The United States Court of Appeals for the Fourth Circuit—which covers federal courts in North Carolina—recently handed a victory to residential real estate lenders dealing with borrowers who file for Chapter 13 bankruptcy protection. The Bankruptcy Code generally prohibits a Chapter 13 debtor from modifying a lender’s claim secured only by the debtor’s principal residence. In In re Birmingham, the Fourth Circuit held that a lender’s additional interest in “escrow funds, insurance proceeds, or miscellaneous proceeds” was incidental to the lender’s lien on the borrower’s residence, not additional collateral that would allow the debtor to modify the loan in Chapter 13. Having these additional protections in its deed of trust did not render the lender's claim to be secured by collateral more than "only" the debtor's principal residence.
In a Chapter 13 bankruptcy proceeding, a debtor files a repayment plan with the bankruptcy court that requires the debtor to pay back all or a portion of the debtor's debts. The amount to be repaid depends on how much the debtor earns, the amount and types of debt owed, and how much property the debtor owns. In any bankruptcy proceeding, creditors are generally classified as having either a "secured" or "unsecured" claim. A secured claim is supported by collateral securing repayment of the claim, while an unsecured claim is not supported by collateral. Debtors routinely seek to bifurcate lender’s claims into secured and unsecured portions. The unsecured portion is then lumped together with the unsecured claims of other creditors, and only a small percentage of the total is repaid. In the bankruptcy world, this is one of the meanings of the term "cram down."
But the Bankruptcy Code limits the ability of a debtor to modify a lender's secured claim when the security is only the debtor's primary residence. Barring limited exceptions, the claim cannot be modified. This means that the debtor cannot lower the interest rate, extend the payment period, or cram down the loan by bifurcating it into secured and unsecured parts based on the residence’s value and then repaying only a small percentage of the unsecured part. This anti-modification provision does not apply, however, if the lender’s claim is secured by more than just the interest in the residence.
In Birmingham, the debtor argued that the lender’s loan was not secured only by the debtor’s principal residence because the deed of trust required him to fund an escrow account for real estate taxes and property-insurance premiums, and assigned his right to any property-insurance proceeds and any miscellaneous proceeds to the lender. The debtor sought to cram down the unsecured portion of the loan based on a recent appraisal of the residence. Approximately $137,000 of the lender’s loan could have been turned into an unsecured claim and repaid only in part had the borrower prevailed, so the stakes were high. The Bankruptcy Court and the District Court ruled for the lender, so the borrower appealed to the Fourth Circuit.
The Fourth Circuit also disagreed with the borrower. They held that the escrow and proceed provisions in the deed of trust did not create separate or additional security interests, but were merely provisions to protect the lender's security interest in the real property. They pointed out that the Bankruptcy Code defines a debtor’s principal residence to include “incidental property” such as escrow funds and insurance proceeds. The Fourth Circuit concluded that these interests—incorporated into the deed of trust by the lender—were additional protections, not additional collateral.
The Fourth Circuit based its analysis on the language of the deed of trust, finding nothing in the document treating the escrow items and proceeds as additional collateral separate from the residence. So although this case is a win for lenders, it is a reminder of the importance of the language used in a deed of trust. Lenders desiring to avail themselves of this ruling should review their deeds of trust to ensure they contain no problematic language.
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