Good news for residential mortgage lenders: the Fourth Circuit recently held that post-petition mortgage payments under a Chapter 13 “maintenance and cure” bankruptcy plan should be calculated using the default interest rate triggered prior to the debtors’ bankruptcy. In Anderson v. Hancock, the court rejected the debtors’ argument that post-petition mortgage payments at the non-default interest rate were permitted under Bankruptcy Code Sections 1322(b)(3) and (5), which allow for the cure or waiver of any default. Instead, the court ruled that the debtors’ proposal to make mortgage payments at the non-default rate constituted an impermissible modification of the loan in violation of Bankruptcy Code Section 1322(b)(2).

Background

In 2011, the debtors purchased a home from the sellers. The debtors financed the purchase with a loan from the sellers. In exchange for the loan, the debtors granted the sellers a deed of trust on the property and signed a promissory note requiring monthly payments based on a 5 percent interest rate over a term of 30 years. The promissory note provided that in the event of default, the interest rate would increase to 7 percent for the remaining term of the loan until paid in full. The promissory note also stated that as an alternative to increasing the interest rate upon default, the lender could, in its sole discretion, either: (1) accelerate the full unpaid amount of the loan, or (2) pursue any other rights available to the lender under state law, including foreclosure.

The debtors defaulted on their loan in April 2013 by failing to make their monthly payment. The sellers notified the debtors of the default and stated that the increased 7 percent rate of interest applied to future payments for the remaining term of the loan. After receiving no additional payments, the sellers initiated foreclosure proceedings. Two weeks later, the debtors filed a Chapter 13 bankruptcy proceeding, invoking the protection of the automatic stay and halting foreclosure proceedings.

The debtors proposed a “maintenance and cure” bankruptcy plan pursuant to Section 1322(b)(5) of the Bankruptcy Code. The proposed plan provided for a cure of pre-petition mortgage arrears over a period of 60 months at the loan’s 5 percent non-default interest rate. The proposed plan further provided that debtors’ monthly post-petition maintenance payments would be calculated based on a 5 percent non-default interest rate.

The sellers objected to the proposed plan, contending that both the pre-petition arrears and post-petition payments should reflect the 7 percent default interest rate triggered pre-petition by the debtors’ payment defaults. The bankruptcy court sustained the sellers’ objection, holding that application of the 5 percent non-default interest rate was an impermissible modification of sellers’ rights under Bankruptcy Code Section 1322(b)(2).

The debtors appealed to the district court, contending that their proposed “maintenance and cure” plan should be allowed under Bankruptcy Code Sections 1322(b)(3) and (5). The district court affirmed in part and reversed in part. The district court upheld the bankruptcy court’s ruling that the proposed non-default interest rate constituted an impermissible modification of the loan, prohibited by Section 1322(b)(2). But the district court reversed the bankruptcy court’s holding that the default interest rate applied despite the loan’s accelerated status. Instead, the district court ruled that once the sellers accelerated the loan and commenced foreclosure proceedings, the interest rate reverted back to the 5 percent non-default rate from the bankruptcy petition date until the effective date of the proposed plan, when the 7 percent default interest rate would resume due to the loan’s decelerated, post-bankruptcy status. The debtors appealed to the Fourth Circuit.

Analysis

Bankruptcy Code Section 1322(b)(2) provides that a bankruptcy plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence.” Chapter 13 bankruptcy plans may also “provide for the curing or waiving of any default,” as set forth in Section 1322(b)(3). Such cure provisions may extend to payments remitted after the debtor’s obligations under the bankruptcy plan have been fulfilled, provided that the bankruptcy plan provisions cure the default within a reasonable time and allow for regular maintenance of contractual payments on the claim while the claim is pending. The debtors argued that application of the 5 percent non-default interest rate was a permissible plan provision intended to cure the default under Sections 1322(b)(3) and (5). The sellers countered that the 7 percent default interest rate triggered prior to bankruptcy applied to post-petition mortgage payments and that an interest rate change impermissibly modified their claim, in violation of Section 1322(b)(2).

The Fourth Circuit agreed with the sellers, holding that the proposed interest rate change was an impermissible modification of the terms of debtors’ mortgage expressly prohibited by Section 1322(b)(2). As a result, the court ordered that payments made after the plan’s effective date reflect the 7 percent default interest rate. The court reasoned that Section 1322(b)(2) prohibited fundamental alterations to a debtor’s mortgage obligations, including lowering monthly payments, converting a variable to a fixed interest rate, or extending a note’s repayment term.

The court explained that Sections 1322(b)(3) and (5) allow the debtor to decelerate the loan and propose bankruptcy plan provisions to cure the default within a reasonable time. The court noted that any cure provisions proposed under these sections must allow the debtor to maintain regular mortgage payments.

The court opined that although the cure provisions are intended to offer debtors a second chance, the legislative history of Section 1322 suggests that Congress balanced this grace with protections for mortgage lenders. Section 1322(b)(2) protects lenders from modifications that would reduce installment mortgage payments, given the valuable nature of what service lenders provide and the desire to make mortgage lending an attractive investment opportunity. Specifically, with respect to interest rates, the Fourth Circuit reasoned that default interest rates allow lenders to adjust upward for increased risk when events reveal that their loan may be riskier than initially thought. As a result, the court held that the sellers were entitled to the benefit of the contractually agreed default interest rate, as application of a lower interest rate impermissibly modified the promissory note in violation of Section 1322(b)(2) and frustrated the balance between homeowner and lender interests.

The Fourth Circuit further disagreed with the district court, reversing the district court’s ruling that the 5 percent non-default interest rate applied to payments made post-petition and prior to bankruptcy plan’s effective date. Holding that the district court’s construction of the promissory note was implausible, the Fourth Circuit stated that the lender’s ability to accelerate the loan was not a true alternative to the higher interest rate, given that acceleration is a more drastic remedy likely invoked only after the less severe remedy of default interest fails to cure existing defaults.

Takeaways

Borrowers and lenders should not assume that a Chapter 13 “maintenance and cure” bankruptcy plan will reset the mortgage loan to its non-default interest rate. As indicated by the Fourth Circuit’s opinion, courts may apply the default interest rate to post-petition mortgage payments in an effort to compensate lenders post-petition for the risk associated with a pre-petition default.