreement is a reaffirmation agreement that is invalid unless it meets the strict requirements set forth in section 524 of the bankruptcy code. Those requirements include, for example, that the agreement is executed and filed with the bankruptcy court before the borrower receives his discharge.

The court found that the forbearance agreement was based at least in part on the debtor's original guaranty, noting that the lender "advanced no new money, and the Forbearance Agreement contained an agreement to repay under the original financing agreement." The court wrote, the debtor had "[e]ssentially ... assumed the obligations that had previously been discharged in his chapter 7 case." The court therefore concluded that the forbearance agreement was a reaffirmation agreement, and because there was no dispute that the forbearance agreement did not meet the reaffirmation requirements of the bankruptcy code, the court ruled that it was not valid as to the debtor.

The court then turned to whether the debtor's signature on the forbearance agreement amounted to a "voluntary" repayment of the discharged debt, as bankruptcy code section 524(f) does allow a debtor to "voluntarily" repay a discharged debt. Unfortunately for the lender, the court concluded that allowing the debtor to sign the forbearance agreement "was an act to collect, not a mere voluntary payment." In this regard, the court agreed with another bankruptcy court that has held that section 524(f) does "not validate repayments of discharged debts that are in any manner induced by the acts of the creditor." The bankruptcy courts in Virginia also take the view that merely allowing a debtor to sign a document that revives his liability on a discharged debt is an act by the lender to collect the debt, not a voluntary repayment by the debtor.^[2]

In a subsequent order, the court awarded the debtor $13,822 in damages, which was equal to the attorney fees he had incurred in defending against the lender's actions, but found that the lender's actions were not so egregious as to justify imposing sanctions or punitive damages.

Case #2 - Prior to filing bankruptcy, the debtor signs a promissory note secured by his real estate, and after bankruptcy he signs two renewal notes.

In the second case,^[3] the debtor signed a promissory note secured by a deed of trust on two parcels of real estate, and several years later he filed a Chapter 7 case. The bank knew of the bankruptcy filing, as well as the fact that the debtor received a discharge of his debts. For approximately four years after the discharge, the monthly payments on the loan were made by a combination of direct payments from an accidental injury and death insurance policy and voluntary payments by the debtor. Then, at around the same time as the insurance policy expired, the note matured. The debtor then executed a new promissory note that matured after about one year, and then another promissory note after that. He paid the bank roughly twelve thousand dollars under the two renewal notes.

Then, in February 2016 - eight months after he stopped making payments to the bank, and over seven years after he received his bankruptcy discharge - the debtor reopened his bankruptcy case and filed a lawsuit alleging that the bank violated his discharge by collecting all the payments that were made after he received his discharge. He requested damages equal to those payments, plus the cost of the insurance, utility service, and real estate taxes he paid subsequent to his discharge, which he claimed he would not have paid had he been aware that his debt to the bank had been discharged. He also requested an award of attorney fees and punitive damages.

The court ruled that the payments that were made after the discharge but before the first renewal promissory note was signed were voluntary payments. The court wrote that there "is no evidence that the Bank made any attempt to collect the discharged debt up until that point. No late notices were sent and no collection phone calls were made. Thus, no violation of the discharge occurred until the execution of the ... [first renewal note]." Also in favor of the bank, the court ruled that the debtor's payment of insurance, utilities, and taxes on the real estate did not arise from his personal obligations under the promissory notes but, rather, were obligations contained in the deed of trust that essentially ran with the land. The court wrote that "[h]ad the Debtor not made the payments, these amounts could have been paid by the Bank and charged against the collateral pursuant to the terms of the deed of trust. Accordingly, these payments did not arise from the violation of the discharge injunction and are not appropriate for recovery."

However, the court ordered the bank to refund the roughly twelve thousand dollars the debtor paid under the renewal notes, as those notes revived the debtor's personal liability on the loan in violation of his bankruptcy discharge. The court suggested that the bank could have avoided this fate by having the debtor execute a note that was non-recourse as to the debtor. The court also awarded the debtor $5,500 in attorney fees that were conceded to have been incurred in the case, as well as almost $600 in court-reporter fees. The court declined to award punitive damages because there was no evidence that the bank acted "egregiously or with malevolent intent" or that there was "a pattern of similar misconduct."

Suggestions to Minimize Risk

The cases reviewed above show the downside that can come with not carefully considering how to deal with a borrower who has received a bankruptcy discharge. While the lender in each case was not required to pay punitive damages, the bankruptcy courts can award punitive damages if they find that the lender's behavior was egregious, malevolent, or showed a specific intention to violate the bankruptcy discharge.

I offer the following takeaways from the cases above and suggestions to mitigate the risks associated with dealing with borrowers after a bankruptcy discharge:

1. If a post-bankruptcy deal with the debtor involves the debtor becoming re-obligated to pay debt that was discharged in his bankruptcy case, the bank will almost surely not be protected by an argument that the deal is not really a reaffirmation agreement but rather is supported by new consideration. The trend in the cases is that if a promise to repay the original debt is any part of the consideration of a deal, then the deal is a reaffirmation agreement and, accordingly, is invalid as to the debtor unless the requirements of bankruptcy code section 524 were met during the bankruptcy case.

2. Post-bankruptcy payments from the debtor will be deemed to be voluntary only if the bank played no role in the debtor making them. The bank can't allow the debtor to sign a new promissory note or other loan document that renews his liability for the loan - even if the debtor says he wants to - and any communications with the debtor should include a disclaimer to the effect that the loan has been discharged, the debtor has no personal liability on the loan, and the bank is not attempting to collect the loan as a personal liability of the debtor. Without a disclaimer of that kind, the bank is vulnerable to a charge that it coerced or tricked the debtor into making payments.

3. If the debtor states an intention to reaffirm his bank loan during the bankruptcy case - which his bankruptcy schedules might state - then follow up with the debtor's counsel to ensure that a proper reaffirmation agreement actually gets prepared and filed with the bankruptcy court prior to the entry of the debtor's discharge. Simple follow through during the bankruptcy case can avoid the scenarios above altogether by preventing discharge of the bank's loan. Bear in mind that reaffirmation agreements generally are entered into with respect to loans secured by personal-property collateral (e.g., vehicles) and are rare with respect to loans secured by real estate.^[4]

4. Assuming the loan was discharged but there is still a mutual desire to extend or modify the loan or enter into a forbearance agreement, make sure that the documents to be signed are very clear that the debtor's discharge is being honored and that the debtor is not incurring any personal liability under the documents for the discharged debts. If form loan documents are used, they should be thoroughly reviewed to remove any language that states or suggests otherwise.

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[1] In re Schwarz, 2016 Bankr. LEXIS 4432 (Bankr. E.D.N.C. Dec. 22, 2016).
[2] In re Mickens, 229 B.R. 114, 118 (Bankr. W.D.Va. 1999) ("Clearly, allowing a debtor to sign a note which places him under the same obligation which he was subject to pre-discharge does not constitute a voluntary repayment by the debtor nor does it leave the debtor in position to make a voluntary repayment under § 524(f)."); In re Cherry, 247 B.R. 176 (Bankr. E.D.Va. 2000) ("Regardless of how non-coercive or voluntary the circumstances of Cherry's execution of the Replacement Notes, the admitted failure to adhere to the requirements of § 524(c) and (d) of the Bankruptcy Code [i.e., the reaffirmation requirements] destroys the validity and enforceability of these instruments.").
[3] In re Boyd, 2016 Bankr. Lexis 2137 (Bankr. W.D.Va. May 27, 2016); and In re Boyd, 562 B.R. 324 (Bankr. W.D.Va. 2016).
[4] Reaffirmation agreements are rare with respect to real estate loans because (a) an individual who is behind on her home mortgage will generally file a Chapter 13 bankruptcy because that chapter provides her the opportunity to cure the arrearage over time, and (b) most mortgage debts are never going to be discharged in a Chapter 13 case anyway because Chapter 13 essentially provides that the discharge does not apply to loans that are longer than the life of the Chapter 13 repayment plan (and of course most mortgage loans are longer than the five-year maximum life of a Chapter 13 plan). Further, if the borrower files Chapter 7, instead of reaffirming the loan she's likely to either (a) surrender the real estate because she's concluded that she no longer can afford it, or (b) use the "ride through" option allowed by the law, which allows her to retain the real estate so long as she keeps the loan current and otherwise complies with her obligations under the deed of trust.