It’s essential for secured creditors, particularly those who deal with consumer debts, to have policies in place that address the effects of a borrower’s bankruptcy. A Texas bankruptcy court underscored this need by ruling that a secured creditor’s claim could be modified, lessening its total recovery from the bankruptcy estate, where the creditor did not participate in the borrower’s bankruptcy proceedings despite being notified.

In a recent Chapter 13 case, the court granted a discharge where the debtors’ plan modified and paid off a mortgage, over the creditor’s objection that it could not be bound by the confirmed plan because it had not participated in the plan confirmation process. Finding that the creditor had received constitutionally sufficient notice of its claim treatment, the court held that the creditor was bound to the terms of the confirmed plan and therefore barred by the res judicata doctrine from relitigating its claim value.

The Facts

The debtors owed approximately $23,000 on their first mortgage to secured creditor Montanaro Investments. As part of their plan of reorganization, the debtors proposed paying Montanaro’s claim pro-rata, making monthly payments on the claim at 5.25 percent interest over a period of 54 months. Montanaro received multiple bankruptcy notices, but did not file a proof of claim or otherwise participate in the confirmation process. The debtor’s plan was confirmed without objection, and a copy of the confirmation order was mailed to Montanaro.

Eleven months after confirmation, the debtors filed a proof of claim on Montanaro’s behalf, listing the $23,000 claim secured by the debtors’ home, paid at the 5.25 percent interest rate given in the plan. No party objected to the late-filed claim, and so the court allowed it as filed.

The debtors completed their plan payments and moved for a Chapter 13 discharge. Only then did Montanaro contact the debtors to advise that they owed a balance of more than $30,000 on the mortgage, due in part because the contract rate of interest (14 percent) was higher than the interest rate provided in the plan (5.25 percent). The debtors moved to deem the mortgage fully paid by the plan, pointing out that they filed a proof of claim on Montanaro’s behalf, which was fully paid by the trustee through the confirmed plan. Montanaro countered that it could not be bound by the confirmed plan because such treatment essentially voided its lien, an action only permitted if the creditor had participated in the bankruptcy proceedings.

Did the Chapter 13 Plan Attempt to Void Montanaro’s Lien?

Montanaro contended that the debtors’ plan attempted to void its lien, an action that is only permitted if the secured creditor participates in the reorganization proceedings. The debtors argued that the plan did not void Montanaro’s lien, but rather provided for payment of the claim until discharge pursuant to the debtor-filed proof of claim.

The court sided with the debtors, focusing on the threshold question of whether the plan voided Montanaro’s lien at all, as opposed to examining whether creditor participation is required to void liens. The court found that the debtor’s plan did not deprive Montanaro of any recovery, as would be consistent with voiding a lien, but rather sought to pay Montanaro its full claim value as stated in its proof of claim. The court also highlighted language in the confirmed plan that explicitly preserved Montanaro’s lien until the debtors’ discharge. As a result, the court held that the debtors’ plan did not void Montanaro’s lien, rendering arguments about Montanaro’s participation moot.

Does a Confirmation Order Bar Relitigating Claim Value?

The court next turned to the question of whether the debtors’ plan bound Montanaro such that res judicata barred the creditor from relitigating claim valuation issues. Montanaro argued that the debtor-filed proof of claim contravened the Bankruptcy Code by reducing the interest rate on a mortgage, and as a result, the plan failed to account for the entirety of its claim.

Section 1322(b)(2) of the Bankruptcy Code generally forbids modifying interest rates on claims secured by the debtor’s principal residence. Once a plan is confirmed, however, the confirmed plan provisions bind the debtor and each creditor, even if those provisions improperly modify an interest rate under section 1322(b) or otherwise contradict the Bankruptcy Code (see 11 U.S.C. § 1327(a)).

Relying on the Fifth Circuit’s res judicata test, the court found that Montanaro was barred from relitigating its claim value because (1) Montanaro and the debtors had been parties throughout the confirmation process and discharge proceedings; (2) the court had jurisdiction to issue the confirmation order; (3) the confirmation order was a final adjudication on the merits; and (4) both suits involved the same cause of action.

Although not required for the res judicata analysis, the court also found that Montanaro received constitutionally sufficient notice of the debtor’s bankruptcy, the plan, and confirmation order to be bound by the plan’s terms, even though it had not participated in the confirmation process.

Montanaro was ordered to release its lien on the debtor’s home upon entry of the debtor’s discharge.

The Takeaway

  • File timely proofs of claim: Creditors should aim to file their own proofs of claim, rather than relying on the debtor or trustee to file for them, to ensure the claim includes the proper interest rate, arrearage, and total claim amount. Notably, the upcoming amendments to the Federal Rules of Bankruptcy Procedure, effective December 1, 2017, require secured creditors to file a proof of claim for their claim to be allowed. Amended Rule 3002(a) also clarifies that failure to file a proof of claim does not, by itself, void the secured creditor’s lien.
  • Address claim valuation issues before plan confirmation: Creditors should establish procedures to timely process and respond to bankruptcy notices, particularly regarding confirmation hearings. If claim valuation issues arise, they should be addressed prior to the plan’s confirmation.

For additional discussion regarding upcoming changes to the Federal Rules of Bankruptcy Procedure, please see Christopher Hawkins’s May 2017 blog post on the new rules.