NJ Appeals Court Holds Failure to Plead Bankruptcy Discharge Not a Waiver of Affirmative Defense in Post-Discharge Action Banner Image

Banking, Title Insurance, and Real Estate Litigation Blog

NJ Appeals Court Holds Failure to Plead Bankruptcy Discharge Not a Waiver of Affirmative Defense in Post-Discharge Action

June 24, 2022

In a decision approved for publication, addressing the intersection of New Jersey Court Rule 4:5-4 and 11 U.S.C. 524(a), the New Jersey Appellate Division recently held that a bankruptcy discharge precluded a creditor from obtaining a judgment of personal liability and debtor’s failure to plead that defense did not waive it. Vadim Chepovetsky and Svetlana Nashtatik v. Louis Civello, Jr. , No. A-0476-21 (App. Div. Jun. 16, 2022). Noting that a bankruptcy discharge prohibits only in personam actions against the discharged debtor, however, the Court further held that creditor was entitled to bring a post-discharge action to foreclose on the mortgage.

The case arose from a note, mortgage, and guaranty provided in connection with the sale of an automobile dealership. Defendant Civello agreed to sell an automobile dealership to Boguslavskiy for $195,500. Boguslavskiy paid Defendant $12,500 and gave him a promissory note for $184,000. The note was secured by a mortgage on the Chepovetsky and Nashtatik (Plaintiffs)’s residence, and Chepovetsky’s personal guaranty. Bogulslavskiy defaulted, which resulted in Defendant filing suit against Boguslavskiy, Chepovetsky, and others in 2008. The action did not result in judgment. In 2011, Plaintiffs filed a joint voluntary Chapter Seven Bankruptcy, but did not list the note, guaranty, or mortgage on their bankruptcy schedules as obligations from which they were seeking discharge. Instead, Defendant was listed as an unsecured nonpriority creditor due to the 2008 civil action. Ultimately, the Bankruptcy Trustee abandoned his interest in Plaintiffs’ residence, and on September 29, 2011, Plaintiffs were granted a discharge that included Chepovetsky’s personal guaranty.

In 2019, Plaintiffs filed an action against Defendant, seeking to quiet title on their residence and bar Defendant from pursuing claims under the note, mortgage, or guaranty. Plaintiffs argued Defendant was barred from pursuing such claims because they claimed that the six-year statute of limitations under N.J.S.A. 2A:50-56 had expired. Defendant filed a counterclaim asking the Trial Court to “maintain the mortgage” and for a judgment on the guaranty. Significantly, Plaintiffs did not plead, nor assert in their answer to Defendant’s counterclaim, that Defendant was barred from seeking a monetary judgement against them due to the bankruptcy discharge. The Trial Court dismissed Plaintiffs’ complaint with prejudice due to violations of discovery orders, but allowed Defendant’s counterclaim to proceed. Following a one-day bench trial, the Trial Court found in favor of Defendant’s counterclaim, holding Plaintiffs waived and were “estopped from asserting” any affirmative defenses that could have been pleaded in their answer to the counterclaim, and Defendant could proceed to enforce the note against Bogulslavskiy and guaranty against Chepovetsky.

Plaintiffs subsequently moved to vacate the judgment as void due to the 2011 bankruptcy discharge and to vacate the dismissal of their quiet title action. The Trial Court agreed with Plaintiffs and vacated the judgment, finding that Chepovetsky’s “personal debt” to Defendant was discharged in bankruptcy under 11 U.S.C. 524. The Trial Court first noted that N.J.S.A. 2A:16-49.1 provides a judgment must be vacated “if it is a year after the debtor obtained a bankruptcy discharge of the debt upon which the judgment is based.” Since Chepovetsky’s bankruptcy discharge “included the debt upon which this action” and the 2008 action were based, the judgment based on the guaranty of the note was void ab initio. Further, the Trial Court held that the effect of discharge is not waived by failure to plead it as an affirmative defense. Additionally, the Trial Court reinstated Plaintiffs’ quiet title action, reasoning that although Plaintiffs’ complaint was dismissed in part due to discovery failures, under 11 U.S.C. 524, Plaintiffs were “entitled to disregard any such discovery that was part of an attempt to collect [] a discharged debt.” The Trial Court also explained that the quiet title action was appropriate because Defendant was barred from enforcing the mortgage due to expiration of the statute of limitations, such that the mortgage “presents a cloud on the title.” Defendant appealed.

While the appeal was pending, Chepovetsky moved in Bankruptcy Court to reopen the bankruptcy and hold Defendant and his attorney in contempt for violating 11 U.S.C. 524. The Bankruptcy Judge denied the motion, but emphasized that “the Bankruptcy Code overrides state rules and . . . 11 U.S.C. 524(a)(2) provides that the discharge is essentially self-executing and is not waivable.” The Bankruptcy Judge also stated, however, that a creditor has a right to pursue in rem relief under the mortgage that survives any bankruptcy discharge.

On appeal, the Appellate Division considered the relationship between New Jersey Rule 4:5-4, which requires pleadings to “set forth specifically and separately” the affirmative defense of discharge and bankruptcy and 11 U.S.C. 524, the federal statutory injunction against prosecuting enforcement of a debt discharged in bankruptcy. Citing the Supremacy Clause, the Appellate Division found that “[a] state court judgment holding a debtor personally liable on a discharged debt is void ab initio as a matter of federal statute.” Therefore, although Plaintiffs failed to plead the affirmative defense of discharge in bankruptcy, this failure did not waive that defense or estop Plaintiffs from asserting it. Under section 524 of the Bankruptcy Code, “the debtors were not required to assert the discharge or otherwise object to the continued prosecution for the discharged claim.” The Appellate Division further noted that the Defendant was listed as a creditor and thus received notice of the bankruptcy and discharge. Additionally, the court concluded that enforcing the waiver of the affirmative defense of discharge under Rule 4:5-4 “would be inconsistent with substantial justice.”

As for the impact of the discharge on the mortgage lien, the Appellate Division noted that a discharge in Chapter Seven bankruptcy only discharges personal liability incurred by debtors, and thus the accompanying lien remains enforceable against real property. Therefore, Defendant could bring a post-discharge action to fix the amount due on a mortgage on the debtor’s residence. As to whether the current six-year statute of limitations of N.J.S.A. 2A:50-56.1 applied, the Appellate Division noted at the time this mortgage was executed (2007), the statute was twenty years. It, therefore, vacated the Trial Court’s decision that the current six-year statute of limitations applied and remanded back to the Trial Court to decide whether the six-year limitations period could be enforced retroactively.

For a copy of the decision, please contact Michael O’Donnell at modonnell@riker.com, Desiree McDonald at dmcdonald@riker.com, Kevin Hakansson at khakansson@riker.com, or Dominique Marino at dmarino@riker.com.

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Michael R. O'Donnell

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