‘Good Faith’ Standard Restricts Debtor Creativity

Mathews v. US Bank, NA, et al.; 10-01243-RGM; March 31, 2011

This case came before the court on the debtor’s complaint to strip-off a wholly unsecured deed of trust and tax lien against her property in a Chapter 13 bankruptcy.

The debtor was the only obligor on the two deeds of trust.  The Debtor was on the title as joint tenants with right of survivorship. The non-debtor had the tax liability.

After the debtor met with her bankruptcy attorney, the debtor decided to have the non-debtor convey her one-half interest in their home to her, file a chapter 13 bankruptcy petition herself, and strip-off the second deed of trust. The debtor argues that she is entitled to strip-off the second trust and tax lien simply because the value of the property is less than the balance due to the first trustholder.

The IRS claimed two defenses that the court addressed, first that it was entitled to sovereign immunity and, second, that the debtor is acting in bad faith.

1. Sovereign Immunity:  Judge Mayer disposes of this defense by citing 11 USC 106 which abrogates sovereign immunity for a governmental unit for certain sections, including section 506.

2. Debtor’s good faith:  Judge Mayer took issue with the transfer of the non-debtor’s one-half interest for no value right before the filing of the Chapter 13.  The court examined Philips v. Krakower, 46 F.2d 764 (4th Cir. 1931), in which the husband and wife structured their filings to achieve a result that they would not have been able to accomplish on their own. The Court in the Phillips case called this a “legal fraud,” but Judge Mayer noted that today, this is simply called “abuse.”

Discussing abuse, Judge Mayer noted that “bankruptcy courts have traditionally drawn upon their powers of equity to prevent abuse of the bankruptcy process and to ensure that a “case be commenced in ‘good faith’ to reflect the intended policies of the Code.”  2 L. King, Collier on Bankruptcy, 301.05[1], at 301-5 to 301-7(1996). Continuing, Judge Mayer noted that such good faith requirement prevents abuse of the bankruptcy process by debtors whose overriding notice is to delay creditors without benefiting them in any way or to achieve reprehensible purposes.  Moreover, a good faith standard protest the jurisdictional integrity of the bankruptcy court by rendering their powerful equitable weapons (i.e., avoidance of liens, discharge of debtors, marshaling and turnover of assets) available only to those debtors and creditors with “clean hands.” In re Little Creek Development Co., 779 F.2d. 1068 (5th Cir. 1986).

Judge Mayer look to the factors applied in In re Lilley, 91 F.3d 491 (3rd Cir. 1996) , which were restated in In re Folotico, 231 B.R. 35 (Bankr.D.N.J. 1999), where the bankruptcy court refused to strip off a wholly unsecured lien on equitable grounds.  In applying the Lilly factors, the court stated: The factors which may be considered in an examination of the totality of circumstances include:  (i) the nature of the debt; (ii) the timing of the petition; (iii) how the debt arose; (iv) the debtors notice in filing the petition; (v) how the debtor’s actions affected creditors; (vi) the debtor’s treatment of creditor’s both before and after the petition was filed; and (vii) whether the debtor has been forthcoming with the bankruptcy court and creditors.

Judge Mayer decided that the debtor seeks to achieve indirectly what the debtor is not able to achieve directly: “The manner in which this transaction was structured allowed the debtor to file bankruptcy and was intended to achieve the discharge of the IRS’s lien from the property by the debtor, but not Ms. Fagan, filing bankruptcy. The result of this bankruptcy case is that the debtor and Ms. Fagan working together seek to achieve a result that Ms. Fagan, the obligor of the tax debt, could not achieve directly.

Judge Mayer ultimately decided that the absence of good faith prevented the court from allowing the strip off of the IRS lien.

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