4th Circuit Rejects Bid for Chapter 13 Mortgage Cramdown

The U.S. Court of Appeals for the Fourth Circuit, which covers Virginia among some other states, recently issued an important opinion for residential real estate lenders. The case is Birmingham v. PNC Bank, N.A. (In re Birmingham), 2017 U.S. App. LEXIS 870 (4th Cir. Md. Jan. 18, 2017). The court ruled that PNC Bank's rights under its deed of trust concerning escrow funds, insurance proceeds, and miscellaneous proceeds were "incidental" to its lien on the borrower's home, as opposed to being "additional collateral" that would expose its loan to being modified in the borrower's Chapter 13 bankruptcy plan. The ruling is important because deeds of trust routinely provide the lender with rights in escrow funds, insurance proceeds, and miscellaneous proceeds. Therefore, if the court had come to the opposite conclusion, many more home loans would be subject to modification in Chapter 13 bankruptcy than is now the case. It's also an important ruling because it may have turned on the mere fact that the deed of trust did not explicitly state that escrow funds, etc. were additional security for the loan – a reminder of the high degree of care that should be taken in preparing a deed of trust.

By way of background, Bankruptcy Code section 1322(b)(2), provides that "a claim secured only by a security interest in real property that is the debtor's principal residence" cannot be modified in a Chapter 13 bankruptcy plan. This means that the typical home loan is normally protected from modification in a Chapter 13 case (though there are exceptions, most notably in a scenario in which the final loan payment is due before the final bankruptcy-plan payment is due). The debtor can cure any defaults, but he doesn't get to, for example, lower the interest rate, extend the payment period, or, worst of all, "cram down" the loan by dividing it into secured and unsecured parts based on the home's value and then repaying only a small percentage of the unsecured part. This protection for home loans, however, is narrow - it protects only loans secured "only by" "real property" that is the debtor's "principal residence." So, for example, if the deed of trust is on a vacation home or on a home that is not real property – e.g., a manufactured home that has not been converted to real property – then the loan is subject to modification. Also, to the point most relevant here, if the loan is not secured "only by" the debtor's principal residence, then the loan is subject to modification.

In the Birmingham case, the borrower argued that PNC's loan was not secured "only by" the borrower's principal residence because PNC's deed of trust (a) required the borrower to regularly fund an escrow account with PNC for real estate taxes, property-insurance premiums, and the like, and (b) provided that the borrower assigned to PNC his right to any property-insurance proceeds and any miscellaneous proceeds (such as funds received from any governmental taking of his residence). The borrower wanted to cram down PNC's loan based on a recent valuation of his residence. If the court agreed with the borrower's argument, approximately $137,000 of PNC's loan could have been turned into an unsecured claim and repaid only in part.

The court, however, disagreed with the borrower's argument, stating that the deed of trust terms relied on by the borrower "do not create separate of additional security interests, but are merely provisions to protect the lender's security interest in the real property." The court mostly supported its ruling with definitions provided in the Bankruptcy Code, noting that "principal residence" is defined to include "incidental property," which in turn includes "(A) property commonly conveyed with a principal residence in the area where the real property is located, (B) all easements, rights, appurtenances, fixtures, rents, royalties, mineral rights, oil or gas rights or profits, water rights, escrow funds, or insurance proceeds; (C) all replacements and additions." (emphasis added) The court stated that the escrow funds and proceeds that PNC had rights in under its deed of trust "are incidental property frequently conveyed in a deed of trust and defined [in the bankruptcy code] as part of a debtor's principal residence," as opposed to being additional collateral.

The borrower pointed the court to cases holding that the lender's interest in an escrow account rendered the loan subject to modification. The court distinguished those cases, however, by noting that the deeds of trust in those cases, unlike the one before the court, "expressly provided that escrow payments constituted additional security for the loan." Indeed, the phrase "additional security" was used in the deeds of trust in at least two of the cases distinguished by the court. The court wrote that it had "no occasion to consider the effect - if any - of additional language in a deed purporting to create a separate security interest in escrow funds, insurance proceeds, or miscellaneous proceeds...." Accordingly, it's possible that the court would have ruled against PNC if the deed of trust had clearly stated that the escrow funds and proceeds were additional security for the loan.

Therefore, while the Birmingham case is a win for lenders, it points to the importance of the language used in a deed of trust. That language in the context of a home loan can carry a significant bankruptcy risk.