December 2005 Legal Briefs

Fed’s Warranty of Authorization for “Telephone Checks”

1. Background
2. Who Uses “Telephone Checks”?
3. What Checks are Covered?
4. Warranty of Authorization
5. FTC Telemarketing Rule
6. Interviewing the Customer  
7. Removing the “Midnight Deadline”
8. Fraud and Errors
9. Limitation on Returning Checks
10. The OBA’s Involvement

Homestead Exemption in Oklahoma Bankruptcies: What’s the Dollar Limit?

Fed’s Warranty of Authorization for “Telephone Checks”

On November 21 the Federal Reserve announced amendments to Regulation CC that create a new “warranty of authorization” for certain checks drawn on a customer’s account, if they don’t bear an apparent signature or facsimile signature in the lower right-hand corner (for example, if the item has only the typed words “authorized by your customer”).  All types of accounts are covered—commercial, consumer, non-profit, etc. The Fed’s changes take effect July 1, 2006.  

The items covered by the new provisions are often called “paper drafts” or “telephone checks,” but the Fed’s new language calls them “remotely created checks.”

The bottom line is this:  Beginning July 1, if these unsigned “telephone checks” are paid but turn out to be unauthorized, a paying bank will be allowed  to return such items to a depository bank, without any “midnight deadline” problem.

Until now, paying banks have often been forced to take the losses on these items; but paying banks have no ability to reduce the number of fraudulent “telephone checks” entering the banking system.  Depository banks, by contrast, are in a much better position to “police” depositors that may be depositing fraudulent “telephone checks.”  By shifting the losses for unauthorized “telephone checks” back to the depository bank (beginning July 1), the regulation gives depository banks a financial incentive to more actively monitor persons who may be depositing these “telephone checks.”  

There’s nothing in the regulation that would impose any sort of depositor- monitoring procedures on depository banks; but, logically, depository banks will need to start looking more closely at whether any customers depositing “telephone checks” (1) are reputable and are engaging in genuinely authorized transactions, and (2) have sufficient net worth to repay the bank’s losses if deposited “telephone checks” are returned “unauthorized.”  

It would be burdensome for any depository bank to sort through deposits to look for “telephone checks.”  But when a bank opens a business account, it can ask whether the customer will be depositing “telephone checks,” and, if so, it can inquire further to determine whether it is comfortable with the nature of the customer’s business.  Later, if a depository bank starts receiving returns of unauthorized “telephone checks,” that bank will tend to close the account if (1) if the number of returns is excessive, or (2) if the customer is not good for the returned items.  Thus, the shifting of liability for unauthorized “telephone drafts” from the paying bank to the depository bank will tend to reduce the amount of fraudulent “telephone drafts” entering the banking system.  And this change certainly will eliminate losses at paying banks.

I will outline the details of the Fed’s new provisions, after explaining further history of these changes.

1. Background

Banks have been uneasy with “telephone checks” for many years.  The new regulatory provisions finally offer a remedy.  Because these items are MICR-encoded and are sent through the collection system just like ordinary checks, they are also paid normally and go directly into a customer’s statement—like all checks do.  Almost all paying banks use bulk filing, so a bank usually will be unaware that it has received “telephone drafts” on a customer’s account.

In a typical check-payment scenario, a paying bank will not examine or even notice “telephone drafts” unless a particular item either (1) exceeds the dollar amount that requires manual examination, or (2) kicks out because it overdraws the account.  (With so many overdraft plans in place today, it is rather unlikely that a single unauthorized item will kick out by exceeding overdraft limits.)

Even when a bank notices that a “telephone check” has been presented for payment, the bank cannot assume automatically that it is unauthorized.  The vast majority of telephone checks are authorized.  It’s easy for a customer to appoint an agent, even verbally (such as over the telephone, authorizing a “telephone check” to be prepared); and the UCC’s definition of “signed” is quite broad, including even a mark or symbol that the customer has adopted or approved.  On this basis, a statement such as “Authorized by your customer” (if true) is enough to bind the customer and the paying bank.  

If a telephone check is authorized, a paying bank would wrongfully dishonor its customer’s item (the same as for any other check) by not paying the item from the customer’s available funds.  But with no signature on a “telephone check,” the paying bank is never completely sure whether the customer has or has not authorized it.  And trying to determine that each “telephone draft” is authorized has never been a workable approach.  (Many customers are not home during the day, when a bank would usually call; and most banks would not want to adopt a policy of trying to call each customer.)

When a “telephone check” is not authorized, that problem usually is not discovered until the customer receives the item in his monthly statement.  But until now, an unauthorized “telephone check” has been treated as legally the same as any other unauthorized check (such as a forged check):  If the paying bank cannot discover a problem with that item quickly enough to return it before the paying bank’s midnight deadline, any attempt to return the unauthorized “telephone check” after that point has failed, as a “late return.” 

When a “telephone check” (or any other type of check) is actually unauthorized, the paying bank must reimburse its customer for the item; but (usually) it is too late for the paying bank to seek reimbursement from the depository bank.  The paying bank therefore has sustained the ultimate loss on most unauthorized “telephone checks.”

Most paying banks think this result is highly unfair.  They point out that if an ACH debit is unauthorized, a receiving bank has thirty days to return it to the sending bank (based on a “warranty of authorization” created by NACHA rules).  Similarly, if an unauthorized charge appears among the customer’s debit card or credit card items, he can have the charge reversed (based on very strong re-credit rights created by VISA and Mastercard rules, and under Regulation E).  But an unauthorized “telephone check” cannot be sent back (until now), outside the “midnight deadline” (because of provisions in Regulation CC and the UCC).  Since all three of these methods of posting a charge to a customer can be initiated by a third party based on telephone authorization (without an actual inked signature), many people believe “return rights” for all such unauthorized items should be similar.  Effective July 1, the Fed has accomplished that result.  Paying banks will no longer need to worry that “telephone checks” may not be authorized, because unauthorized “telephone checks” can be sent back.  

2.  Who Uses “Telephone Checks”?

Telephone checks” have been around for at least twenty years.  They came into existence at a time when ACH transactions were still used mainly for repeated, pre-authorized charges such as monthly insurance premiums.  And of course, no one had a debit card linked to a deposit account.  

The primary advantage of a “telephone check” has always been that a telemarketer or bill collector can quickly prepare and deposit the “telephone check” (with authorization), expediting the collection of funds.  There might have been a delay of as long as a week if the customer had to mail a “manually signed” check to the person who wanted the payment. (A telemarketer selling goods can mail merchandise faster, and a bill collector can credit the customer’s account faster, often avoiding a late fee or preventing the account from being classified adversely.)

Now a majority of all deposit accountholders probably have a debit card linked to their deposit account; and a merchant’s receipt of payment by debit card gives even faster “collected funds” than sending a “telephone check” to the paying bank.  The use of “telephone checks” has certainly declined as customers are increasingly willing to pay for anything by debit card.  

But there are a variety of situations in which “telephone checks” may continue to be used instead of a debit card payment.  For example, some people (particularly the elderly) don’t have and don’t want a debit card; and some customers can’t get one (because of credit history).  In addition, a “telephone check” is not limited in dollar amount, and can be used when the payment exceeds the customer’s debit card dollar limit per day. Perhaps some of the smaller entities originating “telephone checks” cannot initiate debit card items because they are not set up as Visa or Mastercard merchants (including some entities that are no longer part of those systems for various reasons).  Other entities may prefer to use “telephone checks” to avoid paying the Visa/Mastercard fees for processing debit card items.

For all of the reasons just stated, “telephone checks” won’t go away, even if they decline in number.  Reputable telemarketers and credit card companies will continue to originate “telephone checks” drawn on bank customers’ accounts.  Banks should have no hesitation to take “telephone checks” for deposit from reputable companies that are apparently following good business practices and that have ample funds to make good on any “telephone checks” that may be returned to the depository bank as “unauthorized.”

 But I expect that depository banks will stop accepting “telephone checks” for deposit from entities (1) whose activities are poorly understood, (2) who are not long-time bank customers, and/or (3) who operate with marginal deposit levels at the bank. These customers may be a higher risk for originating unauthorized items, may not have the financial strength to stand good for returned items, or may no longer be around when unauthorized items are returned. 

3. What Checks are Covered?

Newly added Subsection 229.2(fff) of Regulation CC provides a definition of “remotely created check.”  (This is the terminology used in the regulation—not “telephone check” or “paper draft.”  From here on I will use “remotely created check” as I discuss the regulation more specifically.)

There are two required “prongs” to the definition of “remotely created check,” and both must be met:  First, it is “a check that is not created by the paying bank.” Second, it is a check “that does not bear a signature applied, or purported to be applied, by the person on whose account the check is drawn.”

The second part of the “remotely created check” definition is the one that’s most relevant.  A “remotely created check” must not have a signature that has been applied by the customer (no “inked” signature, nor any facsimile signature, such as a rubber-stamp signature or machine-imprinted signature).  A “remotely created check” also must not have a signature “purported to be applied by the customer” (or by the customer’s authorized signer or other agent, or by anyone else pretending to pass the check as good).  Checks with forged signatures, or unauthorized signatures, or with facsimile signatures applied by someone not authorized to do so, or even counterfeit checks printed with the wrong name and having any sort of signature, will all drop out of the definition of “remotely created check,” because they pretend to have a signature. To re-emphasize this, a “remotely created check” has no signature at all (no inked signature signed by anyone, and no facsimile signature applied by anyone).  The new regulation will not provide any new basis for returning checks (real or false) that have a signature.

Instead of having a signature, a “remotely created check” may have some sort of printed legend in the lower right-hand corner, such as “Authorized by your customer,” or maybe “Signature on file.”  It may even have an electronically  printed or typed name. But strictly speaking, a legend is not required for an item to be a “remotely created check”:  If a customer prepares a real check and forgets to sign it, this technically will also meet the definition of “remotely created check.”—because it’s not created by the paying bank, and it has no signature.  Thus, even when a payee deposits a check that the customer has forgotten to sign, the depository bank will give an automatic “warranty of authorization,” just like it does for any other “remotely created item.” However, a check that is unsigned because of oversight is rare, and is unlikely to result in fraud losses for either the depository bank or the paying bank.  

The first part of the “remotely created check” definition also technically applies, but won’t be an issue in most situations.  A “remotely created check” must not be “created by the paying bank.”  A paying bank shouldn’t be allowed to create a check itself, then try to send that check back to a depository bank as “unauthorized.”  Anyway, very few items would drop out of being “remotely created checks” because of this part of the definition.  

There’s an additional unusual feature of the Fed’s new definition of “remotely created item.”  Although the definition is added to Regulation CC, that regulation generally covers only checks that are written on deposit accounts.  (Reg CC’s regular provisions do not cover checks accessing a customer’s credit-card line, or checks written against the customer’s home equity line of credit.) However, a special provision is added in the “remotely created check” definition so that it includes checks written on an account that is “a credit or other arrangement that allows a person to draw checks that are payable by, through, or at a bank.”  On this basis, credit-card checks and HELOC checks will be “remotely created items” also–if they have no signature. 

4.  Warranty of Authorization

Beginning July 1, 2006, based on Section 229.34(d)(1) of Reg CC, each bank taking a “remotely created check” for deposit will make an automatic warranty to any transferee bank, and to the paying bank, that the person on whose account that check is drawn has authorized the issuance of the check, both (1) in the amount stated on the check, and (2) to the payee stated on the check.  If this warranty is breached (in other words, if the paying bank’s customer did not authorize the item, or if the payee or amount is wrong), the “remotely created check” can be returned to a transferee bank, and finally to the bank that took the item for deposit—even though that return is outside of the paying bank’s midnight deadline.  

Note that this new “warranty of authorization” only shifts liability between financial institutions (in other words, it allows the paying bank to shift losses, back to the depository bank, or not, depending on the circumstances.)  The Federal Reserve’s  statutory authority on this point (12 U.S.C., Sections 4001 and following), only allows the Fed to shift losses between banks.  The new regulation does not extend to the paying bank’s customer, who, however, can raise claims directly against the paying bank based on the UCC if the paying bank has paid any type of unauthorized item on his account.

(When the customer makes an enforceable claim against the paying bank on an unauthorized item (step one), the paying bank then can use the new “warranty of authorization” (if available) to shift liability from the paying bank to the depository bank (step two).  The paying bank’s customer has no authority under the new warranty to raise a claim directly against a depository bank that has taken for deposit an unauthorized “remotely created check” drawn on that customer’s account.)

The new regulation also does not entitle the depository bank to shift liability for the returned item back to its depositor. Therefore, the depository bank must shift liability to its depositor by contract. For example, a bank could provide in its deposit agreement that the customer will be liable for any “remotely created item” that is returned to the depository bank as “unauthorized.”  But many banks already use broader language (or would want to add broader language) that accomplishes the same thing.  For example, the deposit agreement might state that when an item deposited to the customer’s account is properly returned to the bank for any reason, the bank has the right to charge that item back to the customer’s account.  (This takes care of a whole range of issues–not just “remotely created checks”–including a missing or bad endorsement, alteration, etc.)

5. FTC Telemarketing Rule

As the Federal Reserve points out in its revised Commentary to Reg  CC at Section 229.34(d), the “warranty of authorization” for “remotely created checks” merely supplements the Federal Trade Commission’s existing Telemarketing Sales Rule. (16 C.F.R. Section 310.3(a)(3).)  Telemarketers that submit “telephone checks” for payment are already required by the FTC to obtain the customer’s “express verifiable authorization,” which can be either (1) in writing, or (2) tape recorded.  This information has to be made available upon request to the customer’s bank.

Based upon my various conversations with banks concerning “telephone checks” that their customers say are “unauthorized,” I would guess that in about half of the cases the item really was authorized. It’s just that the customer has changed his mind, and regrets having approved the charge—so he wants it taken off his account.  But this really can’t be done.  After the customer originally gives approval and the “remotely created check” is prepared and deposited, that check does not later become “unauthorized” just because the customer develops “buyer’s remorse.”  This does not change the fact that he gave authorization. 

6. Interviewing the Customer 

In some cases a collection agent calls a debtor on behalf of a creditor.  The debtor might be embarrassed, having no good excuse for not sending a payment, so (when prompted) he gives approval for a “remotely created check” to be prepared.  As soon as he hangs up, the debtor regrets saying “yes”—because he has some other way that he would prefer to spend the money–but the “remotely created check” is still authorized.

In other cases, the customer might authorize a “remotely created check” by telephone, but fails to write down the payee’s name and the dollar amount in his checkbook.  (In some situations, an elderly person genuinely cannot remember ever talking to a telemarketer or collection agent.)  When the “remotely created check” is paid on the account, this may cause other outstanding checks to be returned, or paid into overdraft, with related fees imposed.  The customer gets mad and wants to reverse the debit for the “remotely created check” that messed up his account, as well as the resulting overdraft charges.  But failing to write the item down in the checkbook does not make the “remotely created check” unauthorized.  

I often suggest that a bank officer ask the customer very gently, “How did they get your account number, and the bank’s routing number?”  About half of the customers then admit that they did, in fact, give out the information and authorize the item.

A paying bank can guess pretty well in advance that credit card companies and reputable telemarketing companies are going to have a written approval or recorded verbal approval from the customer, authorizing the challenged item.  A paying bank does not need to reimburse the customer if it can gather reasonable proof that the challenged item was actually authorized.

7. Removing the “Midnight Deadline”

In most cases the “midnight deadline” problem has prevented a paying bank from returning so-called unauthorized “remotely created checks” to the depository bank.  To avoid a loss on these items, a paying bank’s only recourse at that point is to try to prove that a “remotely created check” was in fact authorized, so that the item can be properly posted to the customer’s account.  In order to do this, the paying bank’s only options have been (1) interviewing the customer or (2) trying to obtain proof of authorization from the company that prepared the “remotely created check.  If this process doesn’t get anywhere, or is too time-consuming, or the item is too small to dispute, the allegedly “unauthorized” telephone check often gets resolved in the customer’s favor, with the paying bank taking the loss.  

With the new regulation, some of this will change.  The paying bank won’t necessarily be required to investigate whether a “remotely created check” is authorized—which is what was required previously in order to shift the loss from the paying bank to its customer.  With the new authorization, the paying bank will have an additional option, which is simply to return the item to the depository bank, based on its customer’s assertion that the item is unauthorized. If in fact the item was unauthorized, the depository bank will be required to take the item back, and then will attempt to charge the item to its depositor.  Unlike the present system, the party creating the “remotely created check” will ultimately have the burden to prove authorization, in order to avoid reimbursing the depository banks for the item.  

So, after July 1, a paying bank may think it’s simpler to “just send back” any “remotely created check” that the customer says is unauthorized—no questions asked.  But there still can be good reasons to quiz the customer about the circumstances before acting too hastily to return an item.  It’s time-consuming for the paying bank to return a “remotely created check,” then to handle the item again (posting it to the customer’s account once more) when the depository bank demonstrates that the item in fact was authorized–which the paying bank may have suspected all along.  

I do expect dramatic changes in who takes the losses as a result of the new provisions.  Customers of the paying bank will probably end up being liable for more of these disputed “remotely created checks” than at present, because paying banks now will return the items to the depository bank in all cases where authorization is questionable, and depositors creating these checks will be much more actively involved in proving that those items were actually authorized (if true).  The paying bank then will get proof that the items belong on the customer’s account, instead of the paying bank taking a loss.  Regardless, either the paying bank’s customer, or the depository bank (and the depositor), will almost always have to take any loss, not the paying bank.

8.  Fraud and Errors

I don’t want to suggest that “fraud” or mistakes do not exist in the realm of “remotely created checks.”  Certainly the internet is full of people whose intent is not legitimate.  Sometimes a person obtains a customer’s bank routing number and account number by trickery, with no bona fide transaction involved.  Other times, a customer might approve what he thinks is only a one-time charge, but the person he authorized initiates a series of “remotely created checks,” all in that same amount, or initiates a larger-than-authorized item.   

Unintentional errors also occur, and can be a reason for returning “remotely created checks” as unauthorized.  For example, two numbers of a customer’s account number are transposed, causing the wrong customer’s account to be debited. Once, a credit card company prepared a $40 “remotely created check” on my deposit account, but they typed an extra zero and took $400 out of my account.

9. Limitation on Returning Checks

New subsection 229.34(d)(2) of Regulation CC allows a depository bank to decline to pay, based on the new “warranty of authorization” for unauthorized “remotely created checks,” in any circumstance where the paying bank’s customer is not legally entitled to seek reimbursement for the item from his own (paying) bank because of customer negligence or delay, under various provisions of UCC Section 4-406.

The new “warranty of authorization” shifts the loss from the paying bank to the depository bank in situations where the paying bank otherwise would have a loss because of its duty to reimburse a customer on an unauthorized “remotely created check.”  (The new provision does not shift liability to the depository bank in situations where the paying bank can avoid reimbursing the customer’s loss because either (1) the customer was negligent in failing to examine statements in a timely manner, or (2) there were repeat unauthorized items that resulted from the customer’s failure to discover and report earlier unauthorized items.)

The following discussion of what “remotely created checks” the paying bank must reimburse to its customer relies on the same UCC provisions that determine which unauthorized ordinary checks a paying bank is required to reimburse to its customer.

There are two separate provisions in UCC Section 4-406 that allow paying banks to reduce their liability to customers for bad items charged to the customer’s account.  The first provision is in Section 4-406(f), which creates an outside time limit for liability.  No matter what the circumstances, a customer cannot raise a claim for any bad item unless he reports the bad item within one year after receiving the statement that included the item.

However, Section 1-102(3) of the UCC allows parties to vary by agreement almost any requirement of the UCC (such as time periods), if the changed provision is “not manifestly unreasonable.”  As one example, many banks’ deposit agreements include a provision requiring a customer to examine and report any unauthorized items within either 30 days or 60 days after receiving each statement, or else the bank will not be liable to the customer for such items.  (This shorter time period, if contained in a bank’s deposit agreement, cuts down the one-year time period in Section 4-406(f) to 30 days or 60 days, according to the particular bank’s provision.  But in the absence of a special provision like this in a bank’s deposit agreement, the one-year period in Section 4-406(f) still applies.)  

Let’s say a paying bank (in its deposit agreement and on its monthly statements) imposes a 60-day period to report any unauthorized item, after a statement is received by the customer.  If a bank pays an unauthorized “remotely created check” on a customer’s account, but the customer waits for 75 days to report the item after receiving the statement, this falls outside of the time period in which the paying bank is required to reimburse the customer’s account.  

Under new subsection 229.34(d)(2) of Regulation CC, it would be improper for the paying bank to attempt to recover on the unauthorized item on its customer’s behalf by sending it back to the depository bank.  This is wrong because (1) the paying bank is not liable to its customer on this item (late notice), and (2) the depository bank has an automatic defense to reimbursing the paying bank, if the paying bank itself is not legally obligated to reimburse its customer.  (If paying banks start sending back unauthorized “remotely created checks” to depository banks several months after those items were originally paid, depository banks should ask for verification that the paying banks are still legally required to reimburse their customers on these items.)

Section 4-406(d)(2) of the UCC is the other applicable provision, and allows banks to avoid liability for “repeat” unauthorized items on an account if earlier unauthorized items of the same type were not reported to the bank in a timely manner.  (After a certain point, the repeat bad items become the fault of the customer, who could have prevented the repeat items if only he had bothered to examine his earlier statements to find and report the earlier bad items.)

The “repeat item” rule in 4-406(d)(2) includes a duty by each customer to examine his statements within 30 days of receiving them—but this duty is not for the same purpose as the deposit agreement provision.  If, at any time more than thirty days after a customer receives his first statement containing an unauthorized item, additional (repeat) unauthorized items from the same wrongdoer are paid on the account, the paying bank (still unaware that the items are bad) will not be liable to the customer for those repeat items (items paid more than thirty days after the customer got the first statement containing a bad item of that type.)  This rule applies to forged checks, but also applies to unauthorized “remotely created checks.”

For example, the adult child of an elderly customer comes into the bank and says that an unauthorized “remotely created check” in the amount of $50 was included in the customer’s monthly statement received five days ago. There is an identical $50 unauthorized “remotely created check” in the statements received one month, two months, three months and four months earlier, and the adult child wants the bank to reimburse the elderly parent for all of these.

The first statement with a bad item was received a little over four months ago, and the second statement, including a similar bad item, was received a little over three months ago.  The bad item included in that second statement was probably paid less than thirty days after the date of the first statement containing a bad item.  So the bad charges of the same type that appear in these first two statements are not cut off by the “repeat-item” rule.  But the bank is not liable for the bad items contained in the third, fourth and fifth statements (received two months ago, one month ago, and this month) because of the “repeat item” rule. The loss on all of these later items is allocated to the customer because of her negligence in failing to examine the earlier statements and/or failing to report the problem sooner to the bank.   

The bad items in the first two monthly statements (in the example above) are not cut off by the repeat-item rule.  However, if the bank has also adopted a provision requiring customers to report all bad items within 60 days (or 30 days), the bad items in the earliest two statements are cut off by this rule instead.  The bad items received this month and one month ago are not cut off by the 60-day examination period (because they are not old enough), but are cut off by the “repeat-item” rule.

In the example above, the bank is not liable to its customer for any of the allegedly unauthorized items appearing in five consecutive statements. And when the paying bank is technically not liable to its customer for these items, it would be improper for the paying bank to seek reimbursement for its customer from the depository bank based on breach of the new warranty of authorization.

For customer relations reasons, a paying bank sometimes reimburses a customer for some items although the bank technically is not required to do so. This is a business judgment; but the paying bank that takes a loss that it is not legally required to take will not have the right to be reimbursed for it by the depository bank.

10.   The OBA’s Involvement

For several years the OBA has participated in discussions concerning how the “remotely created check” problem could be resolved.  It’s never been very attractive to try to enact Oklahoma legislation (in the UCC) to solve the problem.  Simply passing a law in Oklahoma could not compel a depository bank in another state to accept a return of an unauthorized “remotely created item,” unless all of the states enacted the same language.  This seemed unlikely to happen any time soon.

Staff of the OBA and other state bankers’ associations participated in telephone conferences with the ABA to reach a consensus on what a solution for the unauthorized “remotely created checks” issue would look like.  Later, the Federal Reserve was asked to use its legal authority in the check-processing area to develop a regulation, as this seemed to be the most workable method of imposing the same provisions in every state, simultaneously.  

The provisions originally suggested to the Federal Reserve were to a great extent developed from the early input by state bankers’ associations, including the OBA.  The Fed’s resulting regulation is what bankers have been asking for on a grass-roots level, and hopefully it will be useful, both in allocating losses on “remotely created checks” more appropriately, and in helping to reduce fraud resulting from unauthorized, unsigned checks. 

Homestead Exemption in Oklahoma Bankruptcies: What’s the Dollar Limit?

Four bankruptcy cases decided recently in other states have challenged whether language in the new federal bankruptcy act actually limits how much equity in a homestead can be exempt in bankruptcy.  

These four cases may have some bearing on whether the new federal bankruptcy law limits an Oklahoma individual’s homestead exemption to $125,000 of equity (in situations where the homestead was acquired or improved less than 40 months before bankruptcy).

Oklahoma’s homestead exemption, in 31 O.S. Section 1(A)(1), is not limited in dollar limit.   Many Oklahomans have centered their net worth in a homestead so that general creditors collecting on a judgment cannot reach that asset.   However, the clear intent of Congress in 2005 was to override all state-based homestead exemptions that are more generous than the “cap” imposed by Congress.

The issue in all four recent bankruptcy cases (one in Arizona, two in Florida, and one in Nevada) is the specific amount of homestead exemption that applies after giving effect to the new federal bankruptcy law (11 U.S.C. Section 522(p)).  Arizona,  Florida, and Nevada (and Oklahoma) are all states that previously had opted out of the federal list of bankruptcy exemptions.  Instead, each of these states enacted its own state-based list of exemptions.  In all of these states, the state statutes allow a homestead exemption larger in value than the federal list of exemptions would permit.  Therefore, these bankruptcy cases in other states may have some relevance to the status of the homestead exemption in Oklahoma.   

Effective April 30, 2005, the new Federal bankruptcy bill limited to $125,000 the amount of equity in a homestead that can be exempted in bankruptcy.  This $125,000 limit applies if the homestead was acquired, or value was added to the homestead, during the 1,215 days (40 months) prior to bankruptcy.  If two spouses file for bankruptcy jointly, each of them can exempt $125,000 of equity in a homestead (a total of $250,000 equity for a couple.)  

The $125,000 limit does not apply to family farmers. It also does not apply to any person who has owned the homestead for more than 1,215 days (40 months) and has not added value to the homestead during those 1,215 days.  And it does not apply if the homestead was acquired in the last 40 months but was a rollover of equity from a prior homestead in the same state.

The argument made in the four bankruptcy cases from other states is that the federal provisions limiting a debtor’s homestead exemption to $125,000 of  equity does not apply unless the debtor is “electing . . . to exempt property under state or local law.”  However, in the states that have opted out of the federal list of bankruptcy exemptions in favor of a list of exemptions approved by the state, the debtor cannot “elect” between state and local law.  As the argument goes, the state’s list of exemptions is the only choice available, so there is no “election” and no limitation on the homestead.  

This is a rather technical (and strained) argument. It prevailed in one state (Arizona), but not in two others. In Arizona, the court decided that a debtor has no ability to “elect” state exemptions, because the state exemptions are the only exemptions available to the debtor.  The court (In re McNabb, 326 B.R. 785) concluded that the $125,000 federal cap on the value of equity in a homestead does not apply, because the debtor cannot “elect.”

In the first Florida case (In re: Kaplan, 331 B.R. 483), the court considered the McNabb case from Arizona, and agreed that on the surface that case had reached one possible interpretation of an ambiguous statute; but the court went further, looking at the legislative intent, and on that basis concluded that Congress clearly wanted the federal cap on exempt equity in a homestead to apply in all states (including Florida), where the individual state’s laws otherwise would allow greater than a $125,000 homestead exemption.

In the second Florida case (In re: Wayryne, 332 B.R. 479), the court again determined that the federal legislative intent was to limit to $125,000 the homestead exemption in all states allowing a larger exemption.  However, in this particular case, the debtor’s homestead was found to be completely exempt because it was a rollover of equity from another homestead that the debtor had held more than 1,215 days before filing bankruptcy.

In the Nevada case (In re: Virissimo, 332 B.R. 201) the court agreed with the Florida cases, finding that Congress intended the $125,000 homestead limit to apply in all states.  The court made a further point that all property of a bankrupt debtor technically belongs to the bankruptcy estate until the debtor elects to exempt whatever items of property the state law allows to be exempted.  Thus, a debtor does affirmatively “elect” the exemptions under state law when he files bankruptcy, even if he does not elect between federal and local exemptions.

There is some risk (if the Arizona case were viewed favorably by a bankruptcy court in Oklahoma) that the federally imposed $125,000 limitation on exempt equity in a homestead will be found not to apply in Oklahoma, leaving this state (temporarily) with an unlimited homestead exemption for persons filing bankruptcy less than 40 months after acquiring the homestead. But the line of argument leading to such a result is technical at best.  The legislative intent seems clear, even if the statute’s wording is ambiguous. Worst case, if the federal $125,000 limit on equity in a homestead is not upheld by the bankruptcy courts here, some debtors might slip through bankruptcy with unlimited homestead equity. However, if a loophole develops, Congress will eventually plug it, clarifying that the federal statute really does intend to pre-empt state limits (such as Oklahoma’s) granting a homestead exemption larger than $125,000 of equity.