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Bankruptcy Reform Brings Both Relief and Uncertainty to Homeowner Associations
The formal ceremony lasted only a few minutes, but it took credit card companies, banks, and large retailers eight years to win Congressional approval of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 that President Bush signed into law April 20, 2005. “This law will protect those who legitimately need help, stop those who try to commit fraud, and bring greater stability and fairness to the system,” President Bush said of the new law, which mandates the most comprehensive overhaul of the nation’s bankruptcy rules in more than 25 years.
The passage of the Act has met with mixed reviews. Critics of the Act argued unsuccessfully that the changes treat consumers too harshly, foreclosing the “fresh start” that bankruptcy is supposed to provide. Supporters, on the other hand, insisted that tighter rules were needed to prevent abuses that allowed many consumers to escape debts they could, and should, be required to repay.
How the Act Will Affect Bankruptcy Filings
In general, the Act creates a threshold that debtors must meet before having the ability to file a Chapter 7 bankruptcy, which is more lenient than a Chapter 13 bankruptcy. The Act also adds procedural requirements that a debtor must comply with before filing bankruptcy and then again before having any debts discharged under that bankruptcy filing. Additionally, limitations on when and how much a debtor can claim under a state’s homestead exemption are imposed by the Act.
Chapter 7 Bankruptcy Filings v. Chapter 13 Bankruptcy Filings
The Act creates an obstacle to a debtor’s use of bankruptcy to eliminate, or “discharge,” their personal obligation to pay their debts by requiring the filing of Chapter 13 bankruptcies instead of Chapter 7 bankruptcies. This change is significant as debtors who file Chapter 7 bankruptcies have more of their debts discharged to the detriment of their unsecured creditors.
Chapter 7 is a liquidation proceeding. Under Chapter 7, the debtor turns over all non-exempt assets to the Bankruptcy Trustee. The Trustee liquidates the assets and uses the proceeds to pay the debtor’s creditors. After all the proceeds are distributed, unpaid debts are discharged with the exception of the few exempted from bankruptcy laws. In contrast, Chapter 13 is a reorganization proceeding. Under Chapter 13, instead of their debts being discharged, debtors pay some or all of their debts over a period of three to five years to the Chapter 13 Trustee. This Trustee distributes the funds according to a plan approved by the Bankruptcy Court. The amount of the debts paid under the plan varies, but must amount to more than what unsecured creditors would have received under a Chapter 7 filing.
The “Means Test”
If a debtor’s gross family income for six months before the bankruptcy filing exceeds the median for families in the debtor’s state, that debtor must meet the threshold of a “means test” before being allowed to file a Chapter 7 bankruptcy. If a debtor’s income and expenses do not meet the means test, the debtor must file a Chapter 13 bankruptcy. The American Bankruptcy Institute has more specific information on how median income is determined from state to state.
Under the means test, the difference between the debtor’s qualified expenses and income is multiplied by 60. If that amount is less than $6,000.00, the debtor has the right to file a Chapter 7 bankruptcy. If that amount is greater than $10,000.00, the debtor is prohibited from filing a Chapter 7 bankruptcy. If that amount falls between $6,000 and $10,000, the debtor may file a Chapter 7 only if that amount is less than 25% of the non-priority unsecured claims. Provisions exist that allow additional expenses or adjustments to the income in special circumstances. In most instances, however, if the debtor’s gross family income exceeds the median for families in the debtor’s state, the debtor will need to file under Chapter 13 rather than under Chapter 7.
Requirement for Financial Counseling and Financial Management Course
In addition to the means test, once the United States Bankruptcy Trustee’s Office has approved non-profit credit counseling agencies, the Act will require these approved non-profit credit counseling agencies to “certify” individuals before they file bankruptcy. This agency will have the responsibility to brief individuals on available credit counseling and assist them with preparing an individual budget analysis. This requirement may be waived if the debtor submits a certification describing exigent circumstances and stating that he or she requested credit counseling services but was unable to receive them within five days from the request. However, even if waived, the debtor must undergo counseling within thirty days of filing the petition unless the court grants a fifteen day extension.
Debtors must also complete a financial management course from an approved financial management course provider prior to any discharge under either Chapter 7 or 13. The U.S. Bankruptcy Trustee’s Office has the responsibility of approving financial management course providers based on criteria contained the Act.
Limits on Homestead Exemptions
Effective as of April 20, 2005, the date President Bush signed the bill into law, the Act places a cap on “homestead exemptions” that allow homeowners to protect a portion of the equity in a primary residence from the claims of creditors. The amount of protection provided varies from state to state with a few states granting debtors unlimited protection. The Act aims to prevent debtors from shielding their assets by buying expensive homes in those no-cap states.
Under the new rules, debtors are limited to the federal homestead cap ($125,000) on any property purchased within forty months of their bankruptcy filing, even if the state cap is higher. In addition, debtors may not claim any homestead protection on properties owned for less than two years unless they previously owned a property in the same state on which a homestead existed. The Act also nullifies a homestead filed within ten years preceding the bankruptcy if the intent was “to hinder, delay, or defraud” creditors. For example, a debtor who created a homestead ten years ago to shield assets from a negligence suit can not apply the homestead protection to a bankruptcy filed today. A homestead protection is also capped at the federal limit if a debtor was found guilty of an intentional tort that caused severe injury or death to another within five years preceding the bankruptcy.
The Act’s Affect on Homeowner Associations
Although community associations were not on the front lines of this prolonged and very expensive lobbying battle, they claimed a significant victory in the outcome. The 500-page law includes language advocated by the Community Associations Institute (CAI) clarifying how delinquent assessments should be handled after a unit owner files for bankruptcy. In 1994, minor revisions to the bankruptcy rules stated that community association fees assessed after an owner filed for bankruptcy protection were not dischargeable in a residential condominium or cooperative if the owner resided in or rented out the unit.
Unfortunately, this language created a loophole exploited by some owners, who moved out of their units, left them vacant, and argued that they did not have to pay post-petition fees as a result. Additionally, the wording of the 1994 revisions specifically addressed only residential condominiums and residential cooperatives, omitting homeowner associations, time-share condominiums, and commercial condominiums. This omission led to confusion as judges in some jurisdictions applied the statutory language to all common interest ownership communities. In other jurisdictions, however, judges ruled that homeowner associations, time-share condominiums, and commercial condominiums could not collect post-petition assessments even if the owners continued to occupy their units.
The bankruptcy reform law addresses both problems. It adds homeowner associations, time-share condominiums, and commercial condominiums to the list of covered entities. Additionally, it closes the collection loophole that had frustrated many associations, by linking the obligation to pay post-petition fees to ownership rather than occupancy of the unit. The new language states that the liability for payments continues “for as long as the debtor or the trustee has a legal, equitable, or possessory ownership interest” in the unit.
That the liability to pay assessments continues once the property is under trustee control will also positively affect many associations. In some jurisdictions, the trustees charged with disposing of a debtor’s property often try to negotiate a reduction in the fees paid to the association or completely refuse to pay them. The new language will shift the balance in those negotiations in favor of the associations by eliminating any question about their right to collect post-petition fees.
What to Expect and How to Prepare
Most analysts agree that the immediate result of the Act will be a surge in bankruptcy filings as financially-troubled consumers race to file before the more restrictive rules take effect. Beyond that, community associations can expect to feel the ripple effects of many provisions that do not affect them directly. For example, because bankruptcy will be a less appealing and often a less viable option, some debtors may address their financial difficulties sooner before bankruptcy becomes the only option. Debtor attempts to avoid bankruptcy may trigger an increase in requests for repayment plans to resolve delinquent association fees.
Association boards should be prepared to handle these requests in a manner that balances efforts to work with troubled homeowners with the need to protect the community’s financial interests. Colorado law already requires associations to have a written collection policy by January 1, 2005, and this policy should address how an association handles requests from delinquent owners to develop payment plans.
Analysts also predict that the Act may discourage some debtors from seeking bankruptcy protection, subjecting them to the collection efforts of unsecured creditors with claims against them. A debtor’s unit provides security for common area fees and assessments so association claims will generally take precedence over the claims of a debtor’s unsecured creditors. Of course, a board should always move quickly to deal with delinquent owners; especially if it is uncertain whether the owner has sufficient equity to cover the secured claims.
Although supporters of the Act expect a significant reduction in bankruptcy filings, such a reduction may not result as the reforms do not eliminate the reasons why consumers seek bankruptcy protection. However, it is certain that for those who do file that the bankruptcy process will be more cumbersome because of the Act’s new procedural hurdles (i.e. the need for a debtor to obtain and pay for credit counseling before filing bankruptcy).
The Act also affects bankruptcy attorneys with provisions that require them to certify the accuracy of the financial statements their clients file. Steep fines are imposed on the attorney if their client’s information is found to be misleading or erroneous. Many bankruptcy attorneys predict that fees will increase causing many debtors to represent themselves, placing bankruptcy judges in the position of needing to dismiss filings with technical flaws or providing debtors legal guidance to navigate the bankruptcy process. An increase of pro se debtors will likely clog bankruptcy courts with pending cases that will take longer to resolve. If so, homeowner associations may find that collecting pre-petition debts will become more difficult and less certain under the Act than previously.
Only time will tell definitively how the Act will affect homeowners association attempts to collect delinquent assessments from a unit owner who has declared bankruptcy. At this point, we can hope that the Act will aid associations in collecting the assessments due to them.
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The Community Associations Institute (CAI) is a nonprofit organization that provides education and resources to community associations. To find out more about CAI visit www.caionline.org
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