This question comes up all the time – either explicitly, or implicitly – during my consultations with prospective and current clients. Because there is no shortage of misinformation on the subject, it’s about time I wrote on it.
I. Secured Debts
In typical consumer bankruptcy practice reaffirmation comes up almost exclusively within the Chapter 7 context, and generally in dealing with secured debt. A secured debt is a debt that is secured by some tangible asset. If the debtor (i.e., the borrower) fails to make the payments, the creditor (i.e., the lender) can repossess the security – i.e., the collateral. For example, a car loan is secured by the car, and a home mortgage is secured by the home.
In order to better understand what is at work here, it helps to know a little more about secured debts. A simple example will suffice to set the stage. When a person takes out a loan to purchase a car, two important things happen.
A. In Rem Claims
First, the creditor gets a security interest in the car, meaning: if the debtor doesn’t make the payments, the creditor can repossess the car. Thus, the creditor has a claim against the car. In law, this kind of claim is known as an in rem claim – a claim against a thing.
B. In Personam Claims
Second, if the creditor repossesses the car after a loan default and resells it for less than the debtor owes, the debtor is personally liable for the post-resale deficiency, and the creditor can sue the debtor to collect it. Thus, the creditor has a claim against the debtor – the person. In law, this kind of claim is known as an in personam claim – a claim against a person.
II. Bankruptcy’s Effect On In Personam Liability
In any bankruptcy, if a debt is of the dischargeable variety then the bankruptcy discharge wipes out the in personam claim against the debtor – even if the debt was a secured debt.
However, if the debt in question was a secured debt, then the bankruptcy discharge does not extinguish the in rem claim against the collateral. In other words, the debtor will not end up with a free car or house as a result of bankruptcy.
This means that if the debtor receives a discharge and subsequently defaults on the secured debt, the creditor can repossess the collateral securing the debt. However, if the creditor resells the collateral for less than the current balance on the loan, the debtor has no personal liability on the shortfall. As you can imagine, creditors have not been thrilled with this scenario.
III. The 2005 Changes To The Bankruptcy Code
As a consequence of the creditors’ loss of in personam claims in bankruptcy discharges, the creditors lobbied Congress to change the law to require that if the debtor is to keep the collateral after the bankruptcy discharge, the debtor must resurrect the in personam claim and become personally liable on the debt once again. A well-paid Congress complied, and in 2005 added the current content of 11 U.S.C. § 524(c):
An agreement between a holder of a claim and the debtor, the consideration for which, in whole or in part, is based on a debt that is dischargeable in a case under this title is enforceable only to any extent enforceable under applicable nonbankruptcy law, whether or not discharge of such debt is waived, only if—
(1) such agreement was made before the granting of the discharge under section 727, 1141, 1228, or 1328 of this title;
(2) the debtor received the disclosures described in subsection (k) at or before the time at which the debtor signed the agreement;
(3) such agreement has been filed with the court and, if applicable, accompanied by a declaration or an affidavit of the attorney that represented the debtor during the course of negotiating an agreement under this subsection, which states that—
(A) such agreement represents a fully informed and voluntary agreement by the debtor;
(B) such agreement does not impose an undue hardship on the debtor or a dependent of the debtor; and
(C) the attorney fully advised the debtor of the legal effect and consequences of—
(i) an agreement of the kind specified in this subsection; and
(ii) any default under such an agreement;
(4) the debtor has not rescinded such agreement at any time prior to discharge or within sixty days after such agreement is filed with the court, whichever occurs later, by giving notice of rescission to the holder of such claim;
(5) the provisions of subsection (d) of this section have been complied with; and
(A) in a case concerning an individual who was not represented by an attorney during the course of negotiating an agreement under this subsection, the court approves such agreement as—
(i) not imposing an undue hardship on the debtor or a dependent of the debtor; and
(ii) in the best interest of the debtor.
(B) Subparagraph (A) shall not apply to the extent that such debt is a consumer debt secured by real property.
along with the current § 521(a)(6):
The debtor shall— . . . in a case under chapter 7 of this title in which the debtor is an individual, not retain possession of personal property as to which a creditor has an allowed claim for the purchase price secured in whole or in part by an interest in such personal property unless the debtor, not later than 45 days after the first meeting of creditors under section 341 (a), either—
(A) enters into an agreement with the creditor pursuant to section 524 (c) with respect to the claim secured by such property; or
(B) redeems such property from the security interest pursuant to section 722 . . .
IV. The Executive Summary
Well, there’s a mouthful. What on earth is going on here? The executive summary is this: If you’re the debtor and you want to keep the car securing the car loan, you must either reaffirm the debt or redeem the car. If you reaffirm the debt you resurrect your in personam liability. If you redeem the car under § 722, you pay the car off in one big payment at current fair market value. If you fail to do either by 45 days after the first 341 meeting of creditors the creditor can repossess the car.
V. The Mechanics Of Reaffirmation
So how do you reaffirm the debt? In common practice, the creditor proposes the reaffirmation agreement by sending it to the debtor’s attorney. If the debtor accepts its terms, the debtor signs it and sends it back to the creditor. The creditor’s representative signs it and files it with the Court. The judge assigned to the case then sets it for a hearing.
Important Caveat: Pursuant to § 524(c)(4), the debtor can rescind the agreement any time within sixty days of filing it with the Court. The rescinding must be in writing and sent to the creditor. It’s a good idea to file the notice of rescission with the Court as well, so it is in the public record.
If the judge deems reaffirmation to be an undue hardship on the debtor because the debtor has insufficient income after covering other living expenses to make the monthly payments, or if the judge feels that the agreement is patently unfair, or not in the debtor’s best interests, the judge will not approve it. Otherwise, the judge will approve it.
A. The Effect Of The Judge’s Approval
If the judge approves the reaffirmation agreement the in personam liability survives bankruptcy. This means that if the debtor subsequently defaults on the loan, say due to a job loss, and the creditor repossesses and sells the car for less the loan balance, the debtor is liable for the shortfall. Therefore, reaffirmation should be entered into with caution.
B. The Effect Of The Judge’s Non-Approval
If the judge refuses to approve the reaffirmation agreement can the creditor repossess the car? Although there is no case law on this question, the consensus among the many judges I have heard opine on it is that the creditor may not. Their reasoning is: The holding in In re Dumont was based on the fact that the debtor refused to reaffirm the debt. In other words, the debtor failed to comply with the Bankruptcy Code’s requirements. However, if the debtor has complied with the requirements of §§ 524(c) and 521(a)(6), and if the only reason there is no reaffirmation agreement in place is because of the judge’s refusal to approve it, then the creditor has no authority to repossess as long as the debtor is current on the payments.
As a result, I do not sign reaffirmation agreements because to do so would mean most judges will rubber stamp them. If I don’t sign, then if the debtor attends the hearing and the judge refuses to approve the agreement the debtor gets to “retain and pay” without reaffirmation. Of course, if the debtor fails to make the payments then the creditor can still repossess. However, since the in personam claim was extinguished in the bankruptcy, the debtor has no post-resale liability.
Some creditors will permit the debtor to retain and pay without reaffirmation. However, they will toss in a sweetener: “If you reaffirm the debt we will send you monthly statements and report your timely payments to the credit reporting bureaus; but if you don’t, we won’t.” Therefore, if you’re the kind of person who forgets to make payments without the prompting of monthly statements, reaffirmation might be worth considering.
Of course, if the debt to be reaffirmed is much larger than the value of the collateral, then reaffirmation is probably a bad idea unless the creditor reduces the balance. Some are willing to negotiate, while others refuse out of hand. If you’re considering reaffirmation, contact a good bankruptcy attorney to discuss the pros and cons.
VI. Reaffirming A Mortgage Debt
In a word: DON’T. Sections 524(c) and 521(a)(6) provide the requirement of reaffirmation if the collateral is personal property. No such requirement exists if the collateral is real estate. Moreover, my sense is that none of the judges in the Central District of California would approve the reaffirmation of a mortgage debt because of the magnitude of the liability involved, unless there has been a significant reduction in the principal balance.
VII. Avoid Loan Shark Loans
I recently filed Chapter 7 papers for a very nice couple. Among their secured debts was a debt secured by a vehicle. The vehicle had been completely paid off when they took out the current loan. It was one of those loans advertised on late-night TV. The interest rate was 96% per annum! In spite of having made all of the agreed upon payments for six months, the current balance was larger than the original loan amount.
Some time ago I had a potential client come in for a consultation. He too had taken out a loan against a fully paid car. The interest rate was 150% per annum! He had borrowed $5,000 three months before meeting with me, and had been paying $800 per month for the intervening three months. Thus, he had already paid $2,400 on the loan. In spite of that fact the current balance was $5,500 – an increase of 10% over the original loan amount in just three months, in spite of his having paid almost fifty percent of the original loan amount in those three months.
That sort of loan leads to the loss of the car and a lot of money to boot. Don’t get one. It’s safer to take heroin – which I don’t recommend either.
Finally, avoid those unsecured Payday and Cash Call type loans too. I just filed Chapter 7 papers for a nice guy who took out one of those loans, this one from CashNetUSA. Buried deep within the loan documents was the APR. It was 495.48%! Yes, you read that correctly: 495.48%. I read it in the contract with my own eyes. Talk about owing your soul to the company store.
Amazingly, in each of these cases the interest rates were perfectly legal. I’ll tell you why in my next blog post. Stay tuned.