BLG Newsletter: Secured Association Debts in Bankruptcy

by Jacob Bair, Esq.

When is a secured debt not a secured debt?  When the bankruptcy court deems it so.  When a delinquent unit owner files a Chapter 13 bankruptcy, each debt must be disclosed, verified, classified, and addressed

First, the owner is required to disclose to the court each debt of which he is aware.  He must then indicate whether it is a secured, unsecured, or priority debt.  Let’s imagine a scenario in which owner John Smith owes $10,000 in assessments, interest, and fees to his Association.  His unit also has a first mortgage of $50,000.  Mr. Smith files his bankruptcy and discloses both of those debts to the court.  He classifies them as secured debts.  Each creditor gets a notice from the bankruptcy court that their debt has been included in a bankruptcy and a request to file a proof of claim verifying the debt.  Each of them does so and thus, the debts are verified

Mr. Smith’s attorney files a proposed Chapter 13 Plan addressing each debt.  In this case, the Plan proposes to pay the mortgage directly, and proposes to change the classification of the Association debt from secured to unsecured.  Additionally, Mr. Smith’s Plan proposes to address unsecured debts by paying them at 5%.  Based on Mr. Smith’s financial circumstances, the bankruptcy court is willing to allow the 5% payment for unsecured debts.

After the proofs of claim are filed, Mr. Smith’s attorney files a Motion to Value Property and Determine Secured Status of Association Claim.  In that Motion, Mr. Smith claims that his unit is only worth $45,000.  As such, if his unit were sold, all of the proceeds would go to the first priority mortgage and none would be left for the Association.  Why does that matter?  The bankruptcy code states that a Chapter 13 bankruptcy plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence” (11 USC § 1322(b)(2) emphasis added).  

 If the debt is not secured by the value of the unit, the Association is not a “holder of” a “secured claim” and its rights can be modified.  Mr. Smith is asking the court to classify the Association debt as unsecured and address it by paying 5% of the total owed and eliminating the balance.

The judge would then allow an evidentiary hearing in which each side would present its argument, usually in the form of testimony from a property appraiser, as to the value of the unit.  If the value is found to be more than the $50,000 owed on the first mortgage, the Association debt remains classified as secure and the full balance will remain attached to the unit. 

 If the unit value is found to be less than $50,000, the Association can have its secured status removed or “stripped” and become an unsecured debt.  Unsecured debts generally receive payouts of 5% or less of their total in Chapter 13 bankruptcies. 

The ultimate classification of the Association debt will come down to a one hour evidentiary hearing that will determine whether the Association will potentially get a $10,000 payment or have to settle for $500.  Associations should be represented by attorneys who are knowledgeable in this area and know how to protect their interests though the nuances of bankruptcy proceedings.  To argue these types of hearings, the attorneys representing the association must be licensed to practice in the bankruptcy court jurisdiction in which the case is filed.