First Residential Mortgages: Do Not Take Anti-Modification Protection for Granted

In re Birmingham, 846 F.3d 88 (4th Cir. 2017)

A chapter 13 debtor sued his lender requesting a declaration that his chapter 13 plan could modify the lender’s mortgage on his primary residence. The bankruptcy court granted the lender’s motion to dismiss; the district court affirmed; and the debtor appealed to the Fourth Circuit.

The case turned on the intersection between two Bankruptcy Code provisions dealing with secured claims:

  • Section 506(a) generally provides that an allowed claim of a creditor secured by a lien on property is treated as (1) a secured claim to the extent of the value of the creditor’s interest in the property and (2) an unsecured claim to the extent of the deficiency. In other words, an underwater mortgagee’s secured claim can be crammed down to the value of the lien on the property.
  • However, in a chapter 13 case section 1322(b)(2) protects a mortgagee’s claim from modification if it is secured “only by a security interest in real property that is the debtor’s principal residence” (emphasis added). The Supreme Court held (in Nobelman) that this provision precludes reduction or cramming down of a claim secured by a debtor’s principal residence. In other words, such a loan cannot be bifurcated pursuant to section 506.

It was clear that the lender’s claim was secured by a deed of trust that included the debtor’s principal residence. The debtor’s argument was that it was not secured only by the principal residence. In particular, he pointed to deed of trust provisions relating to (1) escrow items, (2) property insurance proceeds and (3) miscellaneous proceeds. If he prevailed on this argument this would mean that the mortgage loan was not protected by the anti-modification provision.

The lender responded that these items were “incidental property” which were part of the debtor’s principal residence. Thus, its loan was not subject to a cramdown. The district court agreed with the bankruptcy court that the items were incidental and not additional security for purposes of section 1322. The district court further commented that the items did not have value apart from the property and deed of trust, but existed only to give effect to the lender’s security interest.

The Fourth Circuit started with a close look at the applicable deed of trust provisions.

  • Escrow: The debtor was required to make escrow payments to fund amounts due for (1) taxes and other items that would constitute a lien on the property that could be senior to the mortgage loan, (2) ground rents on the property, (3) property insurance premiums, and (4) mortgage insurance premiums. The lender was required to account to the debtor for any surplus, and the debtor was required to make additional payments to cover any escrow shortfalls.
  • Property insurance: The debtor was required to insure any improvements. (If he failed to do so, the lender was allowed to force place insurance at the debtor’s expense.) Under this section the debtor assigned its rights to insurance proceeds (not to exceed the amount owed) as well as any right to a refund of unearned premiums to the extent applicable to coverage of the property.
  • Miscellaneous proceeds: In the case of a partial taking, destruction or loss in value in which the fair market value of the property was less than the sum secured, “Miscellaneous Proceeds” were to be applied to the loan. Miscellaneous Proceeds were defined to include compensation, settlement, award of damages, or other proceeds paid by a third party (other than insurance proceeds) for property damage, condemnation or other matters relating to the value and/or condition of the property.

The debtor argued that these items provided additional security. However, as a number of courts had held, these types of items are all related to the property and do not extend the lender’s security beyond the real property.

The 8th Circuit distinguished a series of cases cited by the debtor on the grounds that they involved additional collateral beyond the real property. For example:

  • An additional security interest in “any and all appliances, machinery, furniture and equipment (whether fixtures or not) of any nature whatsoever.”
  • Security agreement for personal property – specifically a mobile home on leased property.
  • Interest that includes income producing property in addition to the principal residence – which includes the circumstance of a multi-unit property where one unit is the debtor’s principal residence and the lien extends to the other income-producing units.
  • Security includes “wall-to-wall carpeting, rents and profits.”

The court characterized the referenced deed of trust provisions as merely protecting the lender’s security interest rather than creating separate or additional security.

The debtor also identified a line of cases that allowed modification based on escrow funds. However, the court noted that in each case there was language expressly providing that the escrow funds constituted additional security. It further noted that these same courts agreed that the anti-modification provision applies to the Fannie Mae/Freddie Mac form deed of trust that was before the 8th Circuit. Thus it did not need to parse the deed of trust for language purporting to create additional separate security interests.

The debtor made a final pitch based on the legislative history of the Bankruptcy Code. However, in 2005 Congress clarified the scope of the anti-modification provision by adding a definition of “debtor’s principal residence” to mean “a residential structure, including incidental property” and a definition of “incidental property” that includes, among other things, “all easements, rights, appurtenances, fixtures, rents, royalties, mineral rights, oil or gas rights or profits, water rights, escrow funds, or insurance proceeds.”

The court further noted that the debtor’s interpretation would render the anti-modification provision inapplicable to virtually all residential mortgages – which could not be squared with congressional intent. Accordingly, the 8th Circuit affirmed the lower court decisions.

It is interesting to note the various circumstances where courts have concluded there is additional security. It seems there is little risk in using on of the standard forms (Fannie Mae for example) since, as the court notes, that would mean that the vast majority of residential mortgages would not have the benefit of the anti-modification provision. However, if a nonstandard form is used (for example, if a lawyer starts with a commercial mortgage form when drafting a mortgage on a principal residence that secures a guarantee) that would be a different question.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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