Fourth Circuit Reverses Its Own Precedent to Authorize "Strip Down" of Certain Underwater Mortgages in Chapter 13 Plan
In a recent decision, the United States Court of Appeals for the Fourth Circuit overruled its own 22-year precedent to address the extent to which debtors may “strip down” certain mortgages pursuant to a chapter 13 plan.
Under Section 506(a) of the Bankruptcy Code (the Code), when a secured creditor has an undersecured claim (i.e., its claim exceeds the value of its collateral), the creditor’s claim is bifurcated into a secured claim to the extent of the value of the collateral and an unsecured claim to the extent the claim exceeds the value of the collateral. Under Section 1325(a)(5), a chapter 13 plan may be confirmed over a secured creditor’s objection if the plan provides for payment totaling the present value of the allowed secured claim over the plan’s 3 or 5 year term. Taken together, these two provisions enable a chapter 13 debtor to “strip down” an undersecured claim, effectively reducing the secured claim to the value of the collateral. Generally, however, since a chapter 13 plan may not modify the rights of a holder of a claim secured only by a lien in the debtor’s residence, chapter 13 debtors may not strip down an undersecured homestead mortgage. One exception to this anti-modification provision under chapter 13 applies when a homestead mortgage’s final payment is scheduled to occur before the last payment under the debtor’s chapter 13 plan. For these short term homestead mortgages, Section 1322(c)(2) of the Code authorizes a chapter 13 plan to provide for payment of the claim “as modified pursuant to section 1325(a)(5)” of the Code. Since its prior decision in 1997, the Fourth Circuit has interpreted Section 1322(c)(2) to authorize the modification of the payment schedule of the short term homestead mortgage, but not to strip down the undersecured claim thereby modifying the amount of the secured claim.
This recent case concerns a debtor who filed a chapter 13 petition to halt a foreclosure after he failed to satisfy the mortgage on his residence at the loan’s maturity. The debtor’s chapter 13 plan bifurcated the mortgage lender’s claim into a secured claim based on the value of the residence (less a small tax lien) and an unsecured claim for the remaining balance of the loan. The plan proposed to pay the mortgage lender’s secured claim over the life of the plan and the unsecured claim would not receive any plan payments. The lender objected to confirmation, arguing that the plan constituted an improper modification. Following the 1997 decision of the Fourth Circuit, the bankruptcy court sustained the objection and the district court and Fourth Circuit affirmed. After a rehearing en banc, the Fourth Circuit reversed, overruling its earlier decision and holding that the plain text of Section 1322(c)(2) authorizes a chapter 13 plan to strip down a short term homestead mortgage to the value of the residence, not simply to modify the payment schedule under the loan. The court held that its initial interpretation of Section 1322(c)(2) ran contrary to accepted standards of statutory construction and was later criticized by commentators and other courts.
Though such a reversal of established court precedent is significant, the scope of this decision remains limited. Section 1322(c)(2) only applies to homestead mortgages set to mature before the completion of the debtor’s 3 to 5 year chapter 13 plan payments. However, this decision does enable a limited class of chapter 13 debtors to significantly alter their homestead mortgage obligations. Lenders holding distressed homestead mortgages set to mature in the short term should be mindful of this decision. Please contact Bryan Mull with any questions regarding the topic.