Posted on Jun 30, 2011
(Reprinted From New England Business Journals, January 2007)
Consider this hypothetical. Joe Schmo draws up a business plan for a cross-country ski center that will have the best trails in Vermont. Joe decides not to incorporate. As the first step in setting up his business, he uses his personal savings and purchases a state-of-the-art Swedish snow grooming machine from its manufacturer. Then, he maps the trails and contacts Knock ‘Em Down Timber to clear them. After a less than optimal snow season, Joe cannot pay his outstanding balance to Timber, but they agree to a payment plan. As part of the agreement, Joe grants Timber a security interest in his Swedish grooming machine. Timber properly files a financing statement with the Vermont Secretary of State and awaits Joe’s payments. After another soggy winter with little snow, Joe Schmo can no longer make his payments and he files a personal chapter 7 bankruptcy petition. The overwhelming majority of Joe Schmo’s debts are consumer in nature. Eventually, most individuals and businesses will experience the bankruptcy process as a creditor. Although generally there is not much an unsecured creditor can do in a chapter 7 proceeding, if the creditor’s debt is secured by collateral, the creditor will have more options. In the hypothetical, Timber is a secured creditor in Joe Schmo’s bankruptcy and the groomer is its collateral.
Under the Bankruptcy Code (the “Code”), as recently revised by the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”), individual debtors with primarily consumer debts have three choices with respect to property that is subject to a lien. A debtor may: reaffirm the debt by entering into a reaffirmation agreement; surrender the collateral by turning it over to the secured creditor; or redeem the collateral by paying the creditor the collateral’s present value. To begin a bankruptcy case, a debtor files what is referred to as a petition and several schedules that identify, among other things, their property interests including real and personal property, claimed
exemptions, income, expenses, and a list of all their creditors. When a bankruptcy case is filed, in most instances, the debtor gets some breathing room from his creditors by way of the “automatic stay.” The automatic stay prohibits creditors from taking any action to enforce or collect a debt against the debtor’s property. However, debtors are required, within a relatively short period of time, to notify their secured creditors as to what they intend to do with the collateral–whether they intend to surrender the collateral or keep it.
A debtor has either 30 days from the filing of his case or up until the meeting of creditors (which happens within 20 to 60 days of the petition), whichever is earlier, to disclose whether he intends to keep or surrender the collateral. If the debtor intends to keep it, he must specify whether the collateral is (allegedly) exempt and thus, he intends to keep it without paying the secured creditor anything; whether the debtor intends to redeem the collateral by paying its present value; or whether the debtor intends to reaffirm the debts secured by the collateral by entering into an agreement with the creditor referred to as a reaffirmation agreement.
The debtor has 30 days from the date of the first meeting of creditors (20 to 60 days of filing the petition) to follow through on his statement of intention by either paying the creditor the present value of the collateral (i.e., by redeeming the collateral); by executing a reaffirmation agreement; or by surrendering the collateral. Practically speaking, in most instances, the prospect of surrendering the collateral or of being able to scrape up enough money to redeem the collateral by paying its present value will either be unappealing or impossible for the debtor. Consequently, most debtors seek to reaffirm.
There are other advantages for a debtor to reaffirm a debt. In our case, for example, Joe Schmo may want to retain his groomer as part of his fresh start so that he can generate income after his bankruptcy, perhaps as an independent contractor with another local ski area. Also, Joe may feel obligated to repay this particular debt – either out of a sense of honor and integrity, or because he feels it is in his long-term best interest to maintain a positive working relationship with this creditor. Indeed, in a small state, such as Vermont, debtors often develop close working relationships with their creditors, and reaffirmations tend to be more common.
Most creditors, like Timber in our hypothetical, will also prefer reaffirmation. The snow groomer will be of little use to Timber in the course of its business and if Joe surrenders the groomer, Timber would be forced to try to sell it to recover any value. As Timber is not familiar with the Swedish groomer market (which presumably will be depressed given the shortage of snow), Timber is unlikely to recover the optimal amount in selling the groomer. Similarly, if Joe seeks to redeem the groomer, Timber would only receive the machine’s present value (up to the amount of the debt), which may be substantially less than its original value, and potentially less than the amount of the debt. Also, reaffirmation provides Timber the added protection of being able to look to Joe Schmo personally for any difference between the amount of the debt and the amount received if it ultimately (i.e., post-bankruptcy) has to enforce its security agreement by taking possession of the groomer and selling it. Accordingly, a reaffirmation agreement ultimately may be the best course of action for both debtors and creditors.
A basic premise of bankruptcy law is to grant debtors a “fresh start.” For this reason, bankruptcy allows debtors to “discharge” certain debts, which permanently relieves debtors from any obligation to repay those debts. When a debtor executes a reaffirmation agreement, the debtor agrees to pay an otherwise dischargeable debt, which compromises his fresh start. If a debt is properly reaffirmed, it survives the debtor’s discharge in bankruptcy. Because a reaffirmation agreement compromises a debtor’s fresh start to which he is otherwise entitled, the agreement must meet certain requirements in order to be enforceable.
In order to be enforceable, reaffirmation agreements must contain specific, written disclosures concerning the debtor’s rights under the agreement, and must provide the debtor an opportunity to rescind the agreement. If the debtor is represented by counsel, the debtor’s attorney must file a declaration or affidavit regarding the debtor’s understanding of the agreement, as well as the attorney’s own representation that the agreement does not impose a hardship on the debtor or his or her dependents. If the debtor is not represented by counsel, the Court will conduct a hearing to consider whether the agreement imposes an undue hardship on the debtor or his or her dependents, and whether the agreement is in the best interest of the debtor. These criteria apply to all reaffirmation agreements other than those where the collateral is real property or where the creditor is a credit union.
In order to be meaningful, reaffirmation agreements must be signed and filed with the court before the debtor receives his discharge. Even if the debtor disclosed an intention to reaffirm a specific debt in his statement of intention, the statement does not except a debt from a subsequently issued discharge if an agreement has not been executed and filed with the court. If a discharge is issued and the debtor failed to file a notice of intention as to a specific piece of collateral, then there is no automatic stay with respect to that collateral, and the creditor may retrieve and sell that collateral without permission from the bankruptcy court. For example, if Joe Schmo fails to file a statement of intention with respect to the groomer, Timber would have the option of taking possession of the groomer and selling it with impunity. Hence, it almost always will be in the debtor’s best interest to file a statement of intention with respect to each secured creditor, and to follow through on those intentions in a timely manner.
Although the reaffirmation process can be somewhat technical, debtors and their secured creditors have much to gain by going through the process. If your business faces a similar situation, you should consult an attorney to ensure that your rights are protected.