Discharge Injunction: Secured Claims Can Ride through Bankruptcy Without Regard to a Discharge

Fonseca v. Gov’t. Employees Ass’n. (In re Fonseca), 534 B.R. 261 (Bankr. D. P.R. 2015) –

An individual Chapter 7 debtor sued the Puerto Rico Government Employees Association (AEELA) alleging that it violated the discharge injunction. AEELA made a prepetition loan to the debtor, and after the discharge order was entered sought to recover money owed to the debtor for accumulated vacation and sick leave to apply to repayment of the loan.

A discharge order under Section 727 of the Bankruptcy Code releases an individual debtor from prepetition personal liabilities (with certain exceptions). Section 524 provides that the order operates as an injunction against any attempt to collect a discharged debt as a personal liability of the debtor.

There is a violation of the injunction if a creditor “(1) has notice of the debtor’s discharge; (2) intended the actions which constituted the violation; and (3) acts in a way that improperly coerces or harasses the debtor.” A court may enforce the injunction, and if the violation is willful may grant monetary relief. However, as the bankruptcy court noted: “Unlike personal debts, secured claims may be able to ride through bankruptcy unaffected by the discharge injunction.”

In this case AEELA made a prepetition loan to the debtor that it claimed was secured by statutory liens on certain assets of the debtor. After the bankruptcy court entered a discharge order, it sought to recover its collateral to apply to the outstanding loan balance.

The threshold question for the bankruptcy court was whether AEELA had a secured claim that survived discharge. It began its analysis by a review of the definition of “statutory lien”:

[T]he term “statutory lien” means lien arising solely by force of a statute on specified circumstances or conditions, or lien of distress for rent, whether or not statutory, but does not include security interest or judicial lien, whether or not such interest or lien is provided by or is dependent on a statute and whether or not such interest or lien is made fully effective by statute.

In this case the Puerto Rico Commonwealth Employees Association Act gave powers to AEELA that included the power to make loans to members with security as established by regulation. It was also specifically authorized to deduct sums owed to it from the savings and contributions of employees “permanently separated from service.”

The debtor acknowledged that AEELA had a lien on ~$18,500 that was in savings and dividend accounts that existed at the time he filed bankruptcy, and did not dispute its right to apply that balance as partial payment on the loan. However, AEELA’s claim to a lump sum payment for unused vacation and sick leave due upon the debtor’s retirement was a different matter.

The debtor was a government employee. He filed bankruptcy on September 12, filed a petition for retirement on September 14, received a discharge order on November 20, and officially retired on December 31. He claimed that AEELA’s statutory lien did not extend to the vacation and sick leave lump sum payment because the lien was not created or perfected prior to the bankruptcy petition.

He further claimed that there were three requirements that had to be met before the lien would attach: “(1) that the member has ceased his employment permanently; (2) that the employee has a debt with AEELA at that time and (3) that the available funds have not been alienated by the employee’s retirement system.” Since he retired after entry of the discharge order, he argued that there was no longer any debt to AEELA.

In addition to the authority to deduct from savings accounts, the statutes included broad authority allowing AEELA to recover from assets held by the government as follows:

Any credit, deposit or surplus, for any reason, in the Commonwealth Government, or in any dependency or instrumentality thereof, in behalf of a member who, having ceased in office, is in debt with the Association, shall be retained by the Secretary of the Treasury of Puerto Rico or the competent officer, if not alienated in the corresponding retirement system, and covered into the funds of the Association, partially or fully to pay the debt pending therewith.

The court examined the statute authorizing vacation and sick leave payments: Upon removal from service an employee may be entitled to a lump sum payment for accumulated vacation and sick leave based on his last salary. The court viewed this as a “credit, deposit or surplus” subject to the general collections statute. The statute authorizing a lump sum payment further provided that the sum was subject to certain deductions, including “those voluntarily incurred by the officer or employee by reason of loans from the Employees Association.”

It was clear that AEELA would have been able to collect payment for its loan from the lump sum outside of bankruptcy. However, the question was whether AEELA had a valid statutory lien within the meaning of the Bankruptcy Code so that it had an in rem collection right that survived the discharge order.

The debtor argued that a statutory lien cannot be enforced unless the terms of the statute are met. In this case he contended that the right to the lump sum payment could only arise after he retired on December 31. Since perfection could occur only after retirement, and post-petition perfection is void, AEELA was not entitled to enforce the lien.

The court did not buy the debtor’s arguments. First, the court noted that the same arguments could be made in connection with the savings and dividend accounts – since they were not subject to collection by AEELA until the debtor was “permanently separated from service,” which did not occur until December 31.

In addition, the court was not persuaded by the cases cited by the debtor since in those cases the applicable law included specific perfection requirements. In this case the statutory lien automatically attached to all assets in the possession of the government, and the court saw no further requirements for perfection of the lien other than making the loan itself.

Consequently, the court found that AEELA had a valid statutory lien. Since it was proceeding in rem against its collateral, and specifically did not pursue the debtor personally, the discharge injunction was not applicable.

This is another example of the fact that liens are not necessarily affected by bankruptcy. It also illustrates the potentially broad scope of “secret liens,” and is a reminder that a clean UCC search does not necessarily mean that assets are free and clear.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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