Legal Updates for Home Mortgage Lenders

This month we provide a primer on the federal Protecting Tenants at Foreclose Act of 2009 (the "Act"), which was revived effective June 23, 2018, as part of the Dodd Frank reform legislation. The Act first became law in May 2009 but then expired by its terms at the end of 2014. Now that it's back, any institution that services residential mortgages should re-familiarize itself with it and the procedures examiners will be using to ensure compliance. In addition, this article provides an update on the ever-evolving issue of lien stripping in bankruptcy.

I. The Protecting Tenants at Foreclose Act of 2009

The Act requires anyone who acquires a residential property through a foreclosure, which includes a bank that takes the property back at the foreclosure sale (herein, the "Buyer"), to give a "bona fide tenant" of the property at least 90 days' notice to vacate the property. Further, if the bona fide tenant (a) has a lease, and (b) the lease predates the notice of foreclosure and cannot be terminated at will under state law, then the Buyer takes the property subject to the tenant's right to occupy the property through the end of the lease term. However, if the Buyer then sells the property to a purchaser who will use the property as a primary residence, then the Buyer can terminate the lease, subject to the requirement to give the tenant a 90-day notice to vacate. A notice of foreclosure does not serve as the 90-day notice required under the Act.

A tenant is a "bona fide tenant" only if (a) she is neither the person who mortgaged the property, nor the spouse, parent, or child of that person, and (b) her lease or tenancy was the result of an "arms-length transaction" and requires rent that is not substantially less than fair market rent, or the rent is reduced or subsidized based on a federal, state, or local subsidy.

The Act prescribes the federal minimum amount of notice and does not affect the requirements of any state or local law "that provides longer periods of time or other additional protections for tenants." Virginia's statutes on point require the Buyer to provide only a 30-day notice to tenants of multi-family residences and only a 60-day notice to tenants in single-family residences. Therefore, the Act effectively overrides those statutes.

The Federal Reserve's Division of Consumer and Community Affairs issued a letter dated June 21, 2018, providing that if a consumer compliance examiner includes a review of compliance with the Act in an examination, the examiner will use the following procedures to evaluate an institution's "awareness of the law, its compliance efforts, and its responsiveness to addressing implementation deficiencies":

1. Determine that the institution is aware of its responsibilities under the law through interviews with institution management.
2. Determine that the institution has incorporated its compliance responsibilities under the law into its operations, particularly with respect to its foreclosure notice procedures.
3. Determine that the institution has conducted training for appropriate personnel regarding the law.
4. Determine that the institution has incorporated routine reviews for compliance with the law into its compliance monitoring program.
5. Determine that the institution's internal audit program has been updated to include audit plans for evaluating compliance with the law.
6. Review applicable compliance review and audit materials, including work papers, checklists, and reports pertaining to the law. Evaluate whether the reviews and audits performed were reasonable and accurate, any identified deficiencies were reported to institution management, and effective corrective action occurred in response to any identified deficiencies.
7. Summarize findings and supervisory concerns. Identify actions needed to address any weaknesses and deficiencies in the institution's compliance management systems. Discuss findings with institution management and obtain any necessary commitment for corrective action.

Therefore, banks and other servicers of residential mortgages should promptly update their training, operations, and compliance-monitoring protocols to ensure that obligations under the Act are being fulfilled.

II. Bank's Lien Stripped From Chapter 13 Debtors' Home Despite Not Filing Claim

The law relating to lien strip-offs and strip-downs in bankruptcy continues to evolve. Another issue in that area was decided recently by the federal Fourth Circuit Court of Appeals, which covers Virginia among some other states. The court ruled that a bank's lien could be stripped from a Chapter 13 debtor's home even though the bank did not file a proof of claim in the bankruptcy case. The case is Burkhart v. Grigsby, 886 F.3d 434 (4th Cir. March 29, 2018).

The Chapter 13 debtors' residence was valued at $435,000 but was encumbered by four bank liens. The first lien secured a debt of $609,500, so no actual value supported the other three liens. The bank holding the fourth lien filed a proof of claim, but the bank holding the second and third liens did not. The debtors filed a lawsuit to strip off the second, third, and fourth liens on the ground that they were completely underwater. The bankruptcy court stripped the fourth lien but declined to strip the second and third liens because no proofs of claim were filed with respect to those liens. The bankruptcy court believed that before a lien can be stripped, the Bankruptcy Code requires that the lien holder have a claim that the court can value, which in turn requires that a proof of claim have been filed. On appeal, the district court agreed with the bankruptcy court's ruling.

The Fourth Circuit disagreed. The court first summarized the law related to mortgage lien stripping in the Fourth Circuit. Namely, in Chapter 7 cases, liens cannot be stripped off of a property or even reduced to the value of the property (i.e., stripped down), while in Chapter 13 cases mortgage liens on a debtor's principal residence cannot be stripped down but can be stripped off if they are completely underwater.

Then, after parsing the applicable statutory language and judicial opinions, the court stated that the district court had confused "the claim allowance and lien avoidance process" and "turned a blind eye to economic reality" - the reality being that the second and third liens had no actual value. In the court's view, that reality, along with what the court saw as the odd outcome mandated by the district court - i.e., the bank who files a claim loses its lien, but the bank who doesn't file a claim keeps its liens - dictated that the second and third liens be stripped. The district court's outcome, the court wrote, "cannot be the law." The court acknowledged it has previously said that lower courts "should" look to the claim allowance process to value collateral before turning to the question of lien stripping, but said "we have never required strict compliance with the claim allowance process."

The first takeaway from this case is simple: a bank should be aware that its mortgage lien can be stripped off of a Chapter 13 debtor's home even if the bank does not file a proof of claim in the bankruptcy case. Therefore, documents received in regard to a Chapter 13 case should be reviewed carefully even if the bank did not file a claim. The second takeaway is that the law related to lien stripping remains unsettled, so stay tuned for more developments.