By Taruna Garg – Murtha Cullina LLP, Boston

Cross-Default Provision Inapplicable to Monetary Defaults Arising from Separate Executory Contract or Lease For Purposes of Assumption Under 365(a)

In re Szenda, 406 B.R. 574 (Bankr. D. Mass. 2009)

This case concerned an objection filed by a sublessor and franchisor to a chapter 13 debtor’s motion to assume a non-residential sublease pursuant to 11 U.S.C. § 365(a). The debtor was a franchisee of two Subway restaurants located in Millbury and Worcester for which he executed separate franchise agreements and subleases for each location. Due to the lack of profitability at the Worcester location, the debtor defaulted on his obligations under the sublease which led to the termination of the franchise agreement and sublease.

After filing his bankruptcy petition, the debtor sought to assume the sublease for the Millbury location pursuant to 11 U.S.C. § 365(a). The sublessor objected, arguing that under various cross-default provisions of the debtor’s franchise agreement, the debtor should be prohibited from assuming the Millbury sublease unless he cured monetary defaults arising from the franchise agreement and sublease that governed the operation of the Worcester restaurant.

The court noted the well-established rule that “[c]ross default provisions do not integrate executory contracts or unexpired leases that are otherwise separable or severable.” 406 B.R. at 580. Accordingly, in order to enforce cross-default provisions to apply to the debtor’s defaults under the Worcester agreements, the sublessor was required to demonstrate that the Worcester and Millbury agreements were “economically interdependent.” The court determined that the Millbury and Worcester Agreements were not interrelated, in that Subway did not show that it would not have entered into the Worcester agreement without the Millbury agreement and the consideration for one agreement did not support the other. As a result, the court held that the debtor was not required to cure monetary defaults arising from the Worcester agreements prior to assuming the sublease for the Millbury location.

Debtor’s Rescission of Loan Transaction For Lender’s Failure to Provide Required Notice May Require Tender of Amounts Due

Wells Fargo Bank, N.A. v Jasskelainen, 407 B.R. 449 (D. Mass. 2009)

This case involved an appeal of a final order by the bankruptcy court allowing chapter 13 debtors to rescind a loan transaction due to the mortgagee’s failure to provide each debtor with two copies of a Notice of Right to Cancel (“NOR”), a notice which discloses a borrower’s limited right to rescind a transaction required by the federal Truth-in-Lending Act (“TILA”) and the Massachusetts Consumer Credit Cost Disclosure Act (the “MCCCDA”). After an evidentiary hearing, the bankruptcy court concluded that a) the lender failed to sustain its burden of proof that each debtor received two copies of the NOR, and therefore violated the MCCCDA, b) that the lender’s failure to provide the NOR was not a ‘bona fide error’ entitling it to receive safe harbor protection under MCCCDA, c) the debtors’ rescission became effective immediately upon providing notice of rescission to the lender and d) the debtors’ notice of rescission terminated the lender’s security interest without any requirement for the debtors to return the loan proceeds.

On appeal, the district court determined that the evidence submitted to the bankruptcy court was sufficient to show that the debtors did not receive required copies of the NOR and that the lender’s failure, although likely inadvertent, was not the type of “clerical” error to qualify as a bona fide error pursuant to the MCCDA.

With respect to the bankruptcy court’s findings concerning the debtors’ rescission of the loan, the district court adopted a different view. First, the district court held that rescission did not become automatically effective upon the debtors’ mailing of a notice of rescission. Instead, if a lender disputes a borrower’s right to rescind, then a court must first decide whether the conditions for rescission have been fulfilled. Until such a determination is made, the borrower had only a claim of rescission.

Second, the district court adopted the majority position that courts have the equitable power to condition rescission upon tender by the borrower of the amounts owed on a loan. To hold otherwise, according to the court, would have the “net effect…[of allowing] a debtor [to] receive[] substantial sums of money or what amounts to a free house, while the creditor receives nothing, which would be contrary to the purposes of rescission.” Id., 407 B.R. at 461. Accordingly, the court remanded the case to the bankruptcy court to determine the appropriate conditions to impose upon the debtors’ exercise of rescission and recommended the bankruptcy court to consider traditional notions of equity, including factors such as the severity of the lender’s violation and the debtors’ ability to pay the outstanding balance.

Chapter 13 Plan May Include Payments Contractually Due to Undersecured Junior Mortgagee for Purposes of Calculated Projected Monthly Disposable Income Pursuant to § 1325(a)

In re Marshall, 407 B.R. 1 (Bankr. D. Mass. 2009)

The central issue in this case concerned whether above-median income chapter 13 debtors should be permitted to deduct payments “contractually due” to a junior mortgagee for purposes of determining their monthly disposable income pursuant to 11 U.S.C. §§ 1325(b) in instances where the debtors intend to seek a determination that the mortgagee’s lien is void and its claim unsecured based on the lack of equity in the property.

The debtors filed an amended chapter 13 plan which reflected a deduction for monthly amounts due for a second mortgage. In their plan, the debtors characterized the second mortgage as an unsecured claim due to the lack of equity in the property. On the same day, the debtors filed an objection to the secured status of the junior mortgage, which was subsequently sustained by the court. The chapter 13 trustee filed an objection to the debtors’ plan contending that the debtors should not be entitled to claim an expense deduction for the second mortgage, an unsecured claim, for purposes of determining their plan payment.

In analyzing two recent circuit decisions that considered this issue, United States Trustee v. Rudler (In re Rudler), 388 B.R. 433 (B.A.P. 1st Cir. 2008) and In re Burbank, 401 B.R. 67 (Bankr. D.R.I. 2009), the court considered the interplay between §§ 707(b)(2)(A)(iii) and § 1325(b)(3) of the Bankruptcy Code. For purposes of calculating disposable income under the means test pursuant § 707(b)(2)(iii), the court agreed that the express language of the statute permitted debtors to deduct payments to secured creditors that were “contractually due.” The more challenging issue concerned how the means test calculation of § 707(b)(2)(A)(iii) applied for purposes of calculating a chapter 13 debtor’s projected disposable income under § 1325(b)(3), which incorporated the means test calculation of § 707(b)(2).

The court adopted the approach set forth in Burbank, where the court reasoned that “…the term ‘projected’ modifies ‘disposable income’ and is not synonymous with the word ‘anticipated’ in this context. ‘Projected disposable income’ means ‘disposable income’ as defined by Section 1325(b)(2), projected over the ‘applicable commitment period.’ In turn, for debtors with above median income the ‘amounts reasonable necessary to be expended’ are determined in accordance with Section 707(b)(2). Burbank, 401 B.R. at 73-74 (internal citations omitted). Accordingly, the court held that the debtors were allowed to claim a deduction for ‘contractually due payments’ to a second mortgagee, although a motion for plan modification may later be filed to reflect the debtors’ actual financial situation.

By Kathleen Rahbany – Craig and Macauley, P.C., Boston

Failure to Timely File a Notice of Appeal May Be a Jurisdictional Bar to Obtaining Direct Review by the First Circuit Court of Appeals

Weaver v. Harmon Law Offices, P.C. (In re Weaver), 319 Fed. Appx. 1 (1st Cir. 2009)

In an unpublished decision, the First Circuit Court of Appeals declined to hear a direct appeal from an order of the Bankruptcy Court, even though the question certified for review may have been “sufficiently important” to justify a direct appeal.

The defendants sought to have the First Circuit determine “[w]hether or not the act of postponing a mortgage foreclosure sale during a pending bankruptcy violates the automatic stay.” The Bankruptcy Court’s determination was adverse to the defendants. The defendants failed to timely file a notice of appeal of the Bankruptcy Court’s order or to timely seek consent of the First Circuit Court of Appeals to directly review the Bankruptcy Court’s order. This procedural defect made it ‘substantially possible’ that the First Circuit Court of Appeals was without jurisdiction to hear the defendants’ direct appeal. Consequently, the court held that it would not hear the direct appeal because even it determined the question at issue, its holding would be unlikely to result in a “definitive resolution” because the court may have been without jurisdiction to hear the matter in the first place.

Means Test Permits a Deduction from Income of Installment Payments Due for Property to Be Surrendered

Morse v. Rudler (In re Rudler), 576 F.3d 37 (1st Cir. 2009)

The First Circuit Court of Appeals upheld the Bankruptcy Court and Bankruptcy Appellate Panel rulings that the means test permits a debtor to deduct from his income installment payments that are scheduled to come due to a secured creditor, even for property that is later to be surrendered during the debtor’s bankruptcy proceeding.

The means test requires a debtor to calculate whether a presumption of abuse arises by subtracting certain statutorily permitted deductions from current monthly income. Under section 707(b)(2)(A)(iii)(I) of the Bankruptcy Code, a debtor is entitled to deduct expenses incurred “on account of secured debts” so long as the payment is “scheduled as contractually due to [the] secured creditor[] in each of the 60 months following the date of the petition.” An issue comes up when a debtor intends to terminate those payments by surrendering the collateral but also deducts those expenses from current monthly income on the means test, where, but for that deduction, a presumption of abuse would arise.

The First Circuit Court of Appeals noted that precedent interpreting section 707(b)(2) is split but that the majority view, based on the plain language of the statute, permits a debtor to deduct secured payments even if the property securing the debt will later be surrendered. Courts following the majority view primarily consider the phrase “scheduled as contractually due” in the forward-looking context suggested by the phrase “following the date of the petition.”

The First Circuit Court of Appeals determined that “scheduled as contractually due” requires a current assessment of obligations, not one that envisions the future termination of payments that are contractually owed at the time that the debtor completes the means test calculation. Likewise, the court found that the phrase “following the date of the petition” requires a current assessment of payments scheduled to come due after the petition date, not a projection of anticipated changes in those payments. The court concluded that such an interpretation does not lead to an “absurd” result because it avoids uncertainties attendant when a debtor intends to surrender property, but such intent is unperformed at the time when the means test is conducted.

First Circuit Resolves Questions of First Impression

Braunstein v. McCabe, 571 F.3d 108 (1st Cir. 2009)

The Chapter 7 trustee brought a turnover action to recover certain insurance proceeds which were paid to the debtor. The debtor made a jury demand in his answer to the turnover complaint. The turnover complaint was subsequently consolidated with litigation pending before the United States District Court for the District of Massachusetts.

The district court denied the debtor’s jury demand and the debtor appealed that decision. The First Circuit held that there is no jury right with respect to a turnover action brought under section 542 of the Bankruptcy Code. The court noted that there is no statutory right to a jury trial in section 542 actions brought by a trustee in district court and that the Bankruptcy Code fails to address the issue. Accordingly, the court looked to the Supreme Court’s decisions determining whether a jury right exists under the Seventh Amendment. Those decisions prescribe a three-part test which requires a court to: (1) determine whether the action involves rights that are legal or equitable in nature because the “Seventh Amendment applies to actions brought to enforce statutory rights [as opposed to equitable rights] that are analogous to common-law causes of action ordinarily decided in English law courts in the late 18th century;” (2) “examine the remedy sought and determine whether it is legal or equitable in nature”; and (3) if the first two prongs indicate the existence of a jury right then “decide whether Congress may assign and has assigned resolution of the relevant claim to a non-Article III adjudicative body that does not use a jury as factfinder.” The court observed that the second prong of the test is weighed more heavily than the first. The court then examined American legal history and determined that there was no common law turnover cause of action, that any analogous action was equitable in nature and that the remedy for a turnover action is also equitable. Accordingly, since the first two prongs indicate no jury right, the third prong was inapplicable.

The First Circuit then addressed the meaning of “ordinary course of business” for purposes of using, selling or leasing estate property under section 363 of the Bankruptcy Code. The court established a two-part analysis, the first part being a “horizontal dimension test” and the second being “a vertical dimension, or ‘creditor expectation,’ test.” The “horizontal” test requires a court to determine whether the transaction is common for the industry engaged in by the debtor. The “vertical” test assesses whether the transaction subjects a hypothetical creditor to economic risk that the creditor would find unacceptable when extending credit – in other words, the court must ask whether the transaction is “ordinary” to the creditor-debtor relationship. The purpose of the analysis is to determine whether creditors are entitled to notice and a hearing prior to consummation of the proposed transaction.