Legal Updates for Lenders

There are several recent legal developments of which lenders should be aware. They include the following: HELOC lenders are now eligible to modify their duty to give notice of payment changes in Chapter 13 bankruptcy; an attorney-fee clause has been struck down by a Virginia court as unconscionable and against public policy; and the repeal of a Virginia statute has bolstered the exemption available for life-insurance proceeds. This article summarizes and examines these developments.

1. HELOC Lenders Now Eligible to Modify Notice Duty in Chapter 13

Effective December 1, 2018, a lender under a home equity line of credit (HELOC) may request modification of its obligation to provide notice of payment changes to a borrower in Chapter 13 bankruptcy. Since 2011, Rule 3002.1(b) of the Federal Rules of Bankruptcy Procedure has required lenders who are secured by a borrower's principal residence to file a notice of each change in payment amount at least 21 days before each change takes effect and serve the notice on the Chapter 13 borrower, his lawyer, and the Chapter 13 trustee.

The rule can be particularly difficult to follow for HELOC lenders because payment amounts on HELOCs can change frequently due to interest rate or escrow account adjustments. Further, breaking the rule can result in sanctions, including but not limited to the lender being required to pay the borrower's resulting attorney fees. Nonetheless, HELOC lenders were not excepted from the rule, and at least one court ruled that it did not have authority to excuse a HELOC lender's noncompliance.

Now, however, the rule has been supplemented to include the following sentence: "If the claim arises from a home-equity line of credit, this requirement may be modified by court order." The committee that suggested this supplemental language stated that the referenced "court order" can be either an order entered in a particular bankruptcy case or a "local rule" of the bankruptcy court that applies to all cases pending in that court. As of yet, no bankruptcy court in Virginia has created such a local rule, so if relief from the rule is desired, a HELOC lender needs to request it in each particular bankruptcy case. The lender might, for example, ask the court to allow it to file notices of payment change every six months and then on a quarterly basis during the final year of the debtor's Chapter 13 plan, which is an approach that at least one bankruptcy court outside of Virginia has approved.

2. Attorney-Fee Clause Struck Down as Unconscionable and Against Public Policy

On September 17, 2018, a circuit court in northern Virginia issued an opinion striking down an attorney-fee clause in a contract as both unconscionable and against public policy. The case did not involve a lender/borrower relationship, but it is nonetheless a valuable reminder that there are limits on attorney-fee clauses, which frequently appear in loan documents.¹

The case involved an enrollment contract that the plaintiff signed in order to send her child to a private school. In relevant part, the contract stated that "[w]e (I) agree to pay all attorneys' fees and costs incurred by Flint Hill School in any action arising out of or relating to this Enrollment Contract." The plaintiff ultimately wanted to sue the school for excluding her husband from school grounds but first sought a ruling that the attorney-fee clause was unconscionable under Virginia law and, therefore, unenforceable.

The court agreed with the plaintiff, ruling that the clause was unconscionable both procedurally and substantively. The procedural unconscionability arose from the fact that the plaintiff, as with others enrolling at the school, had no room to bargain with the school over the clause; assent was required as part of an on-line enrollment process. The substantive unconscionability resulted from the fact that clause entitled the school to recover its attorney fees regardless of whether (a) the school prevailed in litigation or (b) the school's attorney fees were reasonable. In other words, under the clause the school could lose a lawsuit and incur an unreasonable amount of attorney fees in the process but nonetheless be entitled to recover its fees from the winning side.

For much the same reason, the court also ruled that the attorney-fee clause violated Virginia public policy. The court found that Virginia's rules governing attorney conduct imply "the policy that the non-prevailing party in litigation is not to be rewarded in loss and without limitation" as to attorney fees. Further, the court stated that the attorney-fee clause contravened "public welfare by significantly barring potentially meritorious resort to the courts by Plaintiff."

The takeaway from this case is worth remembering: while protecting the lender from the cost of attorney fees it may incur in connection with a loan is very important, the process of negotiating an attorney-fee clause and the terms of that clause need to be reasonable. If they are not, the lender could end up without any protection at all. At a minimum, attorney fee clauses should provide for the recovery of lender's reasonable attorney fees.

3. Repeal of Statute Further Bolsters Exemption for Life-Insurance Proceeds

Effective July 1, 2018, Virginia repealed a statute that limited the right to exempt from creditors the cash-surrender value or loan value of a life-insurance policy. Since 1986, Virginia Code section 38.2-3123 had provided that with respect to policies in which "the right to change the beneficiary is reserved," the cash or loan value of the policy is not covered by the general exemption for life-insurance proceeds created in section 38.2-3122. It's common for a debtor to own a life-insurance policy with a substantial cash value that he or she is unable to protect from creditors with other Virginia exemptions, so section 38.2-3123 was valuable to creditors.

However, in 2016, section 38.2-3122 was revised to considerably expand the exemption for life-insurance proceeds. For example, the exemption in the old version operated against only creditors of "the insured or the person effecting the policy," whereas the exemption in the new version also operates against, without limitation, creditors of (1) the owner of the policy and (2) a potential beneficiary of the policy who is also the spouse, child, or dependent of the insured. Further, the new version makes clear that it protects not only policy proceeds but "[a]ll other benefits, indemnities, payments, and privileges of every kind from any such policy."

Also as part of the revision, a section (F) was added, stating in relevant part that the exemption shall apply "regardless of whether ... the right to change the beneficiary thereof is reserved or permitted...." Section (F) therefore put sections 38.2-3122 and 38.2-3123 in direct conflict with each other. In January 2018, a Richmond bankruptcy court, faced with the conflict, ruled that section 38.2-3123 had been implicitly repealed by the addition of section 38.2-3122(F).² Six months later the Virginia legislature made the repeal explicit. Therefore, whether or not the right to change the beneficiary is reserved in a life-insurance policy is no longer relevant to whether the cash or loan value of the policy are exempt from creditors.

When considering potential loan collateral, a lender should keep in mind the broad exemption for life-insurance proceeds reflected in section 38.2-3122 and the repeal of section 38.2-3123. As we've discussed previously here, a lender should review any policy it wishes to have as collateral and take all necessary steps for a valid assignment of the policy to the lender.

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[1] The case is McIntosh v. Flint Hill Sch., 2018 Va. Cir. LEXIS 321 (Cir. Ct. Sept. 17, 2018).

[2] The case is In re Bowman, 582 B.R. 899 (Bankr.E.D.Va. 2018).