A chapter 13 debtor objected to a proof of claim filed by a junior mortgagee. The claim included an advance used to pay off a senior mortgage that was in foreclosure. The debtor sought to have the advance recharacterized as a purchase of the senior mortgage loan. The junior mortgagee responded that recharacterization would violate the prohibition on modifying rights of a holder of a mortgage secured by the debtor’s principal residence.
The debtor had a home equity line of credit behind a large first mortgage. Both loans were in default and foreclosure. Under the junior loan documents the lender was authorized to take such action as was necessary to protect its interests if a proceeding was commenced that materially affected those interests. Amounts disbursed by the lender under this provision became additional debt owed by the borrower and secured by the home. The additional debt was payable upon notice by the lender.
Accordingly, when the senior mortgagee brought a cross-claim to foreclose its first mortgage in the junior mortgagee’s foreclosure proceeding, the junior mortgagee paid off the senior loan. The senior mortgagee recorded a release of its mortgage, and the state court entered an order dismissing the senior mortgagee and allowing the junior mortgagee to file a supplemental claim.
The junior mortgagee’s foreclosure judgment included the following:
- damages in the amount of ~$207,000 plus interest at 6% (i.e. the outstanding balance of the home equity line of credit prior to the payoff),
- damages in the amount of ~$521,000 plus interest at 6% (i.e. the additional advance used to pay off the senior mortgage loan), and
- the junior mortgage was declared to be the first lien against the property.
The home was ordered to be sold with the sale proceeds applied to the judgment amounts. Shortly before the scheduled sale, the debtor filed a chapter 13 bankruptcy.
The chapter 13 plan that was filed proposed to treat the junior lender’s claim as two loans: (1) ~$535,000 (payoff amount) was treated as a separate loan governed by the terms of the first mortgage, including interest at 3.2%, and (2) the rest of the loan in the amount of $201,000 was treated as a loan governed by the junior mortgage documents, including interest at 5.75%. In other words, the debtor treated the junior lender’s disbursement as a purchase of the first mortgage rather than an advance under the junior loan for a payoff.
The junior mortgagee objected and filed a proof of claim for ~$780,000, of which ~$546,000 was a pre-petition arrearage. The debtor objected to the proof of claim, arguing that there was a $51,300 prepetition arrearage on the first mortgage and a $30,600 arrearage on the second mortgage. The debtor’s approach would allow him to (1) reinstate the mortgages by paying arrearages of ~$82,000 (v. ~$546,000) and (2) obtain a lower interest rate on the majority of the loan.
The court began its discussion by noting the difficult position of a junior lender when a senior lender forecloses, typically credit bidding all or a portion of its debt, leaving nothing for the junior lender. The junior lender can either buy the senior debt or pay it off. Although not common, this does occur. Outside of bankruptcy the amount the debtor owes is the same either way. However, in a chapter 13 bankruptcy, the difference is important because the cure allowing reinstatement is easier if the junior lender purchases the senior mortgage (as illustrated above).
In this case the junior loan documents authorized the junior lender to make disbursements for protective advances, so the junior lender was within its rights to pay off the senior debt. Under section 1322(b)(2) of the Bankruptcy Code a chapter 13 plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence.”
All parties agreed that the collateral was the debtor’s principal residence. The court cited Supreme Court precedent (Nobelman v. American Sav. Bank, 508 U.S. 324, 113 S.Ct. 2106, 124 L.Ed.2d 228 (1993)) for the proposition that “rights” are those set forth in the mortgage documents that are enforceable under state law:
They include the right to repayment of the principal in monthly installments over a fixed term at specified adjustable rates of interest, the right to retain the lien until the debt is paid off, the right to accelerate the loan upon default and to proceed against petitioners’ residence by foreclosure and public sale, and the right to bring an action to recover any deficiency remaining after foreclosure …
In this case, one of the junior lender’s rights was to make protective advances. Recharacterizing the payoff as a loan purchase would take away that right and completely change the junior lender’s secured claim. (The change would affect interest rate, maturity date, arrearage, monthly payment and applicable loan documentation.)
There were also practical issues in allowing the debtor to recharacterize the payoff and reinstate the senior debt and no legal basis for the recharacterization. Among other things, only claims secured by liens on the debtor’s residence could be reinstated. Here the senior loan had been paid off and the mortgage released prepetition. So, there was no secured claim to reinstate. Similarly, recharacterizing the payoff would overturn a state court judgment in violation of Rooker-Feldman.
The court noted that the debtor could have avoided these issues by filing for bankruptcy prior to the payoff. But even if the court allowed recharacterization, the debtor did not have enough income to save his house anyway.
Accordingly, the court found that it had no ability to recharacterize the loan payoff on the grounds that it would violate section 1322(b)(2) and contradict a state court judgment. So, the debtor’s objection to the proof of claim was overruled.
Foreclosure strategy can be tricky. Knowledge of applicable state law together with how treatment of the foreclosed loan might play out in a bankruptcy is critical to achieving the best result for a client. That goes for both lender and borrower clients.
Vicki R Harding, Esq.