November 9, 2015
by Craig Rule and Ryan Byrd
Orlans Associates, P.C.
USFN Member (Michigan)
When faced with a proposed cramdown in a chapter 13 case, many mortgage servicers and their attorneys focus primarily on value and interest rate when objecting to confirmation of the plan. There exist, however, a number of other potential objections to confirmation which, depending on the facts of the case, could result in more favorable cramdown terms, or even the complete abandonment of the cramdown attempt by a debtor. This article looks at two of these other possible objections to cramdowns that may not always be on the radar of servicers and their attorneys.
Bait And Switch: A Debtor’s Principal Residence
Beyond value and interest rate, it is important for a mortgage creditor facing a cramdown to investigate whether the claim is protected by 11 U.S.C. § 1322(b)(2), which prohibits cramdowns and other modifications of a debtor’s principal residence. Among the most crucial questions is timing: at what point must a property be a debtor’s principal residence to qualify for the protections of 11 U.S.C. § 1322(b)(2)? Bankruptcy courts have generally adopted a bright-line test, with a majority of courts finding that the relevant date is the bankruptcy petition filing date. A minority of courts reach back to the date that the loan was originated. See In re Baker, 398 B.R. 198, 202 (Bankr. N.D. Ohio 2008).
In recent years, however, it has become common for debtors in jurisdictions that have not adopted the loan origination standard to move out of their residences shortly before or after the petition date in attempts to avoid the application of 11 U.S.C. § 1322(b)(2). Often, these debtors fully intend to move back into the properties after confirmation or plan completion, and bide their time by renting the property, usually to a relative or close acquaintance. On its face, this scheme appears to fly in the face of 11 U.S.C. § 1322(b)(2), which is intended to protect the mortgage market from principal residence cramdowns. See Nobleman v. American Savings Bank, 508 U.S. 324, 332 (1993) (J. Stevens, concurring). A strict adherence to a bright-line standard of the petition date (or even the confirmation hearing date) to determine principal residence results in a debtor, nevertheless, being able to cramdown in the situations mentioned above.
To avoid this apparent loophole, some bankruptcy courts have loosened the bright-line petition date standard to adopt one that looks more to the totality of the circumstances. Confronted with debtors who moved out of their residence and into a previous rental property two months after filing a chapter 13 case, the bankruptcy court in In re Kelly, 486 B.R. 882 (Bankr. E.D. Mich. 2013), found that the latter property was the debtors’ principal residence under 11 U.S.C. § 1322(b)(2). In reaching this conclusion, the Kelly court opined that relying solely on a single date, such as the petition date, to determine principal residence would be “subject to manipulation” and would do “a disservice to 11 U.S.C. § 1322(b)(2)”. Id. at 886. Accordingly, the Kelly court fashioned a six-part test that not only considered where the debtors lived on the petition date but also where the debtors intended to live during and after their bankruptcy case.
At least one other court, the bankruptcy court in In re Baker, 398 B.R. 198 (Bankr. N.D. Ohio 2008), has exclusively employed a hybrid approach to this question. Although the Baker court was not faced with the specter of debtor manipulation of the circumstances to evade application of 11 U.S.C. § 1322(b)(2), it determined that changing circumstances between the time of loan origination, and that of the bankruptcy petition date, required something more nuanced than a bright-line test and adopted a hybrid method that looks to the facts on both dates. Id. at 203. Applying this approach, the court determined that 11 U.S.C. § 1322(b)(2) prevented modification because the inclusion of a second parcel of real property into the mortgage at loan inception was intended to only be a temporary attribute of the agreement and, at the time that the bankruptcy case was filed, the loan was actually only secured by the debtors’ residence. Id. at 204.
Anytime a cramdown is proposed, mortgage creditors and their attorneys should carefully review the schedules and statement of financial affairs to determine if the debtor has recently moved. Question 15 of the statement of financial affairs (Official Form 7), for example, requires a debtor to list all addresses in the past three years. The answer to this question can be compared to the certificate of credit counseling to determine whether the move happened after meeting with a bankruptcy attorney. If this initial inquiry indicates that a debtor may have moved in contemplation of bankruptcy, an objection should be filed and relevant information (including rental agreements, rent payment receipts, municipal rental registrations, and utility bills for the property) should be requested from the debtor’s counsel. Further informal discovery can be obtained through attendance at the meeting of creditors, and an objecting creditor can request formal discovery and an evidentiary hearing from the bankruptcy court. Even if a judge has previously adopted one of the bright-line standards, it might be possible to change his or her mind if presented with facts that strongly infer that a debtor has manipulated the circumstances to avoid 11 U.S.C. § 1322(b)(2).
A Bad Faith Cramdown
A cramdown also may be successfully challenged if a debtor’s plan has not been proposed in good faith. Among other requirements, the Bankruptcy Code mandates that a debtor’s plan be proposed in good faith in order to qualify for confirmation. 11 U.S.C. § 1325(a)(3). If a debtor or a debtor’s dependent does not reside at the property, a cramdown may have been proposed in bad faith if the property does not deliver a net benefit to the bankruptcy estate. In re Brinkley, 505 B.R. 207 (Bankr. E.D. Mich. 2013); In re Jordan, 330 B.R. 857 (Bankr. M.D. Ga. 2005). To make this determination, the court will look at the monthly income that the property generates (most likely from rent) and then subtract the monthly payment by the chapter 13 trustee on the secured portion of the debt, any monthly homeowners or condominium association fees, and the monthly pro-rata taxes and insurance. Brinkley, 505 B.R. at 215-216. If the result is not a positive number, and the debtor cannot provide any other good faith justification for retention of the property, then the debtor will not be permitted to retain the property. Id. at 216.
When reviewing a proposed cramdown, mortgage servicers and their attorneys should have most of the information on hand necessary to make a rough version of the calculation on which the Brinkley court relied. The proposed monthly payment on the secured portion of the claim may be set forth in the plan or be easily calculated. If a debtor’s schedules are complete, the remainder of the information can be obtained in Schedule G (Executory Contracts and Unexpired Leases), Schedule I (Income), and Schedule J (Expenses).
In a very significant number of cases, this calculation results in a negative number. Even if there is a net benefit to the bankruptcy estate based on initial numbers, those can change as a consequence of a higher valuation, interest rate, or pro-rata monthly expense, or a decrease in rent. Consequently, it is recommended to preserve this bad faith objection by filing it timely and then requesting documentary verification of expenses and rent from the debtor’s attorney. While a successful challenge to a cramdown using bad faith will often compel a debtor to surrender the collateral, it could potentially result in the claim being treated as a 11 U.S.C. § 1322(b)(5) claim (maintain post-petition payments and cure pre-petition arrearage), if the total monthly payment is not excessive, or some other arrangement that allows a portion of the debt to extend beyond the length of the chapter 13 plan.
When reviewing a plan that proposes a cramdown, objecting to a “bait and switch” scheme and “bad faith” are options that creditors and their attorneys should always consider if the facts point toward either scenario. Keeping these two potential objections in mind when faced with a proposed cramdown could lead to much more favorable results at confirmation.
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