As we've mentioned in previous articles, the law relating to lien strip-offs and strip-downs in bankruptcy continues to evolve. In May, the federal Fourth Circuit Court of Appeals, which covers Virginia among some other states, overturned one of its own decisions and ruled that a Chapter 13 debtor whose underwater home mortgage had matured before he filed bankruptcy can strip down the mortgage balance to the value of the home. The case is Hurlburt v. Black, 2019 U.S. App. Lexis 15551 (4th Cir. May 24, 2019). This ruling is important, as it may apply to many underwater mortgage loans that have matured or have a short remaining term as of the bankruptcy filing date.
The case involved a home mortgage loan made in 2004 to a borrower named Mr. Hurlburt. The loan called for 119 monthly payments and then a balloon payment in 2014 of remaining principal and accrued interest. Mr. Hurlburt failed to pay the loan upon maturity, and in 2016 the lender commenced foreclosure. Mr. Hurlburt responded by filing Chapter 13 bankruptcy, thereby staying the foreclosure.
In the bankruptcy case, Mr. Hurlburt attempted to strip down the loan from approximately $180,000 to approximately $41,000, as the home had recently appraised for $47,000 and was also encumbered by a priority tax lien of approximately $6,000. Under his proposed Chapter 13 plan, the lender would receive (a) a secured claim of approximately $41,000, which would be paid in full with 4.5% interest (not the 6% rate required by the loan), and (b) unsecured claim of approximately $133,000, which would not be paid at all.
The lender objected, the bankruptcy court sustained the objection, and on appeal the district court affirmed the bankruptcy court's ruling. Mr. Hurlburt appealed to the Fourth Circuit, and a three-judge panel of the Fourth Circuit affirmed the district court's ruling. Mr. Hurlburt then requested that his case be reconsidered by all of the judges of the Fourth Circuit, and the court did so and vacated the three-judge panel's ruling.
Mr. Hurlburt had survived three rulings against him, but he faced yet another obstacle: The Fourth Circuit had already ruled, in 1997 in a case named In re Witt, that the Bankruptcy Code section at issue, section 1322(c)(2), does not authorize the strip down of a home mortgage. By its terms, section 1322(c)(2) applies only to home mortgage claims on which "the last payment on the original payment schedule ... is due before the date on which the final payment under the [Chapter 13] plan is due." If section 1322(c)(2) applies to a mortgage claim, then by the section's terms a Chapter 13 plan can provide for "payment of the claim as modified" by Code section 1325(a)(5), which among other things allows for strip down of secured claims. (emphasis added)
There was no question that section 1322(c)(2) applied to Mr. Hurlburt's mortgage, as the last payment on his original mortgage payment schedule had already become due in 2014 and therefore was clearly due before his final Chapter 13 plan payment would be due. Therefore, the borrower's case, like the Witt case, turned on how to interpret the phrase "payment of the claim as modified". In sum, the question is whether the thing that can be "modified" is (a) the mortgage "claim" itself (i.e., the entire bundle of rights held by the lender), or (b) just the "payment of the claim"? If the former, then the mortgage claim is subject to strip down under section 1325(a)(5), but if the latter, then only the payment schedule can be modified, such as by stretching it out over the life of the Chapter 13 plan. In Witt, the court had ruled that "payment of the claim as modified" is ambiguous and that the legislative history shows that Congress wanted to allow only modification of the payments.
The Witt decision, however, has been criticized by courts around the country and legal commentators. So, at Mr. Hurlburt's prompting, the Fourth Circuit took another look at Witt, and the court concluded that it had erred in that case. In ruling in Mr. Hurlburt's favor, the Fourth Circuit concluded that both "the most natural reading" of "payment of the claim as modified" and the "context of the statute as a whole" compel the result that it is the mortgage claim itself that can be modified.
The court characterized its ruling as applying to "a narrow subset of undersecured home mortgage loans." In a lengthy dissenting opinion, however, three of the court's judges pointed out that the court's ruling applies to "the huge class of short-term mortgages, and to mortgages that will inevitably become short-term mortgages as they near the end of their original payment schedule." Indeed, as stated in a leading bankruptcy treatise, section 1322(c)(2) can "encompass short-term mortgages, fully matured mortgages, long-term mortgages on which the debtor has nearly completed payments, and mortgages with balloon payments", as well as "reverse mortgages that have matured due to the death of the original mortgagor."1 So long as the mortgage is underwater and "the last payment on the original [mortgage] payment schedule ... is due before the date on which the final payment under the plan is due", it is subject to being stripped down.
The dissenters also stated that the court's ruling "will lead to mischief in bankruptcy courts", as debtors "have some measure of control over whether their mortgage will qualify as a short-term mortgage." A Chapter 13 plan can last up to five years, and the dissenters predicted that debtors "near the margins will have obvious incentives to delay filing for bankruptcy or stall proceedings until their final mortgage payment is less than sixty months away. That is, after all, the key to avoid paying the full amount owed on the mortgage under the majority's view."
The court's ruling also invites creative arguments regarding when the last payment on a mortgage's "original payment schedule" is due, so as to expand the ruling's reach. For example, the lawyer who represented Mr. Hurlburt has been quoted as stating that "[w]hether an accelerated mortgage is now subject to cramdown will be the next line of cases now that Witt has been overruled". As another example, there is a reported case in which the borrowers argued that the "original payment schedule" on their home-equity line of credit was the five-year draw period, during which they had to pay finance charges, and therefore that the HELOC was subject to modification under section 1322(c)(2).2 The court rejected the borrowers' argument because the HELOC also included a ten-year repayment period, but the case shows the kinds of arguments borrowers will be tempted to make now that strip down is potentially available.
In sum, the Fourth Circuit has given borrowers a powerful new tool, one that can be very costly to a lender (for example, it may well end up costing Mr. Hurlburt's lender approximately $133,000). Lenders should therefore keep the ruling in mind whenever they are dealing with an existing or potential home mortgage loan that is or might be underwater.
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1 8 Collier on Bankruptcy ¶ 1322.17 (16th Ed.).
2 In re McCullum, 2008 Bankr. LEXIS 2531 (Bankr. S.D. Ohio 2008).
Neil McCullagh is an attorney at Spotts Fain PC who works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors' rights, bankruptcy, and collections.