Fourth Circuit Provides Relief to Chapter 13 Debtors for Some Underwater Mortgages
In a victory for Chapter 13 debtors, the United States Court of Appeals for the Fourth Circuit recently issued a major decision that changes the way bankruptcy courts in North Carolina will deal with certain home mortgages in Chapter 13.
For over 22 years, bankruptcy courts in North Carolina prohibited Chapter 13 debtors from modifying the amount of a claim secured by a principal residence. But in Hurlburt v. Black, the Fourth Circuit reversed itself and held that the Bankruptcy Code allows a debtor to modify some home mortgage claims. Now, debtors with underwater, "short-term" mortgages will only be required to pay the value of their home and can discharge the balance as an unsecured claim.
In 2004, Larry Hurlbert bought his home from Juliet Black for $136,000. He paid $5,000 at closing and financed the balance with Black, signing a promissory note and deed of trust. The note had a 10-year term, requiring payment of $131,000 in principal plus 6% interest in 119 monthly, interest-only installments of $785.41, and a final balloon payment in May 2014. When the loan matured, Hulbert did not pay the balance, Black started foreclosure, and Hulbert filed for bankruptcy protection under Chapter 13.
In the bankruptcy, Black filed a proof of claim for $131,000 and an amended claim for $180,971.72. Hurlbert filed a Chapter 13 plan that valued the home at $47,000 based on a recent appraisal. He proposed to pay Black $41,132.19 – the home value less a county tax lien. The plan treated the rest of the claim as unsecured and proposed to pay none. Black argued that Hurlburt could not modify her claim, or bifurcate it into secured and unsecured categories, and that he had to pay her in full under the loan terms.
In Chapter 13, a debtor files a repayment plan with the bankruptcy court that requires the debtor to pay back all or a portion of the debtor's debts. The amount to be repaid depends on how much the debtor earns, the amount and types of debt owed, and how much property the debtor owns. In any bankruptcy proceeding, creditors are generally classified as having either a "secured" or "unsecured" claim. A secured claim is supported by collateral securing repayment of the claim, while an unsecured claim is not supported by collateral. Debtors routinely seek to bifurcate lender’s claims into secured and unsecured portions. The unsecured portion is then lumped with the unsecured claims of other creditors, and only a small percentage of the total (if any) is repaid. In the bankruptcy world, this is one meaning of the term "cram down."
But the Bankruptcy Code limits the ability of a debtor to modify a lender's secured claim when the security is the debtor's primary residence. Barring limited exceptions, the claim cannot be modified. This means that the debtor cannot lower the interest rate, extend the payment period, or cram down the loan by bifurcating it into secured and unsecured parts based on the residence’s value and then repaying only a small percentage of the unsecured part.
For the last 22 years, this has been the rule in the Fourth Circuit, even in situations like this one where the mortgage matured before the bankruptcy. Unsurprisingly, the bankruptcy court sided with Black and rejected Hurlburt's plan. The district court affirmed, as did a Fourth Circuit panel of three judges. With his options running out, Hurlburt threw a Hail Mary and asked that all the judges on the Fourth Circuit – an en banc panel – re-consider the matter. The Court did and, by an 11-3 margin, reversed the three earlier decisions and its own precedent.
Hurlburt does not apply to all claims secured by a principal residence. It applies to claims where the payment on the debtor's home mortgage falls before the last payment under the Chapter 13 plan. The Court based its decision on a re-reading of Section 1322(c)(2) of the Bankruptcy Code, which creates an exception to the general prohibition on modifying loans secured by a principal residence. That provision allows modification and bifurcation if the last payment on the loan is due before the date on which the final payment under the Chapter 13 plan is due.
Where the Fourth Circuit previously only had allowed Chapter 13 plans to modify payment schedules for this category of claims, the Court now authorizes modification of the entire claim. If the claim fits into this category, the debtor can bifurcate it into secured and unsecured components and cram down the unsecured component.
What is the impact of the Fourth Circuit's decision in real dollars for Hurlburt? Before filing Chapter 13, he had to pay Black $131,000 at 6%. Now, if the bankruptcy court confirms his plan on remand, he only has to pay $41,132.19 at 4.5%.
Since most Chapter 13 plans have a repayment period of three to five years, Hurlburt could have a wide impact. It may, according to the dissenting Fourth Circuit judges, lead to mischief in bankruptcy. Debtors have some control over when they file for bankruptcy protection and the duration of their plan. If a debtor can arrange for his final mortgage payment to be due in the 59th month of a 60-month Chapter 13 plan, and thereby keep his home by paying less than what he owes on his mortgage, he will have a strong incentive to do so. Indeed, it would seem that debtor's attorneys will be obligated to advise their clients about this strategy. As a consequence, lenders may want to weigh this in their loan underwriting and approval process.