Check Yourself Before You Wreck Yourself: Partial Involvement in a Bankruptcy Case May Cause Parties to Lose Protections Under the Bankruptcy Code

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Contributed by Doron P. Kenter.

“When I believe in something, I fight like hell for it.” – Steve McQueen

A recent decision from the Bankruptcy Court for the Eastern District of North Carolina illustrates the dangers inherent in overlooking one’s rights in bankruptcy.  Indeed, unintentional errors may cause creditors to lose sacrosanct protections that they would have been afforded had they simply stayed out of the case altogether.  Creditors and other parties in interest should take care not to imply their “tacit consent” to actions taken in the bankruptcy case that would otherwise be denied sua sponte by the court.

In In re Canovali, the Bankruptcy Court was faced with a motion filed by Bank of America for relief from the confirmation order entered in the Canovalis’ chapter 11 case.  Bank of America was a secured creditor in the Canovalis’ bankruptcy case, holding a first deed of trust in the amount of $988,000 and a second deed of trust in the amount of $368,000, both of which related to the Canovalis’ residence in Raleigh.  Having estimated the value of the property at $1,063,000, the individual chapter 11 debtors scheduled B of A as holding a secured claim in an amount of $988,000 to $1,063,000 and an unsecured claim in the amount of between $293,000 and $368,000 (the list of largest creditors showed that B of A held a $368,000 unsecured claim, but Schedule D showed that only $293,000 of the $368,000 attributable to the second deed of trust was unsecured).

In August 2009, the Canovalis filed their proposed plan and disclosure statement.  The plan valued the Raleigh property at $1,000,000 and proposed to pay B of A’s claims as one claim with a face value of $1,000,000, payable over 30 years at 5% interest.  On August 24, 2009, the Bankruptcy Court entered an order conditionally approving the disclosure statement.

On October 8, 2009, the Bankruptcy Administrator filed a response to the proposed plan, noting that it violated section 1123(b)(5) of the Bankruptcy Code, which prohibits modification of mortgages on an individual debtor’s principal residence in chapter 11.  Accordingly, the Bankruptcy Administrator suggested that the plan was feasible if B of A were to accept such modification, but was not feasible if B of A were to object to the proposed plan.  B of A then voted against the plan, but did not file an objection.

After the Canovalis’ initial confirmation hearing was continued, and more than four months after the proposed plan was filed, B of A formally appeared in the case and filed a proof of claim.  The proof of claim asserted that B of A had a secured claim in the amount of $977,918.36, with a corresponding interest rate of 6.5%, secured by a “Security Deed.”  It also listed the value of its unsecured claim at $0 even though it stated that the value of the property was “[u]nknown.”  Two weeks later, B of A filed an objection to confirmation of the proposed plan, arguing that it undervalued the Raleigh property by $500,000 and that the plan should not provide B of A with a $1,000,000 secured claim at 5% interest for thirty years, but rather that it should characterize B of A as holding a fully secured claim in the amount of $977,918.36, along with interest at 6.5%.

Before the confirmation hearing, however, B of A agreed to withdraw its objection in exchange for treatment of its claims as a fully secured claim in the principal amount of $977,918.36).  The Court confirmed the Canovalis’ plan (as modified), and the confirmation order stated that “the sole amount owing to Bank of America, N.A. under Class 4 is $977,918.36. . .”

Nearly ten months later, B of A moved to set aside the confirmation under Fed. R. Civ. P. 60(b)(1) and Bankruptcy Rule 9024 because the plan violated section 1123(b)(5) of the Bankruptcy Code by eliminating B of A’s second deed of trust.  Applying Fourth Circuit law, the Court suggested that the relief sought by B of A was both untimely and unfairly prejudicial to the debtors and other creditors, and noted that B of A had not shown excusable neglect in failing to assert such an objection to the Canovalis’ plan — any of which would be a sufficient basis for denying B of A’s motion.

Importantly, though, the Court determined that B of A had waived the protections afforded by section 1123(b)(5).  Relying on In re Arns, the Court concluded that B of A had been provided with “enough constructive notice” to have had “imputed knowledge” that the Canovalis’ plan would modify its claims (whether or not B of A actually knew that the plan would modify its claims and security interests).  The Court further noted that, by negotiating with the debtors and entering into a consent order to resolve its confirmation objection, B of A had affirmatively agreed to accept its treatment and modify its claims notwithstanding the anti-modification provision in the Bankruptcy Code.

This decision suggests that, without B of A’s tacit approval (or affirmative actions suggesting acceptance), the Court could not have confirmed the Canovalis’ plan insofar as it sought to modify B of A’s deed of trust on the Canovalis’ principal residence.  Once B of A became involved in the case and took actions implying its acceptance of the plan, the Court held that B of A was deemed to have consented to such treatment, and section 1123(b)(5)’s prohibition on such modifications would accordingly be waived.  Parties in interest should be advised to commit to zealously protecting their interests, as incomplete involvement may result in greater prejudice than no involvement at all.