The possibility of a bankruptcy filing has always affected the pre-bankruptcy conduct of both debtors and creditors. Yet several of the changes the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) made to the Bankruptcy Code go even further in an apparent attempt by Congress to mandate pre-bankruptcy efforts by debtors and creditors to work out their differences—or more specifically, settle their debts and claims—before debtors file a petition for bankruptcy.

A great deal of attention has been given to the new provisions requiring debtors to undergo consumer credit counseling from an approved nonprofit agency before being eligible to file for relief.

Newly effective 11 U.S.C. §502(k) allows a court to penalize unsecured creditors that do not reasonably negotiate reasonable alternative payment arrangements with debtors. Section 502(k) provides a mechanism for debtors to request that the court reduce such a creditor's claim by 20 percent. A creditor is subject to the 20 percent penalty if the debtor petitions the court and proves through clear and convincing evidence that the creditor unreasonably refused to negotiate a reasonable alternative repayment schedule that was offered by the debtor at least 60 days before the bankruptcy filing and that proposed to repay at least 60 percent of the amount of the debt over the original term of the loan or a reasonable extension.

Several other modifications BAPCPA made to Code sections, like those curtailing a bankrupt debtor's rights to modify the terms of certain auto loans, are an effort to remove certain benefits that were available to debtors in bankruptcy, essentially promoting pre-petition negotiations between debtors and creditors.

If these new provisions do prompt debtors and creditors to more frequently engage in negotiations before a bankruptcy filing, there may be more disputes in the bankruptcy courts about the effect those negotiations have, if any, on the nature and terms of those debts.

Novations and Oral Agreements

A novation is the substitution for an existing debt or contract of a new one that may contain different terms or even different parties, such as a new debtor or creditor, in place of the original terms or parties.¹

The U.S. Supreme Court's 2003 decision in Archer v. Warner² addressed the effect that pre-petition litigation can have on the nature of a debt for purposes of determining its dischargeability. The Archer court held that a creditor is not precluded from litigating the dischargeability of its debt merely because that debt was reduced to a judgment prior to bankruptcy. In so holding, the court rejected the debtor's contention that the judgment itself constituted a novation and essentially replaced the pre-judgment debt with the judgment itself. The creditor in Archer was permitted to pursue its assertion that the debt was nondischargeable because it was incurred through fraud.

Countless other cases have arisen involving situations where one or both of the parties claimed to have made an oral contract, or one party believed the terms of an original agreement were later modified or replaced entirely through a novation. When faced with such disputes, courts will make an initial inquiry into the nature of the agreement to determine if it is otherwise governed by applicable statutes. For example, almost every state has adopted a version of the Statute of Frauds, which prohibits oral contracts for certain transactions such as the sale of real estate.³

When not otherwise controlled by applicable statutes, parties are faced with having a court determine whether an oral contract exists and, if so, what the terms are. In such cases, courts will look to the specific facts of the case and the circumstances of the transactions to determine the parties' intentions.⁴ The intent of the parties enables the court to determine if there was the requisite "meeting of the minds" necessary to establish a binding agreement.

Similarly, whether a novation occurs is a question of fact that hinges on a determination of the intent of the parties. The court may find that a novation has occurred where there has been agreement of all the parties to substitute for an existing agreement a new agreement that is otherwise valid and enforceable. The party claiming a novation bears the significant burden of proving that a novation was intended.⁵

Anti-modification Clauses

To avoid the uncertainty created by a judicial interpretation of the parties' intents, many loan agreements contain language intended to ensure that the terms of the agreement are clear and cannot be modified through oral agreements or subsequent negotiations unless those changes are memorialized in writing. These clauses also often contain language to protect the lender from a misinterpretation of its conduct should it fail to enforce its rights in any given situation. Commonly used terminology states:

Forebearance by Lender Not a Waiver.
Any forbearance by lender in exercising any right or remedy hereunder, or otherwise afforded by applicable law, shall not be a waiver of or preclude the exercise of any right or remedy.

These clauses seek to avoid the need to litigate whether a contract was intended to be permanently modified by oral negotiations or was merely an occasional exception permitted by one party. Since the intent of the parties can be less than clear after the fact, debtors and creditors have agreed to the standard anti-modification clauses to prevent such "he said/she said" disputes from arising later. By relying on such terms, parties can openly negotiate and allow exceptions to the original agreement without permanently forfeiting their rights to enforce the original terms of the contract in the future.

Fanucchi and Limi Farms

However, in a recent case decided by the Ninth Circuit U.S. Court of Appeals, Fanucchi and Limi Farms,⁶ the court held that despite the presence of commonly used contract language specifically stating that amendments to the agreement must be in writing and approved by both parties, the oral commitments and the conduct of the parties evidenced a novation—or a complete replacement of the original written loan agreement with an entirely new agreement—the exact details of which were the subject of the dispute between the parties.

Although not a consumer debt, the contract in Fanucchi contained language similar to that found in many loan agreements:

Amendments. This agreement, together with any related documents, constitutes the entire understanding and agreement of the parties as to the matters set forth in this agreement. No alteration of or amendment to this agreement shall be effective unless given in writing and signed by the party or parties sought to be charged or bound by the alteration or amendment.

The creditor in the case held a security interest in the debtor/farmer's crops. After the crops failed and the debtor defaulted on the loan, the creditor worked with the debtor and allowed the debtor to obtain new credit secured by new crops rather than enforcing its rights under the terms of the agreement to foreclose. Despite the language in the original contract, the court found that because the creditor agreed to deviate so significantly from its rights as stated in the agreement, the parties' conduct in this case had created a new agreement that replaced the written contract.⁷

Conclusion

As debtors and creditors both assess the changes to their rights brought about by BACPA and work through settlement negotiations prior to a possible bankruptcy filing, they should be aware of the need to document their intentions to avoid ambiguity or misunderstandings that will need to be resolved through costly litigation later.

The potential for confusion seems to be increasing. Debtors may be compelled to postpone filing while pre-filing requirements are fulfilled. Creditors increasingly outsource collections or sell accounts outright to third parties, increasing the likelihood that the debtor may not recognize the original debt. Debtors frequently do not realize who they have actually borrowed money from in the first place. A purchase of furniture from a national furniture store may in reality be funded by a third-party lender, but the debtor may only recognize the name of the brand or store where the purchase was made.

In these circumstances, the negotiation of payment arrangements adds another opportunity to confuse matters because of the possibility of a court later determining there was an oral contract or novation of an existing agreement. For example, a debtor who defaults on an unsecured debt but disputes the total amount of the debt claimed by the creditor might not want to waste time arguing about it if he is able to negotiate an acceptable payment for a portion of the debt over time. However, by doing so, the debtor could arguably be deemed to have consented to the larger amount claimed by the creditor. Conversely, a creditor that compromises its position to resolve a dispute may have to defend a claim that the arrangement constituted a novation that replaced the original indebtedness and now binds both parties.

In the past, parties could often protect themselves from these problems somewhat by refusing to compromise or by including anti-modification language in their agreements, but that may no longer be the case, especially for those in the Ninth Circuit⁸ and those faced with the possibility of a future 502(k) dispute related to their claim.

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Footnotes

¹ Black's Law Dictionary, Fifth Edition, 1979. Return to article

² 538 U.S. 314 (2003). Return to article

³ Such prohibitions are generally referred to as the Statute of Frauds and are codified separately by nearly every state. See Black's Law Dictionary, Frauds, Statute of. Return to article

⁴ Whether or not a novation exists depends primarily on the facts of each case. Olympic Finance Co. v. Thyret, 337 F.2d 62, 65-66 (9th Cir. 1964). Return to article

⁵ Hofer v. Merchants State Bank of Freeman, S.D., 823 F.2d 271, 272-73 (8th Cir. 1987). Return to article

⁶ 414 F.3d 1075 (9th Cir. 2005). Return to article

⁷ For a further analysis of Fanucci, see Munoz, Peter, "Ninth Circuit Allows Oral Agreement to Supersede Loan Documents," Reed Smith (http://www.mondaq.com/article.asp?articleid=35050&searchresults=1). Return to article

⁸ The Ninth Circuit includes Alabama, Arizona, California, Guam, Idaho, Hawaii, Montana, Nevada, Oregon and Washington state. Return to article