Recent Lawsuits Against Home Mortgage Servicers Focus on Bankruptcy Compliance

The past year has brought notable court decisions regarding alleged failures by home mortgage servicers to comply with bankruptcy rules and orders. The stakes have been high, with the servicers often trying to fight off substantial court-imposed sanctions, and with the extent of a bankruptcy court’s power to impose sanctions at issue. The cases highlight the importance of compliance with sometimes burdensome rules the bankruptcy process imposes on home mortgage lenders and servicers. We review the cases below and provide some takeaways. We also provide an update on new bankruptcy legislation that creates new debt limits for Subchapter V and Chapter 13 bankruptcy filings.

I. In re Gravel[1]

In In re Gravel, the bankruptcy court sanctioned the mortgage servicer $300,000 for multiple failures to comply with Bankruptcy Rule 3002.1 and for also sending the debtors statements indicating their loans were not current even though the court had entered orders declaring the loans were current.

Rule 3002.1 applies in Chapter 13 bankruptcy cases and is designed to keep the lender, the borrower, and the Chapter 13 trustee on the same page regarding the status of the loan during the bankruptcy case. The rule became effective in 2011 after experience had shown that many debtors entered Chapter 13 with the goal of curing a home mortgage arrearage only to learn years later, when they left Chapter 13, that they were still in arrears due to, for example, payment-amount changes or fees that they were not aware of.

In a nutshell, Rule 3002.1 requires the home mortgage lender or servicer to give written notice to the borrower, the borrower’s bankruptcy counsel, and the Chapter 13 trustee of the following:

• Changes in payment amount – including changes resulting from interest-rate or escrow-account adjustments – no later than 21 days before the new amount is due (the rule allows the court to modify the requirement in the case of home-equity lines of credit);
• Additional fees, expenses, or charges incurred during the bankruptcy case or believed to be recoverable against the debtor or his principal residence within 180 days after the fee, expense, or charge is incurred; and
• Whether the lender (or servicer) agrees that the debtor has cured its loan default and is otherwise current. This notice would be given in response to a notice served by the trustee or debtor at the end of the Chapter 13 case stating that they believe the default has been cured.

Rule 3002.1 provides that failure to comply can result in sanctions, including “other appropriate relief, including reasonable expenses and attorney’s fees.” (emphasis added).

The bankruptcy court in the Gravel case interpreted “other appropriate relief” to include punitive damages, which it imposed on the servicer at a rate of $1,000 each for seventy-five mortgage statements that included fees the servicer had not given notice of, for a total $75,000. While the fees themselves were small, aggregating no more than $716 across the seventy-five statements, the servicer had a well-documented history of not complying with Rule 3002.1.

The court then also sanctioned the servicer $300,000 for sending the borrowers mortgage statements that contradicted orders the court had entered only days before confirming that certain mortgage loans were current (the “Current Orders”).[2] The court imposed these sanctions pursuant to its “inherent power” to enforce its own orders, as opposed to its authority to grant “other appropriate relief” under Rule 3002.1.

The bankruptcy court first imposed the sanctions in 2016. In August 2021, the federal Second Circuit Court of Appeals ruled that the bankruptcy court had erred because in the Second Circuit’s view (a) “other appropriate relief” does not include punitive damages, and (b) the servicer had not violated the terms of the Current Orders because the terms did not specifically prohibit the servicer from sending incorrect mortgage statements but only from disputing that the loans were current in a court proceeding.

The bankruptcy trustee in the Gravel case filed a petition to have the Second Circuit’s opinion reviewed by the U.S. Supreme Court, but the Supreme Court denied the petition on June 13, 2022.

II. Blanco v. Bayview Loan Servicing[3]

In September 2021, another bankruptcy court ruled, in Blanco v. Bayview Loan Servicing, that in Gravel the Second Circuit was wrong and that the reference to “other appropriate relief” in Rule 3002.1 does indeed authorize punitive damages. The Chapter 13 debtors in the Blanco case alleged that their mortgage servicer repeatedly violated Rule 3002.1 by not notifying them of changes to their monthly payment amount and the addition of property inspection fees, title costs, and legal fees to their loan balance. They asked for “substantial punitive damages” in addition to actual damages and attorneys’ fees.

In addition to relying on the Second Circuit’s ruling in Gravel, the servicer asked the bankruptcy court to dismiss the borrower’s lawsuit because there was no indication that the alleged violations of Rule 3002.1 had harmed the debtors. The bankruptcy court declined, ruling that Rule 3002.1 does not require that the debtors suffer actual harm from a failure to comply with the rule.

III. In re Legare-Doctor[4]

In December 2021, in In re Legare-Doctor, another bankruptcy court agreed that Rule 3002.1 authorizes punitive damages. The stakes in the Legare-Doctor case were not as significant as those Gravel and Blanco, as the borrower did not request punitive damages. Nonetheless, the bankruptcy court did limit the creditor’s ability to collect an insurance premium that it charged to the loan without complying with Rule 3002.1 and ordered the creditor to pay the borrower’s attorney fees. The court also left the door open to awarding punitive damages in future cases.

IV. Beckhart v. Newrez LLC[5]

In April 2022, the federal Fourth Circuit Court of Appeals, which covers Virginia and four other states, also issued an important ruling involving a mortgage servicer who had been sanctioned by a bankruptcy court. While not involving Rule 3002.1, the sanctions nonetheless arose from a servicer’s failure to adjust its accounting of a residential mortgage loan to reflect the outcome of the borrowers’ bankruptcy case.

The bankruptcy court sanctioned the servicer approximately $115,000 after an attempt to foreclose on a house owned by borrowers who had been through a Chapter 11 bankruptcy case years before and had since timely made all the mortgage payments required by their confirmed Chapter 11 plan. The bankruptcy court held that the servicer was in contempt of court for violating the terms of the Chapter 11 confirmation order. The servicer acknowledged its failure to adjust the loan accounting consistent with the confirmation order but claimed the order was confusing and ambiguous.

On appeal, the federal district court overturned the sanctions on the grounds that (a) the bankruptcy court had used the wrong legal standard to decide the issue of contempt, and (b) the servicer had not acted in contempt because it had “acted in good faith” and “on the advice of outside counsel.”

On further appeal, the Fourth Circuit agreed that the bankruptcy court had applied the wrong contempt standard and explained that the correct standard is whether, from an objective standpoint, “there is a fair ground of doubt as to the wrongfulness” of the conduct at issue. However, the Fourth Circuit also held that the district court had erred in concluding that reliance on the advice of outside counsel precluded a finding of contempt. The Fourth Circuit acknowledged that advice of counsel, while relevant, “is not a complete defense in and of itself.”

The Fourth Circuit referred the case back to the bankruptcy court to reconsider the issues of contempt and appropriate sanctions, if any.

V. Takeaways

1. The above cases may demonstrate that lawyers for Chapter 13 debtors and bankruptcy judges are becoming more aggressive in enforcing compliance with Rule 3002.1. The rule is now over ten years old, so it is reasonable to expect a stricter approach to compliance, and the above cases may generate momentum in that direction.

2. It is reasonable to expect that a court will rule that punitive damages are a potential response to a violation of Rule 3002.1. That is what the courts decided in two of the three cases above, and in the other case (i.e., the Second Circuit’s opinion in Gravel), the court seemed to go out of its way to rule in favor of the servicer, particularly in finding that the servicer did not violate the Current Orders because the orders did not specifically prohibit sending inaccurate mortgage statements.

3. In light of the foregoing, reviewing procedures to ensure compliance with Rule 3002.1 and updating them as needed may be time well spent.

VI. New Law Increases Debt Limits for Subchapter V and Chapter 13 Bankruptcies.

As of June 21, 2022, the debt limit for Subchapter V small business bankruptcy filers is again $7.5 million. In our article in the April newsletter, we noted that the Subchapter V debt limit had reverted to $2,725,625 on March 28, 2022, and then increased to $3,024,725 on April 1, 2022. However, on June 21, 2022, President Biden signed bankruptcy legislation with broad bipartisan support that not only reinstates the $7.5 million debt limit but makes it retroactive to cover cases filed on and after March 28, 2022. Under the new law, the increase in the debt limit is effective only until June 21, 2024.

The new bankruptcy law also increases the debt limit for Chapter 13 bankruptcy cases to $2.75 million and eliminates the distinction between secured and unsecured debt for purposes of the limit. Prior to the new law, the Chapter 13 debt limit was $1,395,875 of secured debt and $465,275 of unsecured debt, and therefore the new limit is $888,850 greater than the old limit. The increase in the Chapter 13 debt limit is also effective only until June 21, 2024.

Note that different issues may arise in determining eligibility for a particular bankruptcy filing, including which debts count against the applicable debt limit, so consulting counsel may be advisable.

[1] PHH Mortg. Corp. v. Sensenich (In re Gravel), 6 F.4^th 503 (2^nd Cir. 2021).

[2] The court subsequently reduced the $300,000 sanction to $225,000.

[3] Blanco v. Bayview Loan Servicing, LLC (Bankr. S.D.Tex. 2021).

[4] In re Legare-Doctor, 634 B.R. 453 (Bankr. D.S.C. 2021).

[5] Beckhart v. Newrez LLC, 31 F.4^th 274 (4^th Cir. 2022).