Bankruptcy and Personal Injury Claims / Modifying a Chapter 13 Plan / Joint and Several Liability

If you have a pending personal injury claim when you file for Chapter 7 bankruptcy, you relinquish to your trustee all control of the settlement of the case, but you retain some control with a Chapter 13 bankruptcy. In rare Chapter 13 cases, the cram-down method of reducing debt for an automobile can be used to reduce the first mortgage payments on a house.

We recently discussed several aspects of bankruptcy with Christopher Holmes and Jess M. Smith, III, partners at Tom Scott & Associates, P.C. The discussion covered several topics, including how a debtor’s pending personal injury claim affects a bankruptcy case; how the cram-down method of debt reduction can be used for a mortgage in rare instances; the willingness of bankruptcy trustees to modify a Chapter 13 payment plan; how the Rash decision affects a debtor’s ability to surrender a car in the middle of a Chapter 13 plan; and the circumstances during a bankruptcy in which divorced spouses can both be held jointly and severally liable for debt incurred during their marriage.

Q: How does a debtor’s pending personal injury claim affect a bankruptcy case?

Jess Smith, III: If a debtor files for a Chapter 7 bankruptcy, he or she loses all rights and control over that personal injury action. The Chapter 7 Trustee has complete authority to prosecute it, settle it, or abandon it. Also, the Chapter 7 Trustee will, in all likelihood, take all of the net proceeds and distribute them amongst those creditors who file a claim against the Debtor. In other words, none of the net proceeds will be turned over to the Debtor unless those net proceeds exceed the total amount of the claims filed against the Debtor.

With a Chapter 13 filing, the debtor maintains some control over the personal injury claim regarding settling it or taking it to trial. If money is paid to the debtor as a result of a trial or settlement, then there is a negotiation between the debtor and the trustee as to how much goes to the debtor’s creditors and how much the debtor is allowed to keep for his efforts to acquire that money. That is why sometimes a debtor will choose to file a Chapter 13 bankruptcy versus a Chapter 7.

Typically, a Chapter 13 trustee will allow a debtor to keep one-third (1/3) of the net proceeds, with the remaining two-thirds (2/3) of the net proceeds going to the creditors.

Q: Have you recently handled any bankruptcies that included a personal injury claim settlement?

JS: Yes. In a current Chapter 13 case, the trustee is allowing the debtor to keep 50% of the net proceeds, because his bankruptcy plan is paying all of his creditors in full; therefore, I was able to acquire a little extra money for my client.

Q: If there is an existing Chapter 13 plan in place, which pays back all of the debt to the creditors, and all of the creditors had already agreed to that plan, why does the trustee want 50% of that personal injury claim?

JS: Because it gives the creditors some money right away, in the event the plan fails down the road. For some unforeseen reason, the debtor might run out of money and won’t be able to pay the creditors according to the plan. The trustee has a duty to at least get some of that personal injury money and disperse it now, as opposed to waiting on the debtor’s good promise and good intentions to pay it.

Q: If the debtor maintains the payment schedule, does that shorten the length of the plan?

JS: Yes, in a full-repayment plan it will shorten the length of the bankruptcy. If the debtor is not in a 100% repayment plan, the money received from the personal injury claim, usually two-thirds (2/3) of the net amount, is extra money for the creditors of the debtor.

Q: What are some of the more common circumstances you encounter in which a debtor does not meet the original payment schedule obligation of the plan to pay back creditors?

JS: Job loss or significant decrease in income after approval of the plan. Also, the divorce or separation of joint debtors can cause a plan to fail. Also, any other significant change in circumstances that causes an interruption in income.

Q: If that occurs, what happens to the filing of the bankruptcy?

JS: The case is dismissed, the Chapter 13 case is converted to a Chapter 7 case, or the Chapter 13 plan is modified and the plan payments are changed to redress the problems caused by a change in disposable monthly income.

Q: Let’s expand upon those options. If a debtor is not able to meet the obligations of a bankruptcy plan, why would that case be dismissed?

JS: Because the creditors are not receiving what they are entitled to receive.

Q: If the bankruptcy case is dismissed, what happens to the debts?

JS: It is as if the bankruptcy proceeding never happened and the creditors can resume their non-bankruptcy actions to try to collect on the debts.

Chris Holmes: It usually is a situation in which the debtor is unable to make their bankruptcy plan payments and they are not eligible for a conversion to a Chapter 7 case. As a result, the case is dismissed and their creditors are free to resume their efforts to collect on the debts. The primary reason a debtor would not be eligible to convert a Chapter 13 to Chapter 7 would be if they filed the Chapter 13 within eight (8) years of the filing of a prior Chapter 7 case. As a result, the only option is to allow the case to be dismissed and the debtor may be able to refile under Chapter 7 if it has been more than eight years since the filing of the previous Chapter 7 case.

Q: In most cases, if you’ve never filed for a Chapter 7 bankruptcy and you’re having trouble meeting the obligations of a Chapter 13 plan, then that option to convert to a Chapter 7 still exists?

CH: Yes, provided the debtor qualifies for relief under Chapter 7 of the U.S. Bankruptcy Code, the debtor has no nonexempt assets that can be confiscated and liquidated by the Chapter 7 Trustee, and the debtor is prepared to deal with certain secured creditors or nondischargeable debts outside the U.S. Bankruptcy Court.

Q: Have you had any extraordinary situations arise that are resolved more effectively by a Chapter 13 case rather than a Chapter 7 case?

CH: Recently, I had a very rare situation in which a woman owned a home that is worth less than the balance due on her first mortgage and, as a result, her second mortgage was wholly unsecured. As a further result, Chapter 13 of the U.S. Bankruptcy Code allows us to, as we say, “strip off” or avoid a wholly-unsecured second mortgage because there is no equity in the home to which that second mortgage can effectively attach.

JS: In other words, the debtor can change a secured debt into an unsecured debt and, as a result, we can treat that debt just like we would treat credit card debt or a medical bill.

CH: What made this particular case extraordinary, however, was how we treated the partially secured first mortgage in the debtor’s Chapter 13 Plan. First, I asked the debtor: “Do you really want to pay off a mortgage that, with interest, totals more than twice the current value of the home?” Given her home is located in a neighborhood in which the value of homes is depressed, and her home is in a state of disrepair, we concluded that it was unlikely that the creditor would want to foreclose on its mortgage and take possession of a home that will be impossible to sell for more than what the debtor owes on the mortgage. Also, the home would be expensive to maintain until it is sold. As a result, the debtor offered to pay the holder of the first mortgage only the current value of the home, plus a reasonable rate of interest, through the plan, and treat the balance of the mortgage as an unsecured debt. (If you recall, we do something comparable with certain auto loans—what we refer to as a “cram-down.” When an auto loan is more than two-and-a-half years old and the payoff exceeds the retail value of the car, the debtor can force the creditor to accept only the retail value of the auto plus a reasonable rate of interest, and then treat the balance of loan and any unpaid interest as an unsecured debt to be discharged.)

Legally, we can’t force the creditor to accept a “cram-down” on residential real estate; however, the debtor decided to give it a chance in the hope that the creditor preferred to accept what she offered rather than assume the risk of a worse outcome if it took possession of the property…and the creditor accepted! And given the debtor’s plan payment is roughly equivalent to her first mortgage payment, she will be able to resolve all of her debts using the money the debtor would have otherwise used for only the first mortgage. And should she successfully complete her plan, the balance due and owing on her other debts will be discharged and the debtor will own her home free-and-clear.

Q: In regards to debtors who do not successfully complete their Chapter 13 plans, what circumstances do you encounter most frequently as the cause?

CH: The primary reasons why Chapter 13 Plans fail: The debtor fails to make regular monthly plan payments due to a reduction in income caused by a job loss, or the debtor must use the money earmarked for their plan payments to pay some unforeseen, extraordinary expense such as car repairs or uninsured medical bills that arise after the filing of the case.

Q: Are there situations in which you adjust the plan payment to make it easier for the debtor to continue to make their payments on time?

JS: Yes, sometimes. If the debtor’s disposable monthly income decreases, then we can reduce the monthly plan payments accordingly.

CH: Also, if the debtor fails to make a few plan payments, then we can ask the Judge to modify or amend the debtor’s plan. For example, if the plan life is shorter than 60 months, then we can extend the life of the plan by the number of months in which plan payments were missed, in order to make up for the shortfall.

Q: What would happen if the debtor’s plan is already set at 60 months?

JS: I’ve just been in communication with a debtor who has a motion to dismiss. Her current plan payment is $1000 per month and she is behind by two months. What we’ve agreed to do is tack on an additional $100 per month for the next 20 months to catch up on the total amount due. This will place her in kind of a probationary status. If she misses another payment, the trustee can then choose a quicker route to get the case dismissed.

Q: How willing are trustees to negotiate to modify plans?

JS: The longer you’ve been in the plan, and the trustee sees your making a sincere genuine effort, the more likely the trustee will be to work with you. For example, I have a married couple as a client and they have a plan that is supposed to be 60 months long. For most of the plan, the debtors were having a portion of the trustee payment deducted from their wages, but one them lost their job, so they fell slightly behind in their plan payments.

At the end of the 60 months, the trustee stated the payments were two months short of the total amount due and filed a motion to dismiss. I objected, because payments were still being made to the trustee. The hearing is now set in about month 63. As long as that money is still coming in, the trustee will agree to just continue the hearing on the motion to dismiss until all of the money due has been paid.

Q: Does the trustee need to go back to the creditors to get them to agree to the extended period of time it will take to fully pay the amount due?

JS: No, it’s within the trustee’s discretion. If a creditor wanted to show up at the hearing and voice their own displeasure, they could. But most of the time the unsecured creditors rely upon the trustee to have the more intimate knowledge of what’s going on with the case and the debtor’s situation.

Q: So in any circumstance where you try to go back and renegotiate the terms of the plan, is it strictly up to the trustee to accept the proposal?

CH: No, the creditors can object if the modification of the plan negatively impacts them. For example, if the debtor’s plan base (i.e., the total of all plan payments) is reduced and, as a result, the amount of money to be distributed amongst the creditors is decreased, then the creditors must be notified and given an opportunity to object if the creditor believes the modification will be unreasonable or unfair.

Q: Is it like you’re going back to the beginning of the bankruptcy filing process?

JS: Yes, if you’re reducing the plan base. There is some interesting case law out there, which fortunately doesn’t come up much in our district.

For example, let’s say a debtor had a $15,000 car that they were going to pay for through the plan. The debtor gets the benefit of driving the car while the trustee is giving the creditor who made the car loan a few dollars every month towards the car payment. Three years into the plan, the car breaks down and the debtor says, “I don’t want the car anymore. I’m going to change the plan, reduce the amount owed on the car by cutting it out of the plan, and have the lender come pick up this piece of junk.”

Most of the time, in this district, the creditor will not object. But there is case law in other circuits outside of Indiana, such as the Rash decision (In the Matter of Elray and Jean RASH; United States Court of Appeals, Fifth Circuit.; Decided: July 30, 1996), which deals with this type of situation. The Rash decision is a widely-followed decision that states if a bankruptcy case is approved and a secured creditor is to receive a specified amount for a car, the creditor can object to a plan modification that surrenders the car back to them, because the debtor is the person who drove the car into the ground, not the creditor.

Those are some issues in limited circumstances—where you try to give back a secured asset after it breaks—in which a creditor will sometimes object. And if the creditor would push it, they would probably win. At that point, the debtor would have to decide to either (A) give the creditor the money they’re entitled to and fix the asset, or (B) to convert to a Chapter 7 bankruptcy, if otherwise eligible, or (C) to let the case be dismissed and start all over. Those are all options, but fortunately we’re fairly lucky in this district that we don’t have a lot of secured creditors object when we try to surrender an asset after the plan has been approved.

CH: I can’t remember the last time a creditor objected to the surrender of a car midway through the plan.

JS: I’ve seen a few instances with certain lawyers based in Kentucky who cite the Rash decision.

CH: In our previous conversation we talked about a debtor who owed his ex-wife a property settlement debt based on their divorce agreement. Because the debtor filed a Chapter 13 bankruptcy, that property settlement debt was dischargeable; whereas, it would not have been dischargeable in a Chapter 7 case.

I had a similar situation recently in which our client told me she had a car loan from the marriage that both her ex-husband and she had co-signed. In the divorce decree, the judge ordered our client to pay that debt and to hold her ex-husband harmless (that is, to protect the ex-husband from any liability thereon).

As it turned out, our client couldn’t make the loan payments, the car was repossessed, and the car was sold for less than the unpaid principal balance on the loan. As a result, there is a deficiency balance—the unpaid portion of the debt—for which both her ex-husband and she are jointly and severally liable.

In a Chapter 7 bankruptcy, her obligation to hold him harmless is a nondischargeable debt. That means the ex-husband could ask the divorce court judge to hold our client in contempt for not holding him harmless, should that car creditor sue him for that deficiency balance. According to Chapter 13 of the U. S. Bankruptcy Code, our client can list her obligation to the ex-spouse—to hold him harmless on that debt—as a debt to be discharged, which is another compelling reason why some people opt for a Chapter 13 case rather than a Chapter 7 case. As a consequence, our client will be able to discharge her personal liability on this $12,000 deficiency balance, and her ex-husband will not be able to go to ask the divorce court judge to hold our client in contempt for not holding him harmless on the underlying debt.

Q: It sounds like the husband thought he was going to be protected, but ended up not being protected. Did he make some sort of a mistake in his negotiation of their divorce agreement?

CH: Sometimes divorce lawyers will insert language into a property settlement agreement that asserts that such obligations are in the nature of alimony or maintenance and, therefore, nondischargeable. Whether such a provision is enforceable is a matter for the Judge of the U.S. Bankruptcy Court to resolve.


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*Disclosure required by 11 U.S.C. § 528(a)(3): We, the law office of Tom Scott & Associates, P.C., are a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code.