November 7, 2014
by Linda St. Pierre
USFN Member (Connecticut)
One of the biggest challenges faced by secured creditors is how to protect their secured claims in Chapter 11 and 13 bankruptcy cases. Motions to determine secured status under Bankruptcy Code § 506 continue to be filed on a frequent basis. This is largely due to the fact that any recent increase in property value has not been significant enough to impede the filing of these motions.
Pursuant to § 506(a), a borrower may modify the rights of a secured claimant by seeking to bifurcate the claim into secured and unsecured portions, based upon the current fair market value of the property. Junior liens can be deemed wholly unsecured and lien-stripped entirely. According to the anti-modification provisions under § 1123(b)(5) and § 1322(b)(2), if the property is a single-family residence that is the debtor’s principal residence, a first mortgage claim cannot be modified if the claim is secured by that property alone. Further, any junior mortgage claim can only be modified upon the showing of zero equity.
Secured creditors are consistently faced with the potential for a claim modification. Nonetheless, servicers should be aware that there are many opportunities available to them in both Chapter 11 and 13 cases that can potentially limit a debtor’s ability to modify a secured claim. These options can protect a secured claim in its entirety — or close to it.
Chapter 11: The Absolute Priority Rule
The absolute priority rule bars junior claimants, including debtors, from retaining any interest in property when a dissenting senior class of creditors has not been paid in full. Under this rule, a creditor holding a potentially unsecured claim can effectively block plan confirmation if its claim is not to be paid in full before the reorganized debtor retains pre-petition property. This rule clearly applies to business debtors; however, courts across the country continue to be divided on whether it applies to individual debtors since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 took effect.
The overwhelming weight of circuit court authority and bankruptcy court decisions support application to Chapter 11 individual debtors. The Sixth Circuit recently joined the Fourth, Fifth, and Tenth U.S. Courts of Appeals (and numerous bankruptcy courts) in holding that the rule applies to individual Chapter 11 debtors. See Ice House Am., LLC. v. Cardin, 2014 U.S. App. LEXIS 8882 (6th Cir. 2014); In re Stephens, 704 F.3d 1279 (10th Cir. 2013); In re Lively, 717 F.3d 406 (5th Cir. 2013); In re Maharaj, 681 F.3d 558 (4th Cir. 2012). If applicable, the absolute priority rule can be a very powerful tool for any secured creditor seeking to protect its secured claim.
Chapter 11: 1111(b) Election
An 1111(b) election prohibits a debtor from bifurcating a claim into secured and unsecured portions. Effectively, this election will protect a secured creditor’s claim in full. This election must be made prior to approval of the disclosure statement unless the court fixes a different date. When this election is taken, a secured creditor will retain its lien for the full amount of its claim. Creditors should be aware that once made, the election cannot be withdrawn, and the creditor will lose its right to vote on the plan as an unsecured creditor.
Although a debtor must propose deferred payments that are equal to at least the full amount of the secured creditor’s claim, and with a present value that is equal to at least the value of the property, the debtor can propose other terms (i.e., extended amortization, balloon payments) that are unfavorable to a secured creditor. Both debtors and creditors may prefer to avoid an 1111(b) election and, thus, choose to reach an agreement to repayment terms that are more valuable to both parties than would be the case if the election were taken. Consequently, wielding the ability to make an 1111(b) election can be a persuasive negotiation technique for a secured creditor.
Chapter 11: Voting Block
A creditor’s right to vote can also be powerful in a Chapter 11 case. Pursuant to 11 U.S.C. § 1126(a), a holder of a claim or interest allowed under § 502 is permitted to accept or reject a proposed plan of reorganization. A class of creditors has accepted the plan if at least two-thirds in amount, and more than one-half in number, of the allowed claims of the class that are voted are cast in favor of the plan. If a creditor is the only secured creditor and potentially will be the largest unsecured creditor, that creditor can effectively block confirmation of the plan. Similarly, multiple creditors in the same case can work together to oppose confirmation. A calculated block may force the debtor to propose repayment terms that are acceptable to the creditors, or otherwise face dismissal or conversion of the case.
Chapters 11 and 13: Residential Status of Property
As mentioned earlier, if the property is a single-family residence and the anti-modification provisions under § 1322(b)(2) are present, a first mortgage claim cannot be modified. (§ 1123(b)(5) is the anti-modification provision applicable in Chapter 11 cases.) Further, a junior mortgage claim can only be modified upon the showing of zero equity. To date, the majority of courts are following an objective standard (“bright line rule”) in looking at whether or not a property is the debtor’s principal residence.
Issues arise when the property is also being used for commercial purposes or has become income property. For example, where the debtor’s former residence is now being rented out. To quote the majority opinion in a recent decision, “… there is nothing in the bankruptcy code indicating that, once a commercial use of a property becomes sufficiently ‘significant,’ that property ceases being the debtor’s principal residence — either a property is a debtor’s principal residence or it is not” [In re Wages, 2014 DJDAR 3648 (9th Cir. BAP Mar. 7, 2014)].
On the other hand, the dissent in Wages sided with the reasoning and holding of Scarborough v. Chase Manhattan Mortgage Corporation, (In re Scarborough), 461 F.3d 406, 410-13 (3d Cir. 2006). In Wages, the dissenting opinion stated that “Scarborough effectively construed the anti-modification provisions to apply only to mortgaged real property the debtor uses exclusively as his or her principal residence.” Also resulting in conflicting judicial opinions on this topic is whether the relevant date for considering the property’s status should be the petition date or the loan transaction date.
Courts have reviewed additional facts, including the timing of the property conversion, as well as whether bad faith on the part of the debtor exists. See In re Smart, 214 B.R. 63 (Bankr. D. Conn. 1997); In re Kelly, 486 B.R. 882 (Bankr. E.D. Mich. 2013); In re Christopherson, 446 B.R. 831 (Bankr. N.D. Ohio 2011); In re Larios, 259 B.R. 675 (Bankr. N.D. Ill. 2011). Accordingly, servicers should review whether the property is multi-family, whether the executed mortgage contained a “Second Home Rider” or “Occupancy Rider,” the conversion timing, and proof of rental income. Further, pre-petition loan modification applications and utility bills can provide servicers with helpful evidence. All of these factors can definitely play a part during plan negotiations.
Chapter 11 and 13: Due-on-Sale Clauses
Due-on-sale provisions are contained in many mortgages. In pertinent part, these provide that the lender may, at its option, require immediate payment in full of all sums secured by the mortgage if all or any part of the property, or if any right in the property, is sold or transferred without the lender’s written permission. Application of this clause can arise when a borrower quitclaims property to a third party who, thereafter, files for bankruptcy. That debtor then seeks to cramdown the secured creditor’s claim.
Whether or not these Chapter 13 plans are confirmable under § 1325(a)(1) and § 1322(b)(2) has been subject to much litigation. Although courts to date have been divided on whether a debtor in default under a due-on-sale clause can modify a creditor’s rights, many decisions have ruled against plan confirmation in these circumstances. See In re Espanol, 509 B.R. 422 (Bankr. D. Conn. 2014); In re Martin, 176 B.R. 675 (Bankr. D. Conn. 1995); In re Tewell, 355 B.R. 674 (Bankr. N.D. Ill. 2006). Using this line of cases, servicers may be able to effectively block plan confirmation.
Chapter 13: Exceeding the Debt Limitations
Pursuant to 11 U.S.C. § 109(e), only an individual with regular income that owes, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts of less than $383,175 and noncontingent, liquidated, secured debts of less than $1,149,525 may be a debtor under Chapter 13.
This article began with reference to motions to determine secured status under Bankruptcy Code § 506. Indeed, application of § 506(a) may turn out to be a deciding factor when determining eligibility for relief under Chapter 13. A debtor seeking to bifurcate a secured claim will effectively increase unsecured debt by the amount of the secured claim that is deemed unsecured. See In re Miller v. United States, 907 F.2d 80 (8th Cir. S.D. 1990). Accordingly, a debtor who proposes a bifurcation that increases the debtor’s unsecured debt over the § 109(e) debt limitations may prove to be ineligible for Chapter 13 relief in those jurisdictions that take these facts into consideration.
As touched on in this article, secured creditors have many options when objecting to a claim modification in both Chapter 11 and 13 cases. Servicers should consult with their local bankruptcy counsel to implement the best course of action, based upon local practice and law in that jurisdiction.
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Autumn 2014 USFN Report