In the Matter of William Douglas Paeplow, Debtor-Appellee. Appeal of Edmond W. Foley, R. Kent Rowe, R. Kent Rowe, III
Aftеr William Paeplow received a discharge in bankruptcy under Chapter 7 of the Bankruptcy Code, a group of creditors filed a suit in state court seeking to collect on a pre-petition debt he owed them. To circumvent the prohibition discharge ordinarily places on such suits, the creditors attempted to proceed
in rem
against property Paeplow and his wife owned as tenants by the entirety. Paeplow sought an injunction to halt that suit; the bаnkruptcy court granted the injunction, the district court affirmed,
I.
The facts in this case are not in dispute. In 1981, William and Janice Paeplow moved from South Bend, Indiana, to Roswell, New Mexico, where they purchased a tire business from Edmond Foley, Kent Rowe, Jerry Huelat, Y.L. Beagles, Betty Beagles, Pete Cassen, and Karen Cassen (the creditors). The Paeplows subsequently took out a $60,000 loan from the First Interstate Bank of Roswell (the Bank), and jointly executed a promissory note which, among other things, secured the loan with inventory, fixtures, and accounts receivables (the security) they held in the tire business. The creditors, who still held an interest in the property securing that note, simultaneously executed an agreement subordinating their rights in that property to the Bank.
The Paeplows later defaulted on the promissory note on September 3, 1982, and on that day William Paeplow individually filed for bankruptcy. Paeplow’s bankruptcy schedules listed the $60,000 promissory nоte as one of his liabilities, and a house he owned in South Bend, Indiana (the South Bend property) as one of his assets. Pae-plow also claimed the South Bend property — which he and his wife held as tenants by the entirety — as property eligible for exemption from his creditors’ claims under Indiana state law. Ind.Code § 34-2-28-1(a). Paeplow received a discharge in bankruptcy in January 1984, prior to which the Bank filed a motion with the bankruptcy court requesting relief from the аutomatic stay. The bankruptcy court granted that motion, giving the Bank the go-ahead to pursue a joint judgment against the Pae-plows in state court and to enforce that judgment against the South Bend property. However, as will later become critical, the Bank failed to take the second necessary step to preserve its claim on the Paeplow’s real estate: moving for a stay of the Pae-plow’s discharge — which he received without objection in January 1984 — to give it time to obtain a judgment lien.
At any rate, the creditors, who still held an interest in the property securing the note, decided to take action to protect their interest. They assumed the Paeplows’ liability on the note, stepping into the shoes of the Bank as its assignee, and then filed their own motion for relief from the automatic stay, so that they could seek a joint judgment and lien against the Paeplows in state court (as the Bank had intended to do). The bankruptcy court responded with an order informing the creditors that the automatic stay had been lifted as to all of Paeplow’s creditors on the day of his discharge. The creditors apparently interpreted that order as a green light to pursue Paeplow’s pre-petition obligation on the note. Accordingly, they filed suit in state court against Janice Paeplow for collection on the note and later amended their complaint to add her husband William as a defendant.
That suit, which the creditors characterized as an
in rem
action, languished for several years until trial was finally scheduled for September 26, 1990. In the interim, Paeplow never raised the defense of discharge in any pleading or pre-trial proceeding. Paeplow finally launched a collateral attack on that action by filing this suit in federal bankruptcy court on July 25, 1990, seeking to enjoin the creditors under
Following briefing and a hearing, the bankruptcy court granted Paeplow’s request for an injunction,
In re Paeplow,
II.
Several sections of the Bаnkruptcy Code are relevant to this case. 11 U.S.C. § 541(a)(1) provides that “all legal or equitable interests of the debtor in property as of the commencement of the case” are pulled into the bankruptcy estate for the benefit of all creditors. 11 U.S.C. § 522(b) provides that, notwithstanding § 541, an individual debtor may exempt from the bankruptcy estate certain enumerated items. Alternately, a state may opt out of the federal exemption scheme in § 522 and prоvide its own list of exempted items. The bankruptcy trustee then has the power to sell or use all non-exempt § 541 property for the benefit of all creditors. § 366(b)(1). Significantly, the trustee may reach property the debtor holds as a tenant by the entirety, subject to either the federal or state exemption scheme, whichever is in effect. § 363(h). After distribution of the estate’s assets, a debtor emerges from bankruptcy under the fresh start policy with a discharge of his or her debts; § 524 provides that discharge enjoins any former creditors from commencing any action to collect a “personal liability” of the debtor.
State property law is also relevant to this case. Indiana continues to recognize tenancy by the entirety, a common law form of marital ownership that creates between spouses joint ownership of an undivided interest in property which may not be transferred or encumbered by either spouse acting alone.
See, e.g., State of Indiana v. Union Bank & Trust Co.,
One further observation about Indiana state law is warranted. As noted, § 522 permits states to opt out of the federal exemption scheme, and the Indiana legislature chose to do so in 1980. Ind.Code § 34-2-28-0.5. The legislature simultaneously amended the state’s existing exemption scheme to exempt
[a]ny interest the judgment debtor has in real estate held as a tenant by the entireties on the date of the filing of the petition for relief under the bankruptcy code, unless a joint petition for relief is filed by the judgment debtor and spouse, or individual petitions of the judgment debtor and spouse are subsequently consolidated.
Ind.Code § 34-2-28-l(a)(5) (emphasis added). As will become important later, the plain language of the statute, which applies only to bankruptcies, appears to grant an individual debtоr who holds an interest in entirety property a complete exemption from the claims of all creditors, including those made by joint creditors of both spouses.
The creditors argue that the district court erred in three respects: (1) in not allowing the creditors to follow the old Indiana practice of permitting post-discharge
in rem
proceedings against a debt- or’s entirety property; (2) in concluding that the South Bend property entered Pae-plow’s bankruptcy estate under 11 U.S.C. § 541; and (3) in concluding that Paeplow received an exemption on his South Bend property under Ind.Code § 34-2-28-1. Another panel of this Court recently confronted these same issues,
In re Matter of Hunter,
A.
The creditors first argue that the district court improperly refused to follow the old Indiana practice of permitting post-discharge
in rem
actions against the entirety property of a discharged debtor. Such actions were permitted by Indiana courts as long as the creditor held a joint claim against both spouses, rather than a claim against the filing debtor alone.
See Smith v. Beneficial Fin. Co.,
Those decisions emerged largely in response to a feature of the Bankruptcy Act of 1898 (the Act) — since superseded by the Bankruptcy Code of 1978 — which presented an opportunity for debtors to perpetrate legal fraud on unsuspecting joint creditors. The Act provided that property which the debtor was capable of “transferpng] or which might have been levied upon” would become “property of the estate.” 11 U.S.C. § 110(a)(5) (1970) (repealed 1979). This provision, by definition, did not include the debtor’s entirety property (unless the debtor had jointly filed bankruptcy with his or her spouse). The Act, by precluding the trustee from reaching the debtor’s entirety property, allowed spouses to fraudulently shield such property from joint creditors simply by having one spouse individually file for bankruptcy.
See, e.g., In re Hunter,
The creditors argue that the rationale underlying that approach remains viable today. The district court disagreed, relying on more recent decisions, both under the Code,
Munoz v. Dembs (In re Dembs),
The creditors maintain that the cases on which the district court principally relied—
Harris
and
Gilbert
— are pre-Code cases of questionable validity in light of language in the Code which reinforces the old Indiana рractice. Whereas the Act discharged all “provable debts” of the debtor, 11 U.S.C. § 35 (1970) (repealed 1979), the Code discharges only the
“personal liabilities]
of the debtor.” 11 U.S.C. § 524 (1988) (em
The creditors further point to an amendment to § 524 which they claim buttresses their position. Although that provision formerly included language prohibiting creditors from commencing actions against “the property of the debtor,” 11 U.S.C. § 524(a)(2) (1979), Congress chose to eliminate those words in 1984. This revision, according to the creditors, effectuated Congress’ intent to preclude through discharge only
in personam
proceedings against the debtor and not
in rem
suits against the property of the debtor. It follows, the creditors maintain, that the traditional Indiana practice of permitting post-discharge
in rem
actions to attach entirety property is consistent with the Code.
See In re Snow,
We conclude that the district court properly declined to follow the customary practice in Indiana of permitting post-discharge
in rem
actions. Congress did indeed intend to permit such actions, but
only
to the extent a creditor first obtained a judgment lien against a debtor’s property prior to discharge.
In re Hunter,
Moreover, contrary to the creditors’ assertion, the legislative history behind § 524, and its amendment in 1984, weakens, rather than reinforces, the justification for the old Indiana practice. In dropping the “property of the debtor” language from § 524, Congress did not implicitly open the door to post-discharge in rem action against all discharged debtors; rather, it attempted
to clarify that discharge precludes only actions to establish personal liability, not actions to enforce a lien against property of the debtor. Cases and commentators agree that the Congress intended to resolve the apparent inconsistency between section 524(a)(2) and other portions of the Code, such as section 506(d)— which allows certain liens to pass through bankruptcy unaffected — and section 522(c)(2) — which states that exempt property is still subject to certain liens.
In re Hunter,
B.
The creditors argue alternatively that (1) entirety property under Indiana law does not enter the bankruptcy estate under 11 U.S.C. § 541(a)(1), and (2) Indiana law does
The creditors first maintain that, notwithstanding provisions in the Code permitting a trustee in bankruptcy to administer entirety property,
i.e.,
§ 363(h), Indiana’s definition of entirety property does not permit that property to enter the bankruptcy estate. The creditors acknowledge that the language of § 541(a)(1) — which broadly defines the bankruptcy estate to include “all legal or equitable interests of the debtor in property as of the commencement of the case” — has almost uniformly been interpreted to permit courts to pull a debtor’s entirety property into the bankruptcy estate.
See, e.g., Sumy v. Schlossberg,
The creditors also assert that even if entirety property does enter the bankruptcy estate, Indiana law does not provide an еxemption for such property in this case. According to the creditors, in enacting Ind. Code § 34-2-28-1, the Indiana legislature did not intend to exempt entireties property from the claims of
joint
creditors, but simply to continue the common law practice of immunizing entirety property from execution by
individual
creditors.
See In re Marino,
The creditors base this argument on 11 U.S.C. § 522(b)(2)(B), which incorporates into the Code any “exempt[ions] from process” entirety property receives under a state’s nonbankruptcy law. Because Indiana has never afforded holders of entirety property protection from the claims of
joint
creditors under its
nonbankruptcy
law,
Sharpe v. Baker,
We disagree and conclude that the South Bend property both entered Paе-plow’s bankruptcy estate and received an exemption under Indiana law. First, the holding in
Jeffers
is of questionable validity in light of modifications to Indiana exemption law adopted subsequent to that decision.
Jeffers
held that entirety property in Indiana did not become part of the bankruptcy estate under § 541 because Indiana law did not permit either spouse to claim an
individual
interest in entirety property.
Id.
at 53. However, shortly after
Jeffers,
the Indiana legislature amended § 34-2-28-l(a)(l) to grant each spouse such an individual interest in entirety рroperty, Act of Mar. 3, 1980, Pub.L. 196 § 2, 1980 Ind. Acts 1625, thereby undermining
Jeffers.
Under current Indiana law, a debtor in bankruptcy has a sufficient individual in
At any rate, the legislative history behind § 541 makes clear that Congress intended a debtor’s interest in entirety property, at least initially, to enter the bankruptcy estate.
Hunter,
the undivided interest of a spouse who is a debtor in a case under the Act is property of the estate. This is contrаry to the present Act which looks to state law to determine what happens with respect to property jointly owned by husband and wife.
H.R.Doe. No. 137, 93d Cong., 1st Sess. 195 (1973). That is not to say Congress intended to circumvent the protection afforded entirety property under state law. It simply means congress intended entirety property to enter the bankruptcy estate and to pass out of the estate if subject to an exemption, and if claimed by the debtor on his or hеr bankruptcy schedules.
In re Hunter,
We also reject the creditors’ suggestion that the Indiana legislature intended § 34-2-28-l(a)(5) to merely codify the Indiana common law practice of immunizing entirety property from execution by individual creditors (but not joint creditors). The problems with this argument are fully detailed in
In re Hunter,
We acknowledge that this interpretation may create the same potential for legal fraud availablе to unscrupulous debtors under the Act.
In re Hunter,
IV.
The creditors’ other arguments merit only limited discussion. First, they contend that, despite their failure to obtain a judicial lien on the South Bend property, an equitable lien arose nonetheless by actions the Bank took prior to discharge. They claim that when the Bank sought the bankruptcy court’s permission to obtain a judicial lien, Paeplow was put on notice that the Bank intended to levy against his entirety property. And, in fact, the bankruptcy court granted that request in an order dated January 16,1984. Consequently, the creditors argue, an equitable lien arose on that date because Paеplow had notice of the Bank’s plan to obtain a judgment lien. The creditors offer no legal authority directly supporting this proposition and we decline to accept it, particularly in light of our duty to narrowly construe exceptions to discharge in bankruptcy.
The creditors also assert that the January 16, 1984 order, by granting permission to proceed in state court, bars Pae-plow from seeking an injunction under principles of
res judicata.
We disagree. The bankruрtcy court’s order was not a final judgment on the merits, but simply a determination that the Bank, as a joint
Finally, the creditors argue that we should abstain from enjoining the state court proceeding under principles of comity. Specifically, they contend that Paeplow has waived his right to invoke the ancillary jurisdiction of this Court by failing to timely plead discharge as a defense in the state court proceedings. Paeplow’s failure to do so was an imprudent litigation decision, but we agree with the district court that Pae-plow did not waive the protection afforded him as a discharged debtor under § 524 by his inaction in state court. No trial has been held in Indiana state court, nor has a judgment been entered against him there, and we decline to withdraw our ancillary jurisdiction in this matter on grounds of comity.
V.
In sum, § 541 defines what property of a debtor enters the bankruptcy estate, § 522 permits the debtor to exempt certain property from the reach of creditors, and § 524 provides an absolute discharge of the debtor’s pre-petition debts. This comprehensive statutory framework severely limits the ability of creditors to reach discharged debts and property. Here, Paeplow listed his indebtedness on the promissory note аnd his right to an exemption on the South Bend property on his bankruptcy schedules. He received a discharge before the Bank or its assignees reduced that claim to a judgment lien, and the district court properly held that the creditors were enjoined from the date of discharge from taking any further action to collect from Paeplow on the note 3 or to obtain a lien on the South Bend property.
The creditors’ arguments in this case were not frivolous and the district court properly denied Paeplow’s request for sanctions under Rule 11. The decision of the district court is Affirmed.
Notes
. Bankruptcy courts developed a mechanism of their own to avoid fraud: a joint creditor could seek a stay of the debtor's discharge, allowing it time to reduce its claim to a judgment lien against the spouses' entirety property.
See In re Hunter,
. In so holding, we do not pass on whether Indiana’s statute, by its express limitation to the bankruptcy context, violates the mandate of U.S. Const, art. I, § 8 which requires geographic uniformity in bankruptcy law.
See In re Hunter,
. We note that Janice Paeplow, as a non-filing debtor, has no such protection.