After filing a chapter 7 bankruptcy, the debtors tried to surrender their residence to the mortgage lender.  After the bankruptcy the lender refused to accept a surrender, refused to foreclose and refused to release its lien.  The debtors brought an adversary proceeding claiming that, among other things, this refusal constituted a violation of the discharge injunction they received in bankruptcy.  The bankruptcy court found no violation; the Bankruptcy Appellate Panel agreed; and on appeal the 1st Circuit affirmed – but with some cautionary comments.

All parties agreed that the mortgage loan was substantially underwater.  The loan had a balance of ~$186,000, while initially the debtors valued the property at $130,000 and the lender valued it at $86,000.  Although a foreclosure proceeding was pending at the time the bankruptcy was filed, the lender voluntarily dismissed the foreclosure without prejudice based on the bankruptcy.

The debtors received a discharge under Section 727 of the Bankruptcy Code, which means that they were discharged from all prepetition debts, including the mortgage loan.  Under Section 524(a) of the Bankruptcy Code a discharge "operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived."

After they received their discharge, the lender advised that it would not proceed with foreclosure, and that the debtors remained responsible for taxes, insurance and maintenance of the property.  In response, the debtors reminded the lender of the discharge and demanded that it either commence foreclosure or discharge the mortgage.  The bank declined, although it advised that it would consider a settlement option or a short sale.  After exchanging a few additional letters, the debtors vacated the property, turned off the utilities and notified municipal authorities and the sewer company that the lender was the party responsible for any obligations pertaining to the property.

The debtors then reopened the bankruptcy case and brought claims against the lender based on its violation of the discharge injunction, including a request that it be required to either take possession of the property or deliver unencumbered title.  The bankruptcy court did find a violation in connection with a letter that stated that the debtors still had "a financial obligation to pay [Beneficial] for the money borrowed.  This financial obligation... remains intact..."  The lender was ordered to pay $7,000 in sanctions.  (This part of the order was not appealed.)  However, the court declined to find a violation based on the lender's refusal to foreclose or release its lien on the property.

The 1st Circuit acknowledged that the purpose of the injunction is to provide debtors with a "fresh start" without the burden of prepetition debts.  However, it also noted that:

Despite its broad scope, the discharge injunction does not enjoin a secured creditor from recovering on valid prepetition liens, which, unless modified or avoided, ride through bankruptcy unaffected and are enforceable in accordance with state law.

The debtors' argument that the lender's refusal was a violation of the discharge injunction was based on a 1st Circuit case in which the court held that the refusal to foreclose or release a lender's lien on "an inoperable, worthless car" was intended to coerce the debtor to pay a discharged debt, and thus was a violation. (Pratt v. General Motors Acceptance Corp. (In re Pratt), 462 F.3d 14 (1st Cir. 2006).)

The court drew various distinctions between the Canning and Pratt cases to support its conclusion that in this case the lender was only seeking to obtain the value of its lien.  It noted that although there was a discharge of personal liability for the mortgage debt, that did not affect the ongoing burdens of owning property.  The court found no legal authority that would allow a homeowner to simply walk away from a residence with no strings attached.  Although debtors may seek to free themselves from the lien by surrendering the collateral, the lender is not required to accept the surrender as long as its decision is not "a subterfuge intended to coerce payment of a discharge debt."

So, the court found that the lender's refusal in this case did not constitute a violation of the discharge injunction.  However, notwithstanding the lender's victory, the 1st Circuit closed with a sobering admonition:

A coda is necessary before we conclude.  Today, where both lenders and homeowners strive to recuperate from hard economic times, this opinion should not be relied upon to leverage a way out of the bargaining table.  It is one thing to insist upon state-law rights in refusing a recalcitrant "foreclosure or release" demand by a debtor, and completely another to refuse negotiating with a debtor willing to compromise.  Put differently, while this case may provide some guidance on the dos and don'ts applicable to the bargaining dynamics between secured creditors and bankruptcy debtors, our remarks in Pratt still control:  "the line between forceful negotiation and improper coercion is not always easy to delineate, and each case must therefore be assessed in the context of its particular facts."  462 F.3d at 19.

In determining whether to exercise rights with respect to collateral, lenders dealing with individual debtors post-bankruptcy need to recognize that things may not be back to business as usual.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.