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Short-term Loans -
Some Residential Mortgages Can Be Modified Under Bankruptcy Code § 132 2
By Marc A. Ben-Ezra and Asher Perlin
Marc A. Ben-Ezra and Asher Perlin are attorneys with Marc A. Ben-Ezra, P.A., of North Miami Beach, Florida.
Home mortgage lenders have long enjoyed favorable treatment under the Bankruptcy Code. 11 U.S.C. §§ 101-1440 (2000). In a delicate balancing act to protect consumers, Congress excepted home mortgages from the "strip down" provisions of the Code. A recent flurry of cases in the federal courts of appeal, however, has limited this protection in the context of undersecured and wholly secured loans. The advantage that home lenders enjoy under the Code represents a compromise between two competing interests. The first interest was one of the principal motivations behind the 1978 Code: Congress wanted to give debtors a greater opportunity to make a fresh start. In fact, one of the most significant innovations of the Code was that it permitted debtors to modify the claims of secured as well as unsecured creditors. See Grubbs v. Houston First Am. Sav. Ass'n, 730 F.2d 236, 243 (5th Cir. 1984). This change was significant because modification of debts, commonly referred to as "strip-down," often strips the value of the debt to such an extent that creditors end up collecting mere pennies on the dollar. Nonetheless, the hope was that if debtors could emerge from bankruptcy with a chance to reestablish themselves and their credit ratings, they would have a greater incentive to repay their creditors.
Competing with the "fresh start" philosophy was a desire to maintain the flow of capital into the home lending market. If bankruptcy debtors could strip down secured home loans, many mortgage lenders would be reluctant to make money available to anyone deemed to be a risk. Housing construction, sales, and renovations would decline. Recognizing this risk, Congress afforded unique protection to creditors whose rights were secured exclusively by a debtor's home.11 U.S.C. § 1322(b)(2) .
The Section 1322(b) strip-down protection is relatively straightforward when the home loan is fully secured by the property. When the value of the property exceeds the amount due on the loan, the debtor cannot modify the debt. But the question becomes more complicated when the creditor's interest is either partially secured (also referred to as being undersecured) or wholly unsecured. These scenarios will be illustrated by the cases discussed below, focusing on the leading cases emanating from the Eleventh Circuit.
Nobelman: Undersecured Home Loans Are Protected
Although Section 1322 protects claims secured by the debtor's home, the statute is silent (with some exceptions discussed below) about home loans that are undersecured. A debt is considered undersecured or partially secured when it exceeds the value of the collateral securing it. On the one hand, the mortgage creates a lien on the home and is therefore secured up to the value of the home. On the other hand, technically speaking, that part of the loan that exceeds the value of the home is "unsecured." If the mortgagee forecloses, it will likely recover no more than the value of the home. Would such a mortgagee's claim be considered " secured" for antimodification purposes?
The U.S. Supreme Court answered this question in the landmark case of Nobelman v. American Sav. Bank, 508 U.S. 324 (1993). American Savings Bank had loaned the debtors $68,000 for the purchase of their home. The loan was secured by a deed of trust, which for purposes of this discussion is the equivalent of a mortgage. When the borrowers filed for bankruptcy six years later, the outstanding balance on the loan was $71,000. The home, however, was valued at merely $23,000.
The debtors proposed a plan that would "bifurcate" the debt, dividing it into its secured and unsecured parts. They reasoned that the $48,000 in debt that exceeded the value of the home was not "secured only by . . . the debtor's principal residence." Thus, they urged, this amount could be modified under Section 1322. The result of the debtors' proposed plan would have been to protect the bank's interest up to the $23,000 value of the home, but to leave the remaining $48,000 vulnerable to modification. The bank objected to the plan.
The Supreme Court ruled in favor of the bank. It agreed with the debtors that under the Code's definition, technically speaking, the bank held an unsecured claim to the extent that the claim exceeded the $23,000 value of the house. Nonetheless, the Court held that Section 1322(b) focused on the rights of the creditor in the claim rather than the nature of the claim itself. Justice Thomas, writing for the Court, explained that the mortgage gave the bank numerous rights, including: " the right to repayment of the principal in monthly installments over a fixed term at specified adjustable rates of interest,  the right to retain the lien until the debt is paid off,  the right to accelerate the loan upon default and to proceed against petitioners' residence by foreclosure and public sale, and  the right to bring an action to recover any deficiency remaining after foreclosure." Id. at 329 (enumeration added).
Justice Thomas reasoned that if the debtors could modify the unsecured part of the claim, they would inevitably impinge upon the rights in the secured part of the claim, as well. The Court concluded that Section 1322 would be unmanageable if it protected only that part of the loan that remained technically secured.
Petitioners propose to reduce the outstanding mortgage principal to the fair market value of the collateral, and, at the same time, they insist they can do so without modifying the bank's rights "as to interest rates, payment amounts, and [other] contract terms." . . . That appears to be impossible. The bank's contractual rights are contained in a unitary note that applies at once to the bank's overall claim, including both the secured and unsecured components. Petitioners cannot modify the payment and interest terms for the unsecured component, as they propose to do, without also modifying the terms of the secured components.
Id. at 331 (citations omitted).
Thus, Nobelman looked beyond the literal definition of secured and unsecured claims and focused on the effect that modification would have on the rights in the secured amount of the claim. Congress, the Court explained, never intended to allow debtors to modify secured elements of home mortgages. Because it would be impossible to bifurcate a mortgage without adversely affecting the secured portion, the Court held that a debtor may not modify an undersecured debt secured exclusively by the debtor's home. The Supreme Court left open, however, the question of how it would treat a wholly unsecured home mortgage. The appellate courts' treatment of this question will be discussed below. But first, a look at the Bankruptcy Reform Act of 1994.
Exception No. 1: Short-term Mortgages Can Be Modified
Congress passed the Bankruptcy Reform Act of 1994 one year after the Nobelman decision. According to a congressional report issued at the time, the Act was intended to address, among other things, "a number of problematic court opinions construing the Bankruptcy Code." H.R. Rep. No. 103-835, at 32 (1994). The report did not name Nobelman among some 40 decisions identified by name as "problematic."
One of the amendments to the Code, however, effectively limits Nobelman in several situations. Section 1322(c)(2) provides in part:
Notwithstanding subsection(b)(2) . . . in a case in which the last payment on the original payment schedule for a claim secured only by a security interest in real property that is the debtor's principal residence is due before the date on which the final payment under the plan is due, the plan may provide for the payment of the claim as modified pursuant to section 1325(a)(5) of this title.
11 U.S.C. § 1322(c)(2) (emphasis added). This subsection addresses three types of loans: (1) short-term mortgages, (2) long-term mortgages that are nearing expiration (these two types of loans will be referred to collectively as short-term loans), and (3) mortgages with balloon payments. The subsection clearly allows some kind of debt modification in these types of loans. The question, as highlighted in the italicized section quoted above, is whether the words "as modified" relate to the "claim" or the "payment."
The difference would be the following: Nobelman held that partially secured home loans could not be modified under Section 1322(b). If Section 1322(c)(2) allows modification of the claim, then the antimodification provisions recognized in Nobelman would not apply to short-term loans or mortgages with balloon payments. If the modification of Section 1322(c)(2) is limited to the payments, however, then the subsection would not permit debtors to strip down the undersecured portions of claims; it would merely permit debtors to modify the timing of those payments, extending the time within which the claims must be paid.
One federal court of appeals has held that Section 1322(c)(2) allows modification of payments, not of claims. Witt v. United Cos. Lending Corp. (In re Witt), 113 F.3d 508 (4th Cir. 1997). The Fourth Circuit observed that the legislative history stated that the amendment was intended to overrule First National Fidelity Corp. v. Perry, 945 F.2d 61 (3d Cir. 1991), a case that refused to allow modification of the debtor's payment schedule. By comparison, the legislative history did not mention Nobelman. "Had Congress intended to overrule Nobelman, we expect Congress would have discussed that in the legislative history." Witt, 113 F.3d at 513.
Most other courts, however, reject the idea that legislative intent can be inferred from what is not stated. In August 2002, the Eleventh Circuit addressed this question in American Gen. Fin., Inc. v. Paschen (In re Paschen), 296 F.3d 1203 (11th Cir. 2002). The debtors in Paschen argued that in this new subsection, Congress partially overruled Nobelman. They claimed that subsection (c) allowed the modification of the unsecured portion of a partially secured short-term mortgage. The court agreed with the debtors.
Paschen rejected Witt's interpretation of the statute as "grammatically strained." Id. at 1208. By holding that the statutory words "as modified" refer to the word "payment" and not "claim," Witt deviated from the rule of the last antecedent. Paschen also noted that the "modification" referred to in Section 1322(c)(2) is to be made "pursuant to section 1325(a)(5)." That section discusses the manner in which secured claims may be modified. If the modification permitted under Section 1322 merely allows rescheduling payments, the Paschen court held, the reference to Section 1325(a)(5) is meaningless:" 'Payments' cannot be modified pursuant to § 1325(a)(5); only claims are subject to § 1325(a)(5)'s modification provisions." Id. at 1209. Accordingly, Paschen held that Section 1322(c)(2) partially overruled Nobelman and that notwithstanding the antimodification provision of Section 1322(b), debtors could modify short-term loans.
The consequences can be illustrated by applying the Paschen holding to the Nobelman facts. If the mortgage in Nobelman were to have matured before the completion of the proposed Chapter 13 plan, the debtors would have been allowed to modify the unsecured portion of the debt—in other words, the total amount of the debt beyond the $23,000 value of the home. Although Nobelman explicitly held that this unsecured portion was not modifiable, Nobelman was not dealing with a short-term mortgage. And, to the extent that Nobelman did not distinguish between short-term and long-term mortgages, Paschen says that Congress overruled the Supreme Court's holding. Witt, however, says otherwise. Under that holding, the debtor would not be permitted to modify the claim.
As of this writing, Paschen is the most recent appellate court decision on this issue.It notes that the weight of authority is swinging away from the Witt interpretation. Thus, Paschen seems to represent the more authoritative interpretation. Witt, however, is still binding precedent in the Fourth Circuit, so the question remains open.
Another Probable Exception: Balloon Mortgages
Paschen did not directly address mortgages with balloon payments but its reasoning may be equally applicable in that context. Section 1322(c)(2) treats mortgages with balloon payments similarly to short-term mortgages. Therefore, it is reasonable to suggest that a court applying Section 1322(c)(2) to a mortgage with a balloon payment would likewise allow modification of the claim, notwithstanding Nobelman.
The Eleventh Circuit has already predicted such a conclusion. In Tanner v. FirstPlus Fin. Inc. (In re Tanner), 217 F.3d 1357 (11th Cir. 2000), a decision that preceded Paschen by two years, the court anticipated the holding of Paschen, and at the same time, indicated that under the new subsection (c), balloon mortgages would receive similar treatment to short-term mortgages. Id. at 1359 n.5. This portion of the opinion is not binding; together with Paschen, however, it is a clear signal as to how the majority of courts will likely treat partially secured balloon mortgages. The Fourth Circuit would likely be the sole holdout from this view based on that circuit's decision in Witt. As a result, at least in the Fourth Circuit, balloon mortgages are likely to remain unmodifiable.
Exception No. 2: Wholly Unsecured Loans Can Be Modified
In Tanner, the Eleventh Circuit addressed the related issue of unsecured loans. There, the debtor had filed for bankruptcy. She had previously financed the purchase of her home, taking a $62,000 loan from Inland Mortgage Company. A few months after the purchase, she took a $23,000 home improvement loan from FirstPlus Financial, Inc. Both loans were secured solely by mortgages of the debtor's residence. When the debtor declared bankruptcy, the amount due on the first mortgage exceeded the value of the home, leaving the home improvement loan with no security in the residence.
The debtor claimed that the second mortgage was not a "claim secured only by a security interest in . . . the debtor's principal residence." Id. at 1358 (emphasis added). Therefore, the debtor argued, Section 1322(b) did not protect the second mortgage. The debtor distinguished her case from Nobelman, noting that Nobelman held only that partially secured claims could not be modified. FirstPlus's mortgage, by contrast, was rendered wholly unsecured because the first mortgage exceeded the value of the home. The Eleventh Circuit accepted this argument and held that the FirstPlus mortgage could be modified. This decision was not based on the issue of whether Section 1322(c) amended Nobelman. It was merely a holding that limited Nobelman's reach on its own terms.
Two months later, in the case of American General Fin, Inc. v. Dickerson (In re Dickerson), 222 F.3d 924 (11th Cir. 2000), three different judges on the same circuit court criticized the Tanner court's holding. They pointed out the arbitrary results that could ensue:
[P]roviding "anti-modification" protection to junior mortgagees where the value of the mortgaged property exceeds the senior mortgagee's claim by at least one cent, as prescribed by the Supreme Court's decision in Nobelman . . . , but denying that same protection to junior mortgagees who lack that penny of equity, places too much weight upon the valuation process. As we have noted "valuation outside the actual market place is inherently inexact."
Id. at 926 (citation omitted). Because Tanner was decided first, however, it was binding precedent in the Eleventh Circuit, and the Dickerson panel was forced to follow its lead. Recently, the federal courts of appeal have reached a consensus on this point and have consistently ruled in accordance with Tanner.
Two recent cases, in particular, have cemented this position. In February 2002, the Sixth Circuit reversed a lower court decision affording antimodification protection to a second mortgage in which the value of the collateral was less than the debt secured by the superior mortgage. Lane v. Western Interstate Bancorp (In re Lane), 280 F.3d 663 (6th Cir. 2002). Following Tanner, the Sixth Circuit held that the second mortgage could not be considered a claim "secured by . . . the debtor's principal residence." The court declared this to be the majority position, noting that all four federal courts of appeal ruling on the issue have adopted this narrow reading of the antimodification clause of Section 1322.
In December 2002, the Ninth Circuit also reversed a lower court decision that had extended antimodification protection to an unsecured home lender. Zimmer v. PSB Lending Corp. ( In re Zimmer), 313 F.3d 1220 (9th Cir. 2002). Thus, the Ninth Circuit joins the Second, Third, Fifth, Sixth, and Eleventh Circuits in holding that the strip-down protection of Section 1322(b) does not apply to wholly unsecured home mortgages. Id. at 1225 (listing cases). Although lower court opinions from the late 1990s disagree with this position, no recently published opinions have sided with the reasoning of the Dickerson panel of the Eleventh Circuit. This could indicate that the lower courts, even from the circuits that have not addressed the issue, will fall into line with the dominant view among the courts of appeal.
Section 1322(b)(2) unambiguously provides that a Chapter 13 debtor may not modify a wholly secured mortgage on a debtor's principal residence. The rule of Nobelman extends the antimodification provision to partially secured mortgages on a debtor's primary residence. Paschen recognized, however, that Congress limited Nobelman through the 1994 amendments to the Code. Thus Paschen held that the antimodification provision would not protect any unsecured portion of a partially secured short-termmortgage. This limit on Nobelman would probably also apply to balloon mortgages. Tanner held that even if a mortgage is "secured" by the debtor's principal residence, the debtor can modify the lender's claim if that claim is wholly unsecured (for example, when the amount secured by prior mortgages exceeds the value of the residence). In a concurring opinion in Nobelman, Justice Stevens observed:
At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual's interest in retaining possession of his or her home than of other assets. The anomaly is, however, explained by the legislative history indicating that favorable treatment of residential mortgagees was intended to encourage the flow of capital into the home lending market.
Nobelman, 508 U.S. at 332. This goal was accomplished, at least in part, by disallowing modification of debt secured exclusively by a borrower's residence. The federal courts of appeal have since explicitly recognized two limitations on this protection and implicitly recognized a third. Whether these cases will cause reluctance among lenders to approve certain home loans, time will tell.