Example of How Chapter 13 Handles a Creditor with a Disputed Lien

Here’s a scenario showing how Chapter 13 solves problems that Chapter 7 doesn’t solve in dealing with a creditor’s disputed lien. 

Our last blog post got into what happens when you don’t think a creditor has a legally enforceable lien in something you own. We explored some practical problems if you addressed this situation in a Chapter 7 case. Essentially, the creditor has a lot of leverage to make you pay the debt, even with a questionable lien. We showed how Chapter 13 elegantly takes that leverage away, minimizing what you pay on that debt.

That last blog post begged for an example how this all works. We’re giving you that here today.

Our Example

Imagine that a year ago you bought one of those laptop computers that fold into a tablet for $500.  You got it an electronics store where you had an account, and put the whole purchase price on that account. The previous balance had been $750 from the purchase of a variety of items over the previous couple years. Then during the 6 months after buying the computer you bought other minor items totaling $250. After making minimum monthly payments for most of the last year you now owe $1,300 on the account.

For unrelated reasons you now have serious debt problems and need bankruptcy relief.

The Questionable Lien

So you meet with a competent bankruptcy lawyer who carefully reviews your situation with you.  You are left with the conclusion that both a Chapter 7 “straight bankruptcy” and a Chapter 13 “adjustment of debts” would greatly help, and you are trying to decide which way to go.

After this first meeting the lawyer reviews your paperwork from the electronics store. He or she informs you that the store arguably does not have a lien on anything you bought there. That includes your only significant purchase there, the laptop/tablet. The paperwork shows that the store likely intended to create a lien in the items purchased but did not seem to follow the legally required steps to do so.  In other words, the store would likely assert that it has a right to repossess the laptop/tablet, but there’s a good chance your lawyer could persuade a court that it does not have that right.

What Would Happen under Chapter 7

Your lawyer informs you that this situation causes some practical problems under Chapter 7. The store could try to enforce a lien against the laptop/tablet and whatever else you purchased. Your bankruptcy documents would have asserted that no valid lien attaches to this debt. But the store could instead demand that you pay the $1,300 debt to be allowed to keep what you bought.

Your lawyer would counter by arguing on your behalf that:

• The store did not have a valid lien on anything that you had purchased.
• Even if there was a lien, the only item sensibly worth repossessing and reselling was the laptop/tablet.  
• But even that had greatly depreciated in value because electronics become quickly obsolete and are hard to resell.

So with your prior permission your lawyer would offer a compromise: you’d pay $100 to keep the computer. That’s sensible because the store would not likely get any more for it, especially after accounting for its resale costs.

But the store may dig in its heels. It may sensibly figure that the computer is worth a lot more than $100 to you.  Over the last year you may indeed have gotten really comfortable with it and now greatly rely on it. So the store could threaten to ask for a bankruptcy court determination that the lien is valid and, if successful, would repossess the computer, unless you agreed to pay the entire debt of $1,300 in monthly payments.

Your lawyer would inform you that you have a better than even chance of persuading the court there’s no valid lien. But the litigation to get there would cost you at least $1,000. So, because you really do need the laptop/tablet, you’d agree to settle the dispute by making monthly payments totaling some compromise amount, say $750.

The Chapter 13 Solution

But paying $750 is not a very satisfying result if the store really doesn’t have a legal right to anything you bought. So, to avoid the above scenario, on your lawyer’s advice you decide to file a Chapter 13 case instead.  You had other unrelated reasons to do so, but this store debt helped swing your decision in that direction.

So, you and your bankruptcy lawyer list the store’s debt as unsecured in Schedule F. Your Chapter 13 payment plan treats the debt accordingly.

One of two things then happens.

If the Store Objects

The store may object to it being treated as an unsecured creditor. If it does, and does so before the “confirmation hearing” (which is about two months after you file your case), there’s a streamlined court procedure for determining whether or not the store has a valid lien in what you purchased.

If the bankruptcy judge determines there’s no lien, the debt is treated as an unsecured debt just as you’d proposed.

This means that you pay only as much of the $1,300 balance as you can afford to pay during the length of the case. That’s after reasonable living expenses plus after first paying other debts that legally have higher priority. Often you would pay only pennies on the dollar; sometimes you would pay nothing of that $1,300. Then after you finish your Chapter 13 case the court permanently writes off whatever you haven’t paid.

This all assumes that the store files a proof of claim on time. If it doesn’t do so within a deadline about 4 months after your case is filed, it’s paid nothing. Then the entire debt is written off at the end of your case.

But what if early in the case the court instead determines that the store DOES have a valid lien? Then you’d have to pay a portion of that $1,300 as a secured debt in your Chapter 13 plan. That portion is determined by the fair market value of whatever the lien attaches to. Here the only item of meaningful value is the laptop/tablet. Although there would likely be some dickering about the appropriate dollar value, the store would not likely be able to establish that it’s worth more than about $150. So you would pay that amount over time in your plan. The rest of the debt—$1,150—would be treated as an unsecured debt, as discussed above.

If the Store Doesn’t Object

It’s not unusual for a creditor in the position of the store to simply not object to be treated as unsecured. Why would such a creditor just stay silent?

Because it knows that it has so much less leverage under Chapter 13 than under Chapter 7. It knows that you and your lawyer have a relatively inexpensive way to establish that its lien isn’t valid. It knows that even if it has a lien, its debt’s secured portion is going to be small. Depending on the case, even without objecting the store knows it will be paid something as an unsecured creditor (as long as it files a timely proof of claim). So any additional money the store would get by objecting would not likely justify its costs in doing so.

If the store doesn’t object by the time of the “confirmation hearing,” its debt is treated as unsecured. If it also doesn’t file a proof of claim by the deadline (about 4 months after filing), you pay it nothing in the Chapter 13 case. And the entire debt is permanently written off.

If the store doesn’t object but it does file a proof of claim for the $1,300 debt, the entire debt will be treated as unsecured. So you pay only what you can afford during the case (if any), and the rest is permanently written off.

Conclusion

Chapter 13 gives you so much more leverage in this situation than under Chapter 7. For a bunch of practical reasons the debt would more likely be treated as an unsecured one. If the lien is found to be valid you will much more likely be able to pay a relatively modest amount to keep your property. So, especially in a situation in which you are paying a small portion or nothing of your unsecured debts, Chapter 13 may well be the way to go if you have a disputed lien.