By: Donald L Swanson
Chapter 11 Debtor owns her home and uses it as a Bed & Breakfast.
The mortgage on Debtor’s B&B/residence is her primary debt. This raises Subchapter V issues like:
- Eligibility—is her primary debt a consumer debt or a business debt?
- Eligibility—is her bankruptcy a “single asset real estate” case?
- Mortgage Impairment—can the mortgage debt on her residence be divided into secured and unsecured portions for Subchapter V plan purposes?
The case is In re Ventura, Case No. 8-18-77193, in the Eastern New York Bankruptcy Court (opinion issued 4/10/2020, Doc. 107).
Since October of 2018, Debtor has been in a Chapter 11 proceeding. Once Subchapter V becomes effective, she designates herself a small business debtor and elects to proceed under Subchapter V. Her mortgage lender and the U.S. Trustee object.
Here’s what happened.
In December 2007, Debtor becomes co-owner of a Long Island residence known as the “Harbor Rose Property,” using a $1 million dollar loan secured by a purchase money mortgage on the Property.
The Property is not a typical Long Island residence:
- The original structure was built in the mid-1800’s;
- It is located in a small waterfront village on Long Island’s North Shore;
- The Property is registered on The National Registry of Historic Places and is recognized as a significant historic structure by the Town of Huntington Historic Preservation Society;
- From the beginning, Debtor advertises rooms for rent at the Property on Craigslist, Facebook and Wimdu;
- Paying guests begin staying at the Property within the first year of purchase; and
- At the time, the Town Code permits individuals to rent only two guest rooms out of their property.
As part of the Great Recession of 2008, Debtor defaults on the Mortgage.
On January 18, 2013, Debtor files a Chapter 7 petition (“First Case”) as a no-asset case. The majority of debts are listed as consumer debts. Debtor receives a discharge and the case is closed.
Then, Debtor files a Chapter 13 bankruptcy (“Second Case”), describing her debts as primarily consumer debts. Her Schedule I identifies Harbor Rose as her sole source of income. The case is dismissed for failure to file necessary documents.
Meanwhile, Debtor becomes sole owner of the Property, and the Lender agrees to modify the terms of the mortgage.
The Town Council requires the owner/operator of a bed and breakfast to reside there.
Debtor forms Harbor Rose LLC (“Harbor Rose”) to operate the Property. Harbor Rose offers lodgings at the Property, along with health and wellness packages, including yoga classes, acupuncture treatments, massage treatments.
- obtains a permit to operate as a bed and breakfast;
- successfully lobbies the Town Council to allow bed and breakfasts to rent up to four guest rooms and permit a maximum stay of 29 days;
- obtains the appropriate bed and breakfast permits; and
- upgrades the Property to provide four guestrooms, replaces HVAC, upgrades electric service, and builds an enclosed/heated porch.
Debtor defaults on the modified loan. Lender begins foreclosure on the Property, which it values at $1,200.000.
The Current Chapter 11
Debtor files a Chapter 11 petition on October 2, 2018 (the “Current Case”). In the initial Petition and schedules, Debtor:
- describes her debts as primarily consumer debts;
- does not designate herself as a small business debtor;
- describes the Property as a place of business and as a “Bed & Breakfast”;
- lists her income and expenses from the operations of Harbor Rose in her Statement of Current Monthly Income.
Debtor and Lender file competing plans: a plan of reorganization and liquidating plan, respectively.
The viability of Debtor’s plan hinges on bifurcating the Mortgage into secured and unsecured portions and paying only the secured portion in full. But Debtor can’t do that because she resides at the Property:
- § 1123(b)(5) prohibits modifying a claim secured by debtor’s residence.
So, the Court declares Debtor’s proposed plan unconfirmable and, therefore, declines to approve her disclosure statement.
By contrast, the Court approves Lender’s disclosure statement and sets a confirmation hearing on Lender’s plan for February 26, 2020.
–Subchapter V Becomes Effective
Seven days before the confirmation hearing on Lender’s plan, Subchapter V becomes effective.
At the Confirmation Hearing, the Court advises the parties of the new law and continues the hearing so Debtor can amend her petition.
On March 6, 2020, Debtor amends her petition, designating herself a small business debtor and electing to proceed under Subchapter V.
Lender and the U.S. Trustee object.
The definition of “small business debtor, in the newly amended § 101(51D)(A) of the Bankruptcy Code, includes:
- a person engaged in commercial or business activities;
- that has aggregate, noncontingent, liquidated, secured and unsecured debts as of the date of the filing of the petition in an amount not more than $2,725,625;
- not less than 50 percent of which arose from the commercial or business activities of the debtor; and
- excluding a debtor whose primary business is owning “single asset real estate.”
Do more than 50% of Debtor’s debts arise from commercial or business activities?
Many cases hold that residential mortgages fall within the definition of “consumer debt”—but those are residence-only cases and do not involve a substantial use of the residence for business purposes.
The fact that a debtor incurs mortgage debt to buy a residence does not automatically mean that the debt is consumer debt. The test is this:
- whether a debt is incurred with an eye toward profit.
In applying this test, courts must look at the substance of the transaction and the borrower’s purpose, rather than merely looking at the form of the transaction.
Lender’s argument points to various details, including:
- the form of the transaction, at the beginning, was solely a residential loan for the purposes of purchasing a primary residence, not operating a business;
- in the mortgage, Debtor declared, “I will occupy the Property and use the Property as my principal residence within 60 days after I sign this Security Instrument”;
- Debtor formed Harbor Rose six years after granting the mortgage to Lender, and any subsequent change in the Debtor’s use of the Property does not change the nature of the debt;
- none of Debtor’s debts are derived from the operation of Harbor Rose;
- none of the mortgage proceeds were used to renovate the Property for the benefit of the business; and
- Debtor characterized the mortgage debt as consumer debt in her prior bankruptcy filings, including initial filings in the Current Case.
Debtor’s argument points to:
- her long history in the hotel business;
- her stated need to create a business that would keep her close to her adopted daughter,
- the unique characteristics of the Property;
- purchasing the six-bedroom historic mansion with the intention of converting it into a guest house;
- renting the guest rooms, from the outset, by advertising on various websites;
- making improvements to the Property; and registering the Property as a legal bed and breakfast.
The Bankruptcy Court concludes that Debtor is eligible for Subchapter V because:
- Debtor’s primary purpose in purchasing the Property was to own and operate a bed and breakfast;
- Debtor’s goal was to combine her business with the needs of her life as a single parent
- Debtor residing at the Property does not control whether the mortgage arose from Debtor’s commercial or business activities;
- Town Council will not grant a permit to run a bed and breakfast, if the owner/operator does not live inside the facility itself; and
- the Bed & Breakfast is not a single asset real estate business, because of the multiple activity offerings made to customers for additional fees.
Judicial estoppel is not an impediment
Lender argues that Debtor is judicially estopped from asserting that the mortgage debt arose from her commercial or business activities because: her current position (that her debts are not primarily consumer debts) is inconsistent with her contrary declarations in prior bankruptcy filings.
A debtor may be judicially estopped from changing its legal position when, (i) a court has adopted and relied on it, and (ii) the party claiming judicial estoppel suffers an unfair detriment as a result, (iii) unless mistake or inadvertence is an applicable defense.
Judicial estoppel has been applied in the bankruptcy context to prevent a debtor from changing a description of debts as “consumer” to “business.” But that was when the timing of the debtor’s change indicated “gamesmanship” by debtor—not because of a mistake or inadvertence.
The Bankruptcy Court refuses to apply judicial estoppel in this case because:
- Debtor’s representations in the Current Case clearly and forthrightly reflect the business nature of the Property by, (i) describing the Property as a “Bed & Breakfast,” and (ii) including her income and expenses from operations of Harbor Rose.
- The Court took no specific action based on a description of the mortgage debt as consumer debt, and it was not misled about the nature of the mortgage debt.
- Debtor changed the description of her debts to fit within a statute that did not exist at the time the voluntary petition was filed—the change is more akin to correcting an innocent choice than to gamesmanship.
- None of the judicial estoppel precedents upon which Lender relies involves a newly enacted law designed to protect the Debtor.
- Debtor is entitled to utilize 11 U.S.C. § 1190(3) to modify the mortgage
Subchapter V provides, in § 1190(3), as follows:
“A plan . . . may modify the rights of the holder of a claim secured only by a security interest in real property that is the principal residence of the debtor if the new value received . . . was-(A) not used primarily to acquire the real property; and (B) used primarily in connection with the small business of the debtor.”
Here’s how the Bankruptcy Court construes such § 1190(3) provisions:
- The plain language of this statute specifically permits the modification of claims secured by mortgages on the debtor’s principal residence; and
- As to subparagraphs (A) and (B), the Court must determine whether the mortgage proceeds were used primarily in connection with the debtor’s business—this requires a qualitative analysis of the principal purpose, not a bright-line test.
The Bankruptcy Court identifies the following factors for determining whether the mortgage is subject to modification under § 1190(3):
- Were the mortgage proceeds used primarily to further the debtor’s business interests;
- Is the property an integral part of the debtor’s business;
- To what degree is the property necessary to run the business;
- Do customers need to enter the property to utilize the business; and
- Does the business utilize employees and other businesses in the area to run its operations.
In the Debtor’s case:
- Debtor had a larger business purpose than merely buying a residence and using one room for office space;
- Debtor bought real property, immediately began advertising rooms for rent, and spent time and resources to obtain permits for running the Property as a bed and breakfast;
- The primary purpose of the Property is to offer rooms for nightly fees;
- Harbor Rose serves a variety of guests, including guests visiting the nearby Cold Spring Harbor labs;
- Harbor Rose also provides holistic services to the guests staying at the Property with package services offered for additional fees;
- Although the mortgage proceeds were not used to refurbish the Property or to obtain the proper zoning changes and permits, such proceeds were used to purchase the building that houses the business run by the Debtor.
Accordingly, the Bankruptcy Court allowed the case to move forward as a small business under Subchapter V, with opportunity to bisect Lender’s claim into secured and unsecured portions.
The Bankruptcy Court’s ruling is, of course, on appeal.
This case offers insight into the construction and application of Subchapter V eligibility and mortgage modification rules. It looks to be a well-reasoned case and to have a good shot on appeal at being affirmed.
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