Taming the bankruptcy beast: the Chapter 13 "cramdown" monster is eagerly devouring lenders' rights to fully secured home mortgage claims.
The Chapter 13 "cramdown" monster is eagerly devouring lenders' rights to fully secured home mortgage claims.
Because personal bankruptcies continue to soar, the lending industry has no choice now but to focus on the absolute necessity of becoming more involved in protecting its interests in bankruptcies.
Mortgage lenders involved in Chapter 13 bankruptcy proceedings today should be aware of recent court decisions that put their full mortgage payment recovery at risk. Once only used in Chapter 11 corporate filings, the Chapter 13 "cramdown" is the new bankruptcy dragon residential lenders must slay.
"Cramdown," as it is commonly termed, refers to the process by which a debtor is permitted to restructure his or her debts over the objection of the creditor. A recent interpretation of the Bankruptcy Code regarding borrower cramdown, however, could have enormous repercussions in terms of (1) prospective losses to the lender; (2) loan program re-evaluation and (3) modifications to bankruptcy servicing procedures.
A resolution adopted by the Mortgage Bankers Association of America's Loan Administration Committee in June 1990 refers to the Chapter 13 cramdown as possibly becoming the no-bid of the 1990s. In fact, this monster has the distinct possibility of totally eclipsing the no-bid problems faced by the industry in recent years.
While the simplest way to eliminate potential losses from cramdown is to amend the Code through legislative action, such legislation may not be enacted in the near future. At this juncture, lenders need to know how to apply these court decisions to daily lending situations with their borrowers and in the bankruptcy courts.
Nationally, the number of personal bankruptcy has more than doubled since the early 1980s. In 1989, 616,753 filings were lodged, an all-time record and an increase of 12 percent compared with 1988. Thus, one household out of every 138 in this country is in bankruptcy. (See Chart 1.)
Two significant factors have ensured that the 1990s will continue to witness relatively high levels of bankruptcy. First, the impact of attorney advertising cannot be overlooked. Many people are swayed by ads that claim to "help you save your home" through a Chapter 13 filing. The stigma attached to personal bankruptcy that was prevalent 10 years ago no longer exists. Instead of being regarded as a social disease, bankruptcy filings are now a commonly accepted economic strategy. Second, the increase in consumer debt relative to income and rising interest rates have been economic factors associated with increasing bankruptcies.
This is the environment in which the Chapter 13 cramdown has reared its head.
The nature of the beast
Until recently, it was believed that under the Code, lenders in Chapter 13 cases were given a secured priority to the full extent of their lien on a debtor's principal residence. Indeed, while other lienholders could have their liens modified, the lender secured by a debtor's principal residence was protected and required to be fully repaid on the pre-bankruptcy default (pre-petition debt). In addition, the lender received maintenance of regular post-bankruptcy filing payments (post petition payments). The sanctity of the note and home mortgage instrument essentially was a "sacred cow" and could not be modified, altered or otherwise changed pursuant to Section 1322(b) (2) and (b)(5) of the Code. If a debtor completed an accurate reorganization plan, the lender should have found itself with a totally current loan.
However, out of the eleven United States courts of appeal, at least two have set a dangerous precedent for lenders in Chapter 13 cramdown situations. The courts have decided that, under Section 506(a) of the Code, lenders on principal residences will be secured only to the extent of the value of the subject real property. (See In re Houghland 886 F.2d 1182 [9th Cir 1989], and In re Wilson 895 F.2d 123 [3rd Cir 1990.]) As a matter of federal judicial structure, decisions of the circuit courts of appeal are binding upon all U.S. district court and bankruptcy court judges in their respective regions. Likewise, U.S. district court decisions control all bankruptcy court judges within that jurisdiction. Correspondingly, Alaska, Arizona, California, Delaware, Hawaii, Idaho, Montana, Nevada, New Jersey, Oregon, Pennsylvania and Washington are the jurisdictions currently following Houghland. In addition, several bankruptcy courts in Virginia and Ohio have issued rulings following the Hougland interpretation.
The following example will explain exactly what the new interpretation means for lenders:
Total Mortgage Loan $150,000
Property Value $100,000 Negative Equity <$ 50,000>
If the court finds this property valuation accurate, it would allow the lender a "secured claim" of $100,000 and an "unsecured claim" of $50,000. Once confirmed, this type of reorganization would bifurcate a lender's claim into two classes.
As most consumer lenders painfully acknowledge, unsecured creditors generally get far less than 100 percent of their claims paid. Typically, completed Chapter 13 plans provide between 10 percent and 50 percent on unsecured claims. In recent Chapter 13 cramdown cases my firm has handled in different parts of the country, I find a 20 percent figure quite prevalent.
Using a 20 percent payment rate on unsecured claims, under our example, the lender would be paid only $10,000 on a $50,000 claim. A few of these cases could ruin a servicing manager's entire day.
Armed with such ammunition, lenders are now dealing with aggressive debtor attorneys in areas such as Texas, Colorado, Arizona, Oklahoma, Minnesota and other locales where property values have declined. There is a very real possibility that in such areas, significant portions of loans may be "crammed down" into unsecured status. Under the Hougland case, once a Chapter 13 cramdown plan is discharged, any unsecured portion of the loan that is not paid back will be extinguished.
Cramdown issues and applications
Rewriting the loan--When the bankruptcy court levels the hammer and divides the loan into secured and unsecured classes, it is, in a sense, ordering the lender to rewrite the loan. Many bankruptcy courts have held that the loan must be rewritten, with the lender limited to only the secured portion as a new principal balance to be paid over the remaining life of the loan at the original contract rate of interest.
Debtors have argued that after the loan is rewritten, the regular monthly payments should be adjusted downward to reflect the modified secured status. However, most bankruptcy court judges have required that the original mortgage payments be maintained. In fact, in one of the first bankruptcy cases seeking to implement Hougland, we were successful in urging a bankruptcy judge in Billings, Montana to require that original payments be maintained regardless of the cramdown. (See In re Marshall, 111 BR 325 [Bkrtcy. D. Mont. 1990].) The result is obviously an accelerated pre-payment of principal on the loan.
Sale of property during bankruptcy--If the loan becomes partially secured under a confirmed Chapter 13 cramdown plan and the property is sold by the debtor, what should the lender's "demand" statement include? An argument could be made that the lender would be limited to only the secured portion of the lien plus any post-bankruptcy accrued interest, taxes or other advances. Because the unsecured portion is no longer attached to the property, the lender may not be entitled to priority lien pay-off. Further, the lender may only be entitled to a pro-rata share of any profits with other unsecured creditors.
Correspondingly, the lender should be allowed, during the course of the plan, to demonstrate any significant appreciation in the property and have the bankruptcy court re-evaluate the secured status of the loan. Although such a strategy may be difficult to accomplish, the argument should be that the property value was the lender's risk and the debtor should not be unjustly enriched by the cramdown. This argument may possibly lead to increasing the lender's secured position for purposes of loan pay-off. Equity mandates such a judicial review.
Foreclosure after discharge--Another problem arises if and when a debtor discharges a Chapter 13 cramdown plan. Upon subsequent default, and initiation of foreclosure proceedings, the lender may be limited to only the secured principal balance plus applicable interest, accrued late charges, expenses and advances. The debtor's attorney will argue that the loan was rewritten as a matter of law and, therefore, it is not possible to enforce the original loan terms. The general concept of discharge and res judicata seem to support this proposition.
Will the filing of post-foreclosure claims present a problem? It is unclear whether or not the lender will be entitled to: (1) any claim, because the loan was modified; (2) a pro-rata share of the original loan amount or (3) the complete required claim payment. Again, uniform policy decisions have not yet been established.
Dismissal, relief or conversion--If the debtor's plan is confirmed and the bankruptcy case is subsequently dismissed, the lender either obtains relief from the automatic stay or the case is converted to a Chapter 7. At that time, the lender's positoin should be that the original note, terms, arrearages, etc. should be reinstated. In essence, the failure of the debtor to complete the plan obligations reinstitutes original lien in full.
Although this may appear to lenders like an elaborate game of "mortgage ping-pong," the object is to regain the original loan for purposes of claims and possible deficiency judgment processing.
Now you see it--Now you don't--Debtors in anti-deficiency states such as California, Washington and Nevada, where the lender may not seek a personal judgment against a borrower after non-judicial foreclosure, may seek to avoid the lender's unsecured claim. Debtors will argue that the entire loan obligation is extinguished upon foreclosure and the unsecured claim is unenforceable because it no longer attaches to the property. Therefore, the debtors may seek to "wipe out" even the unsecured claim from the plan.
In the Marshall decision, the debtors' efforts to avoid the lien were defeated. However, lenders should carefully watch for such debtor tactics in the future.
Servicing the monster
Another possible ramification of modifying the lender's note via the bifurcation into secured and unsecured classifications is the risk of servicing devaluation. Under GNMA guidelines and regulations, it is unclear whether or not the lender/servicers would be required to repurchase the affected loans. The potential pay-downs or outright repurchases from GNMA pools could spell economic disaster for many financial institutions.
The court may, in effect, be forcing servicers to violate those GNMA requirements. The costs attributable to borrowing money to buy back the loan, loss of servicing fees and losses on unsecured claims could form the basis of hundreds of millions of dollars in losses.
Missing the policy mark
At a time when the industry is being continuously squeezed for more services, reports, etc. on VA, FHA and other government-backed loan products, the Chapter 13 cramdown presents a dire condition.
It is patently clear that Hougland and related decisions ignore the purpose and intent of most government-sponsored loan programs. For example, VA loans were designed to give the first-time homebuyer a chance at obtaining a piece of the "American dream" with little or no down payment. Lenders engaged in such programs currently service a significant share of all domestic mortgages outstanding. Those lenders expect the property to appreciate, rely on the creditworthiness of the borrower and depend on insurance to minimize any potential losses.
The outcome of recent Chapter 13 cramdown decisions, however, may make lenders reluctant to lend in areas where there is risk involved. Are these courts inadvertantly urging lenders to pull back on their lending activities? Will redlining become a lending policy with respect to low down payment loan programs? The cramdown crisis brings many of these questions to the forefront.
The key to effectively deal with Chapter 13 cramdowns is for lenders to aggressively monitor loan administration. Bankruptcy, foreclosure and collection departments must be attentive to potential bankruptcy litigation. Attorneys should engage debtors at all crucial points. Keep a clear perspective on the tremendous losses that could result from a less-than-appropriate response. I have already seen too many lenders allow cramdown circumstances to arise because the proper opposition tactics weren't employed. A few Texas or Colorado loans could amount to tens of thousands of dollars in potential write-offs.
In order to effectively challenge Chapter 13 cramdown plans, your staff should "red flag" the following bankruptcy documents:
* Chapter 13 bankruptcy notice--The
first notice that you get from the
court typically sets a plan
confirmation hearing date and a short
summary of the plan. Carefully
note if the debtor lists you as
secured or unsecured. * Objections to proof of claim--Review
to see if the debtors are objecting to
your status as secured. When you
state the amount of your arrearages
as a secured creditor, the debtor will
likely challenge your position based
upon property value--seeking to
have a portion of the debt declared
unsecured. * Chapter 13 plan and schedules--This
is the debtor's plan and it must
be carefully reviewed for the
classification of your debt, the amounts
due, reasonableness of payment and
pay-off period and the property
valuation (if listed). * Motion or complaint to determine
value of property under Section
506--The purpose of this action is
to request that the court value the
property. You must be most
attentive to these pleadings and deal with
them immediately. You will need to
obtain appraisal evidence to
contradict, where possible, any debtor
"low-ball" value. * Motion to avoid lien--This is an
action brought typically in an
anti-deficiency state to extinguish
any unsecured portion of the debt.
Be aware of such tactics
particularly in California, Montana and
Crippling the cramdown
In bankruptcy courts where binding legal precedent has not followed Hougland, lenders' attorneys must vigorously put forward the public policy considerations and negative ramifications discussed in this article. It is not surprising that most Chapter 13 cases are filed by delinquent homeowners seeking to reorganize. However, Sections 1322(b)(2) and (b)(5) of the Code were designed to protect the lending industry. Additionally, lender protection is necessary in cases where depressed real estate markets exist. Such protection will benefit lenders and borrowers by preserving the sanctity of the loan contract and many advantageous loan programs.
Now, more than ever, review of bankruptcy court notices and plans are of great importance and lenders must be most vigilant when it comes to review of Chapter 13 plans. At all stages, upon receipt of the court documents described here, prudent mortgage servicers must position themselves to object to any effort to bifurcate the loan.
Objections can be based upon the lender's obtaining, whereever possible, appraisals depicting equity sufficient to cover the debt. This will give the bankruptcy court at least a reason to find a cramdown unrealistic.
The plan's budget must also be carefully reviewed for defects--such as the failure to include all appropriate disposable income. Many plans have been defeated when the court forced more income into the debtor's plan. The debtors may ultimately decide that it would not be worth it to keep such a depreciated property.
Another argument that must be made is that the underpinning of a Chapter 13 reorganization plan is to provide creditors with a better chance of recovery than under a Chapter 7 liquidation. It is clear that under a Chapter 7, where there is no equity in the property, the lender would be allowed to proceed with its foreclosure and thereby submit and be paid the full amount of its claim. Under a Chapter 13 cramdown, the lender is in a worse position, because there may be a significant write-off of an unsecured portion of the lien (as well as the likelihood that the full claim amount would not be paid if there is a subsequent foreclosure).
Lenders should challenge the reasonableness of the plan regarding the overall treatment of the unsecured claims. If the payment to all unsecured claimants is minimal, many bankruptcy courts will deny the plan's confirmation. The notion of fair and equitable treatment of all creditors is a favorite argument that can be persuasive to particular judges.
When possible, specifically request a hearing on the property value issue. If the difference between the lender's appraisal and that of the debtor is significant, the lender must have the opportunity to intensely cross-examine the debtor's appraiser. Remember, extreme losses are at stake and all efforts should be made to convince the judge that the lender's evidence is more credible than the debtor's.
Last, when faced with the cramdown confirmation, at least obtain an order that requires the original loan payment to be made during the case. Obviously, if the debtor is required to maintain the original payments on a depreciated property there is a greater possibility that a default may occur-generating the opportunity to file a motion for relief from automatic stay or dismissal motion.
Finally, the mortgage lending industry can best protect its interests over the long term by seeking legislative reform on this critical issue. The Code could be amended to state that the lender's claim should be fully secured, regardless of the property's value. Fortunately, several district courts and bankruptcy courts in Minnesota, Missouri, Nebraska, North Dakota, Oklahoma and Virginia have ruled contrary to Hougland. Mortgage lenders must be aware of these decisions and deal with the impact of cramdown cases. In this way, they can avoid becoming a victim of the cramdown monster. [Chart 1 Omitted]
Michael S. Polk is the principal of Polk, Scheer & Prober, a Los Angeles-based law firm specializing in representing lending institutions in the areas of bankruptcy, eviction, real estate/foreclosure and civil litigation.
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|Author:||Polk, Michael S.|
|Date:||Aug 1, 1990|
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