Bankruptcy filings have continued to decline since their peak during the Great Recession. Nonetheless, lenders should be aware of recent court rulings impacting bankruptcy law. In this article, we highlight those rulings. We also provide an update regarding the ongoing battle over whether the Consumer Financial Protection Bureau's structure is unconstitutional.
1. Supreme Court limits "Structured Dismissals." On March 22, 2017, the U.S. Supreme Court ruled that a bankruptcy court cannot approve a settlement that ends a bankruptcy case if (a) the settlement provides for a distribution of assets that diverts from the Bankruptcy Code's payment-priority rules, and (b) a creditor affected by the diversion doesn't consent. The ruling is important because while Chapter 11 bankruptcy cases are sometimes concluded with a settlement – a "structured dismissal" in bankruptcy parlance – instead of a confirmed plan of reorganization or a simple dismissal of the case, the limits on such settlements have been undefined. The Supreme Court faced a proposed settlement among the debtor, the debtor's secured lender, the debtor's shareholder, and the committee of general unsecured creditors that provided a payout to the committee's constituents but, contrary to the Code's payment-priority rules, provided nothing to a group of priority claimants. The proposed settlement also provided for dismissal of a lawsuit the committee had filed against the secured lender and dismissal of the bankruptcy case. The lower courts approved the settlement because it provided for some distribution to general creditors whereas those creditors, as well as the priority creditors, were otherwise likely to receive nothing. The Supreme Court, however, noted that the Bankruptcy Code's payment-priority rules have "long been considered fundamental" to the Code, and it found nothing in the Code or established law to suggest that those rules can be disregarded in connection with the dismissal of a bankruptcy case. The ruling places some limit on deals that debtors and creditors can strike to resolve bankruptcy cases and, accordingly, might make those deals more expensive. The case is Czyzewski v. Jevic Holding Corp., 2017 U.S. LEXIS 2024 (U.S. Mar. 22, 2017) (aka In re Jevic Holding Corp.).
2. Appellate Courts: Deposits and Wire Transfers Not Subject to Clawback. On January 31, 2017, the Fourth Circuit Court of Appeals, which covers Virginia among other states, affirmed the dismissal of a clawback lawsuit against a bank, ruling that a debtor's regular deposits into his own unrestricted checking account were not "transfers" to the bank and, therefore, not subject to being clawed back as "fraudulent transfers" under the Bankruptcy Code. The debtor ran a Ponzi scheme under the guise of a purchase-order factoring business, and he used a personal checking account in his name to make deposits and receive wire transfers as part of his scheme. After the scheme was discovered and the debtor forced into bankruptcy by his creditors, his bankruptcy trustee sued the bank, alleging that certain deposits and wire transfers were made with actual intent to hinder, delay, or defraud the debtor's creditors and therefore could be avoided under Bankruptcy Code section 548 (entitled "Fraudulent transfers and obligations"). The Fourth Circuit disagreed, writing that when the debtor "made deposits and accepted wire transfers into his checking account ... he continued to possess, control, and have custody over the funds, which were freely withdrawable at his will. ... The Bank's mere maintenance of ... [the] account does not suffice to make deposits and wire transfers in that account 'transfers' ... to the Bank...." While the outcome might seem obvious, there is disagreement among the courts about whether a bank deposit constitutes a "transfer." The Bankruptcy Code's legislative history suggests that Congress intended for bank deposits to be "transfers," but the Fourth Circuit wrote that that history did not expressly contemplate a debtor's regular deposits into his own unrestricted checking account. The court wrote that "[w]e express no opinion on whether other types of deposits, such as those made to restricted checking accounts, would constitute transfers...." The case is Ivey v. First Citizens Bank & Trust Co. (In re Whitley), 848 F.3d 205 (4th Cir. N.C. Jan. 31, 2017).
Coincidentally, just eight days later, on February 8, 2017, the Sixth Circuit Court of Appeals also ruled that a bank was not a "transferee" of deposits that it received in connection with a Ponzi scheme. The court based its ruling on the notion that the customer who owned the deposit account retained "dominion and control" over the deposits, notwithstanding the bank's security interest in the deposits. Unfortunately for the bank, however, the court also held that the bankruptcy trustee could claw back from the bank all loan repayments received after one of the bank's investigators discovered that the customer's CEO had a fraudulent past, including bank fraud, but failed to disclose that history to the bank manager in charge of the customer relationship. The case is Meoli v. Huntington Nat'l Bank, 848 F.3d 716 (6th Cir. Mich. 2017).
3. Bankruptcy Court: No Mortgage Strip on Two-Family Property. Bankruptcy Code section 1322(b)(2) generally protects home-mortgage loans from being modified in a Chapter 13 bankruptcy case, but its protection is limited to "a claim secured only by a security interest in real property that is the debtor's principal residence." (underline added) On January 18, 2017, the Fourth Circuit court ruled that a bank's rights under its deed of trust concerning escrow funds, insurance proceeds, and miscellaneous proceeds were "incidental" to its lien on the borrower's home, as opposed to being "additional collateral" that took its loan outside of the protection of section 1322(b)(2). Our summary of that case can be found here. On March 9, 2017, a bankruptcy court in New York took on a slightly different, but related, question: Is a mortgage on a two-family property, one unit of which is the debtor's principal residence and the other unit of which the debtor rents to a third party, protected from being modified by section 1322(b)(2)? The bankruptcy court ruled that it was, reasoning that the fact that the debtor received rents from one of the two units was consistent with the Bankruptcy Code's definition of "debtor's principal residence," since that definition includes "incidental property," which in turn includes "rents." The New York case is not binding in Virginia, but it's useful for highlighting an important issue for mortgage lenders. For example, if the New York bankruptcy court had ruled the other way, the lender's mortgage claim could have been reduced by $177,000. The case is In re Addams, 2017 Bankr. LEXIS 641 (Bankr. E.D.N.Y. Mar. 9, 2017).
4. Bankruptcy Court: $75k Sanction for Mortgage Lender's Rule 3002.1 Failures. In January 2017, we reported on recent amendments to Federal Bankruptcy Rule 3002.1. That article can be found here. As we noted in that article, Rule 3002.1 requires a home-mortgage lender to serve and file with the bankruptcy court notices of the following while the borrower is in Chapter 13 bankruptcy: (1) changes in payment amounts, (2) "fees, expenses, or charges" that were incurred after the bankruptcy filing and will be added to the loan, and (3) at the end of the bankruptcy case, whether the loan is then current.
As we also noted, failure to comply with the rule can result in sanctions against the lender. A bankruptcy court in Vermont has provided an example of those sanctions. The court sanctioned the lender a total of $75,000 for its repeated failures to comply with the rule. The lender had, for example, charged debtors post-bankruptcy property-inspection fees, NSF fees, and late fees (a) without filing a notice of those fees, and (b) notwithstanding that the fees were more than 180 days old - both of which are violations of Rule 3002.1(c). The total of the fees at issue was less than $1,000, but the lender had a history of violating Rule 3002.1(c) and had previously agreed to pay a $9,000 sanction. In light of that history, the court sanctioned the lender $1,000 for each of the twenty-five months it was in violation of Rule 3002.1 in each of three separate cases, resulting in the $75,000 sanction. Even worse for the lender, the court imposed an additional $300,000 of sanctions because the lender had also violated court orders declaring the debtors to be current on their mortgages by sending the debtors statements to the contrary. The court ordered the lender to pay the $375,000 to a non-profit legal organization. The case is In re Gravel, 556 B.R. 561 (Bankr. D.Vt. 2016).
5. Constitutionality of CFPB's Structure to be Considered Again. The D.C. Circuit Court of Appeal is going to reconsider its earlier ruling that the structure of the Consumer Financial Protection Bureau (CFPB) is unconstitutional. The CFPB is headed by a single director who is appointed by the President for a 5-year term and may only be removed for "inefficiency, neglect of duty, or malfeasance in office." In October 2016, a 3-judge panel of the D.C. Circuit held that this structure violates the constitutional separation of powers. On February 16, 2017, the court granted the CFBP's petition for a rehearing before a 10-member panel of the D.C. Circuit. The constitutional issue was raised in the case of PHH Corporation v. CFPB, which arose out of a $109 million penalty the CFPB imposed on PHH.
The transition from the Obama administration to the Trump administration has added a twist to the case: while the CFPB seeks to defend its constitutionality, the U.S. Department of Justice (DOJ) is now siding with PHH. The DOJ and others siding with PFF, including the Independent Community Bankers of America, argue that the CFPB, as an agency headed by a single individual, lacks the structural attributes that justify the "independent" status of certain multi-member regulatory commissions. The CFPB has broad authority to enforce consumer finance laws, promulgate rules implementing those laws, and conduct investigations of consumer-market actors. DOJ argues that the CFPB's broad authority is unchecked due to the President's inability to remove the CFPB director except for limited reasons noted above, especially given the CFPB's automatic funding through the Federal Reserve.
Oral argument is scheduled for May 24, 2017. The D.C Circuit's opinion is likely to be appealed to United States Supreme Court.
Neil McCullagh is an attorney at Spotts Fain who works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors' rights, bankruptcy, and collections.
Elizabeth Turner is an attorney at Spotts Fain who works closely with secured and unsecured lenders, loan servicers, commercial landlords, and other creditors to provide a wide range of legal services both in and outside of court.