Bankruptcy is all about the debtor’s assets, specifically how many and who gets them. The reason that many bankruptcy cases are contentious is that the parties often disagree about the amount of assets available for distribution to creditors, as well as how the assets should be divvied up.

In a recent appeal from the bankruptcy court, the U.S. District Court for the Eastern District of Michigan (the “Court”) considered the issue of whether, in a Chapter 13 case, payments to a debtor’s attorney can take priority over payments due to a homestead mortgagee.[1] The Court held that the priority payments to debtor’s counsel in this case impermissibly modified the mortgagee’s rights and, thus, violated the Bankruptcy Code.

Background

The debtor/appellee in this case obtained a loan to purchase his primary residence from appellant United Financial Credit Union (“UFCU”). The debtor fell behind on mortgage payments and ultimately filed for Chapter 13 bankruptcy protection. At the time of his filing, the debtor owed UFCU almost $60,000.

The debtor filed a Chapter 13 plan - based on the Eastern District of Michigan model plan - that called for payment in full ($2,910) to the debtor’s attorney before beginning payments to UFCU. UFCU objected, arguing that the plan impermissibly altered it rights to receive payments each month during the pendency of the plan. The debtor countered that prioritizing payment of attorney fees over payments to UFCU served policy interests, such as ensuring a debtor’s ability to obtain competent counsel. The bankruptcy court adjourned the confirmation hearing until the debtor was able to pay the Chapter 13 trustee sufficient funds to cover the debtor’s attorneys fees.

At the confirmation hearing, UFCU informed the bankruptcy court that, because it had not received a payment from the debtor since he filed for bankruptcy, it was owed an additional $3,019.18 in post-petition arrearage. UFCU also renewed its objections to the plan.

The bankruptcy court confirmed the plan, and UFCU appealed.

The Appeal

The appeal focused on the analysis and reconciliation of two Bankruptcy Code sections - sections 1322(b)(2) and 1326(b)(1). The Court cited the U.S. Supreme Court’s decision in Nobelman v. Am. Sav. Bank [2] in explaining that while a plan may modify the rights of holders of most secured claims, section 1322(b)(2) does not allow a plan to modify the rights of “a claim secured only by a security interest in real property that is the debtor’s principal residence.” Section 1326(b)(1) gives priority to administrative fees, including debtor’s attorney fees.

In this case, the bankruptcy court noted the tension between sections 1322(b)(2) and 1326(b)(1), but ruled in favor of the debtor in part because the bankruptcy court “had a long tradition of allowing debtors’ counsel to receive full priority payment before other creditors” and cited Bankruptcy Code section 1322(b)(5) as authority for allowing a debtor to cure non-payment of post-petition monthly payments to all other creditors.

The tension between the rights of homestead mortgagees, such as UFCU, and debtors’ attorneys can arise in cases such as this where the trustee does not have sufficient funds on hand to pay both parties. The issue faced by the Court, therefore, was how to reconcile the competing interests and protections afforded to the parties in this case.

UFCU’s primary argument on appeal was that, by not providing for payments on the mortgage until the debtor’s attorney was paid in full, the Chapter 13 plan impermissibly altered its rights. The debtor’s response was that the gap in mortgage payments was permissible pursuant to section 1322(b)(5). UFCU countered that while section 1322(b)(5) may allow for the cure of post-petition defaults, a Chapter 13 plan itself may not create a curable post-petition default by requiring all post-petition income be paid first to cover debtor’s attorney’s fees.

The Court analyzed the issue from many angles, examining and distinguishing a number of cases that dealt with similar issues. The Court rejected the debtor’s argument and ruled in favor of UFCU. It held that a plan could not create a post-petition default in favor of one creditor at the expense of a homestead mortgagee which is a protected creditor under section 1322(b)(2). The Court explained, therefore, that under the circumstances the bankruptcy court should have denied confirmation of the plan.