By Reuel Ash
Ulmer & Berne, LLP
Cincinnati, OH
The
Fourth Circuit recently decided that the provisions of Bankruptcy Code Sections
1322(b) allowing Chapter 13 debtors to cure a prepetition mortgage arrearage do
not enable debtors to bring the interest rate on the mortgage note to its original
rate, where the default rate had been in place prepetition. Anderson v. Hancock, No. 15-1505, 2016 WL 1660178 (4th Cir.Apr. 27, 2016)(click on citation for link to opinion). This case sensibly limits the scope of modification by debtors
of residential first mortgages, which is consistent with Congress’ intention of
protecting mortgage holders in the residential market.
What Happened
The
facts of the case may stated simply. The
debtors bought a $255,000 house, which was financed by a seller mortgage for a
30–year term at an interest rate of 5%.
The promissory note provided a default rate of interest of 7%. The debtors defaulted, and the mortgagees
sent the debtors a notice of default invoking the default rate of interest, but
the mortgagees did not accelerate the note.
The debtors made no payments after being notified of the default, and
the mortgagees initiated foreclosure proceedings. The debtors filed a Chapter 13 bankruptcy
case to stop the foreclosure.
The
debtors filed a Chapter 13 plan that proposed paying off the arrearage over a
60 month term at the note’s original interest rate of 5%, and reinstating the
original maturity date along with proposing post-petition note payments at the
5% original interest rate. The
mortgagees objected to the plan, contending that the default interest rate of
7% must apply to both the repayment of the arrearage and the post-petition
payments going forward.
The Fourth Circuit’s Ruling
In finding for the seller mortgagees, the Fourth Circuit
harmonized three provisions of Bankruptcy Code Section 1322(b): (b)(2), on the
one hand, and (b)(3) and (b)(5) on the other hand. On the one hand, Section 1322(b)(2) prohibits
a debtor from modifying a first mortgage on the debtor’s residence. On the other hand, Section 1322(b)(3) says
that a plan may “provide for the “cure or waiver of any default,” and Section
1322(b)(5) provides that “notwithstanding
paragraph (2) of this subsection, provide for the curing of any default
within a reasonable time and maintenance of payments while the case is pending
on any unsecured claim or secured claim on which the last payment after the
date on which the final payment under the plan is due.”
The
question before the court was whether the plan’s proposed change to the
debtors’ rate of interest was part of a permissible cure under Sections
1322(b)(3) and (b)(5), or an impermissible modification of the note under
Section 1322(b)(2). The Fourth Circuit
ruled that the plan’s providing for the original, pre-default interest rate was
an impermissible modification of the note, and sustained the mortgagees’
objection to the Chapter 13 plan. The
debtor must pay the default rate of interest both on the arrearage and the note
payments going forward. The Fourth
Circuit observed that while the “rights” that cannot be modified under Section
1322(b)(2) are not defined in the Code, case authority from the Supreme Court
in Nobelman v. Am. Savings Bk, 508 U.S. 324, 329, 113 S. Ct. 2106 (1993), and the
Fourth Circuit in In re Litton, 330
F.3d 636, 643 (4th Cir. 2003) held that such rights included those
bargained for by the two parties and enforceable under state law (Nobelman), and that Section 1322(b)(2)
prohibited “any fundamental alteration of a debtor’s obligations, e.g.,
lowering monthly payments, converting a variable interest rate to a fixed
interest rate, or extending the repayment term of a note.” (Litton)
The Fourth Circuit also found that the core of Section 1322(b)(5)
concerns the maintenance of payments, i.e. decelerating the promissory note and
continuing paying the loan, thereby avoiding foreclosure.
Analysis
The
Fourth Circuit reached the proper result. Allowing Chapter 13 debtors to change
material terms of a loan contract post-petition, including a default interest
rate provision, would cause a major torrent of problems in the first mortgage
market, and conflict with secured creditors’ legitimate expectations that the
terms of their loan documents cannot be altered in bankruptcy, other than
deceleration.
That
said, the Code language appears not to answer the question raised, since
Section 1322(b)(5) does not define the limits of what note and mortgage rights
a debtor may modify when its plan proposes to cure arrearages. The Fourth Circuit had to fill in the silence
in (b)(5) through case authority, policy arguments, and legislative history. Clarity might be promoted by the inclusion in
Section 1322(b) of a provision stating that contract rights other than
acceleration clauses in first residential mortgages and notes may not be
modified.