Monday, June 20, 2016

Fourth Circuit Precludes Modifying Default Interest on Home Mortgage Loan



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.

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