Fresh Look at Curing Mortgage Defaults in Ch. 13
As more homeowners in foreclosure seek bankruptcy relief, the time has come to fix the systemic problems in chapter 13 related to curing mortgage defaults. Although cure plans have been part of chapter 13 practice since the Code’s enactment, mortgage creditors continue to struggle with the application of payments in a manner that the law requires. This article looks at ways in which interested parties in the bankruptcy system may take steps to encourage compliance with the Code’s cure provisions, primarily through plan provisions implementing the new remedy found in §524(i) created by BAPCPA.1
Problems with Curing Defaults on Home Loans
The effect of a cure in a chapter 13 case is to nullify all consequences of the prebankruptcy default.2 Once the debtor’s chapter 13 plan is confirmed in a case involving a long-term mortgage, the debtor’s ongoing regular mortgage payments should be applied from the petition date based on the mortgage contract terms and original loan amortization as if no default exists. See In re Wines, 239 B.R. 703 (Bankr. D. N.J. 1999); In re Rathe, 114 B.R. 253 (Bankr. D. Idaho 1990). All pre-bankruptcy arrearages are paid separately under the plan as a part of the mortgage servicer’s allowed claim. See Rake v. Wade, 508 U.S. 464, 473 (1993) (noting that as authorized by § 1322(b)(5), mortgage creditor’s claim is effectively “split…into two separate claims-the underlying debt and the arrearages”).
The problem is that mortgage creditors continue to treat timely payments received after the bankruptcy is filed as if they were late. This occurs because of the industry practice outside of bankruptcy of crediting payments received to the oldest outstanding installment due. While servicers attempt to manually override their automated systems, it is unrealistic to expect that this can be done regularly without error every month for the three to five years of the plan.
What this means for consumer debtors is additional costs in the form of unauthorized fees. As payments are deemed late or insufficient, the automated systems treat payments as unapplied and divert them to suspense accounts, impose late fees and additional interest charges, and order property inspections and other default-related services. see In re Nosek, 363 B.R. 643 (Bankr. D. Mass. 2007) (awarding $250,000 in actual damages to the debtor for her emotional distress and $500,000 in punitive damages under §105(a) for servicer’s violation of §1322 by diverting plan payments to a suspense account). Legal fees are imposed on debtors for groundless stay relief motions, typically without disclosure to the debtor or court approval.
This breakdown of the servicing system also results in debtors often not being notified of interest-rate adjustments on adjustable-rate mortgages or payment changes on escrow accounts. It is not uncommon for debtors who successfully complete their chapter 13 plans to receive a bill for thousands of dollars of previously undisclosed improper fees once they emerge from bankruptcy. For example, in In re Dominique, 368 B.R. 913 (Bankr. S.D. Fla. 2007), the servicer failed to send escrow account statements during the chapter 13 plan and, just before plan completion, provided debtors with an escrow account review showing that a $6,397 escrow deficiency was owed. see also In re Jones, 366 B.R. 584 (Bankr. E.D. La. 2007) (mortgage creditor collected additional $24,450 in unlawful post-petition fees and interest charges at closing on court-approved refinancing).
Making Use of §524(i)
A new and specific cause of action to remedy plan payment application problems was created by BAPCPA. Under §524(i), a creditor’s willful failure to properly credit payments received under a confirmed plan constitutes a violation of the injunction under §524(a).3 To make use of §524(i), the debtor’s chapter 13 plan must contain precise language directing how payments are to be applied. In other words, §524(i) is not self-executing and can only be invoked if the debtor proves that the creditor failed to “credit payments in the manner required by the plan.”
Courts may wish to take a fresh look at model plans, local rules and plans proposed by debtors to ensure that the intent of Congress in enacting §524(i) is implemented. While there are many different ways to approach these issues, and several courts have already taken on this task, several sample plan provisions are discussed below.
Section 5240) Chapter 13 Plan Provisions
Effect of Cure
This first provision specifies how ongoing post-petition payments received by the mortgage creditor are to be applied under the terms of the plan:
* Post-petition Mortgage Payments. Payments received by holders and/or servicers of mortgage claims for ongoing post-petition installment payments shall be applied and credited to the debtors’ mortgage account as if the account were current and no pre-petition default existed on the petition date in the order of priority specified in the note and security agreement and applicable nonbankruptcy law. Post-petition installment payments made in a timely manner under the terms of the note shall be applied and credited without penalty.
Consistent with case law interpreting § 1322(b)(5), this provision requires the creditor to override its regular payment application regime of applying payments to the first installment due. see In re Jones, 366 B.R. 584 (Bankr. E.D. La. 2007) (confirmation of plan providing for cure “recalibrates” amounts due as of petition date). It also requires the creditor to apply payments in the customary order of priority under the terms of the mortgage,4 and recognizes that late fees may be charged only if post-petition payments are not made timely.5 A similar plan provision approved in In re Collins, 2007 WL 2116416 (Bankr. E.D. Tenn. July 19, 2007), requires the mortgage creditor to “apply the post-petition monthly mortgage payments paid by the trustee or by the debtors to the month in which each payment was designated to be made under the plan or directly by the debtors…”
Another approach approved by the court in In re Jones, 2007 WL 2480494 (Bankr. E.D. La. Aug. 29,2007), focuses on the bifurcation required by a cure plan and specifies that the debtor’s mortgage account shall be “divided into two new, internal administrative accounts.” The first account consists of the amounts to be disbursed under the plan for the pre-petition arrearage. The second account is the principal amount due on the petition date, and includes post-petition interest accrual and escrow expenses.6 The plan would then provide that the “debtor’s regular monthly note payments will be posted to this [second] account, reducing post-petition interest accrual, post-petition property and tax expenditures, and principal.” Id. at *5.
Escrow and ARM Issues
The next provision attempts to avoid the problem of debtors being surprised by large, catch-up bills after emerging from bankruptcy for amounts the creditor was entitled to based on escrow and interest rate changes but which were never disclosed:
* Post-petition Payment Changes. Holders and/or servicers of mortgage claims shall make adjustments to the ongoing installment payment amount as required by the note and security agreement and applicable nonbankruptcy law, including changes based on an escrow analysis for amounts required to be deposited in any escrow account or based on an interest rate provision in an adjustable-rate mortgage. Holders and/or servicers shall timely notify the debtors, debtors’ attorney and trustee of such payment adjustments and any shortage, deficiency or surplus of funds in any escrow account.
This provision simply requires mortgage creditors to service the loan in the customary manner as they would for homeowners outside of bankruptcy. Based on the Real Estate Settlement Procedures Act, this would mean performing an annual escrow analysis and notifying borrowers of any changes in escrow deposits and balances at least once per year within 30 days of the analysis.7 The creditor must also inform the debtor if there are insufficient funds in the escrow account.8 For adjustable-rate mortgages based on the Truth in Lending Act, it would require notification of payment amount changes at least 25 days before the due date for the new payment amount.9 A similar plan provision was approved by the court in Collins, 2007 WL 2116416, supra at *18, requiring notice not less than 60 days in advance of the effective date of any payment change.
Compliance with RESPA and TILA during a chapter 13 case promotes successful plan completion and is consistent with § 1322(e), which states that the amount necessary to cure a default in a chapter 13 plan shall be determined in accordance with the “underlying agreement and applicable nonbankruptcy law.” Applicable nonbankruptcy law includes federal nonCode statutes such as TILA and RESPA, and a determination of the cure amount includes consideration of ongoing postpetition payments based on § 1322(b)(5) and its reference to the “maintenance of payments while the case is pending.”
Separate Treatment of Arrearages
The next provision deals with the payment of the pre-petition arrearages and compels the mortgage creditor to separately treat these payments:
* Pre-petition Arrearages. Payments disbursed by the trustee to holders and/or servicers of mortgage claims shall be applied and credited only to the pre-petition arrearages necessary to cure the default, which shall consist of amounts listed on the allowed proof-of-claim and authorized by the note and security agreement and applicable nonbankruptcy law. Holders and/or servicers of mortgage claims shall deem the pre-petition arrearages as contractually current upon confirmation of the plan.
A mortgage account being cured in a chapter 13 is not fully reinstated until the pre-petition arrearage has been paid. In re Wilson, 321 B.R. 222 (Bankr. N.D. Ill. 2005). To effectuate a cure plan and avoid the imposition of late fees and other charges, however, it is critical that the mortgage creditor segregate payments being made on the pre-petition arrearage and treat the arrearage amounts as if they are not in default. In rejecting an argument that such a plan provision was an impermissible modification under § 1322(b)(2), the court in Collins 2007 WL 2116416, supra at *14, stated:[A] provision requiring [creditor] to ‘deem’ the pre-petition arrearage amounts contractually ‘current’ as of confirmation is merely procedural and requires only that [creditor] update its accounting procedures to ensure that the debtors’ account is not subject to any additional charges associated with any pre-petition default.
This provision does not take a position on whether certain fees may be properly included in the arrearage amount, such as post-petition, preconfirmation bankruptcy fees. Some courts have held that the inclusion in a proof-of-claim of attorney fees incurred in connection with a bankruptcy case that are to be paid from estate property is improper unless the fees have been sought and approved under Federal Rule of Bankruptcy Procedure 2016. see, e.g., In re Tate, 253 B.R. 653 (Bankr. W.D .N .C. 2000). The more widely accepted position as to post-petition, preconfirmation fees, however, is that a creditor may include such fees in a proof-of-claim without filing a Rule 2016 application if the claim is sufficiently detailed and provides adequate notice to the debtor. In re Atwood, 293 B.R. 227 (B.A.P. 9th Cir. 2003) (proof-of-claim lacking specific detail fails to meet creditor’s evidentiary burden on reasonableness of fees); In re Madison, 337 B.R. 99 (Bankr. N.D. Miss. 2006); In re Powe, 281 B.R. 336 (Bankr. S.D. Ala. 2001).
The more significant concern has been with the lack of disclosure of postconfirmation fees.10 The final provision sets up a procedure that mandates disclosure of such fees and provides interested parties with an opportunity to seek a court determination on the allowance of such fees:
* Mortgage Current upon Discharge. The holder and/or servicer of a mortgage claim shall provide to the debtors, debtors’ attorney and trustee a notice of any fees, expenses or charges that have accrued during the bankruptcy case on the mortgage account and that the holder and/or servicer contends are (1) allowed by the note and security agreement and applicable nonbankruptcy law, and (2) recoverable against the debtors or the debtors’ account. The notice shall be sent annually, beginning within 30 days of the date one year after entry of the initial plan confirmation order, and each year thereafter during the pendency of the case, with a final notice sent within 30 days of the filing of the trustee’s final account under Bankruptcy Rule 5009. The failure of a holder and/or servicer to give such notice for any given year of the case’s administration shall be deemed a waiver for all purposes of any claim for fees, expenses or charges accrued during that year, and the holder and/or servicer shall be prohibited from collecting or assessing such fees, expenses or charges for that year against the debtors or the debtors’ account during the case or after entry of the order granting a discharge. Unless the court orders otherwise, an order granting a discharge in this case shall be a determination that all prepetition and post-petition defaults with respect to the debtors’ mortgage have been cured, and that the debtors’ mortgage account is deemed current and reinstated on the original payment schedule under the note and security agreement as if no default had ever occurred.
Mortgage creditors may argue that this provision amounts to an impermissible modification in violation of § 1322(b)(2), namely with respect to the clause likely to be found in the security agreement permitting the creditor to “do and pay for whatever is reasonable or appropriate to protect lenders’ interest in the property and rights under this security instrument.”” However, consistent with the opinion in Mann v. Chase Manhattan Mortgage Corp., 316 F.3d 1 (1st Cir. 2003), this provision does not prohibit the creditor from tracking in its internal bookkeeping fees it believes may be assessed to the debtor’s account. The provision simply requires the creditor to notify the debtor and interested parties if it intends to charge the debtor for such fees and recognizes that any attempt to collect such fees during the case without notification would violate the automatic stay, and after the case would violate the discharge injunction (and §524(i)) if the debtor successfully completes the case and obtains a discharge. It also makes clear that successful completion of the plan fully reinstates the mortgage account.12
For post-confirmation attorneys fees charged to the debtor’s account, some courts may take the view that mere disclosure in this manner is not sufficient and that court approval and compliance with Bankruptcy Rule 2016 is required.13 Courts may also wish to specify by local rule the type of notice that should be provided and the procedure for affording parties with an opportunity to object to any disclosed fees. For example, as an alternative to imposition of punitive damages against a mortgage creditor, the court in In re Jones, supra at *6,2007 WL 2480494, approved a procedure that would require that an annual notice from the creditor be filed with the court and “contain an itemization describing the charge, amount provisionally incurred, the date incurred, and if relevant, the name of the third party to whom the charge was paid,” and the legal authority for assessing each charge. The procedure in Jones also gives the debtor, trustee and interested parties 30 days to object to any fees contained in the notice, and describes various methods for the payment of approved fees.
Another approach adopted by several courts requires the trustee to serve on the mortgage creditor, the debtor and the debtor’s attorney, shortly after the final payment under the plan, a notice stating that the cure amount has been paid and that all pre-petition arrearage obligations have been satisfied by the debtor. see In re Andrews, 2007 WL 2793401 (Bankr. D. Kan. Sept. 26, 2007); In re Jones, supra, 2007 WL 2480494; In re Collins, supra, 2007 WL 2116416; In re McDonald, supra, 336 B.R. 380. If the mortgage creditor does not file a statement itemizing outstanding payment obligations it contends are still owing, the creditor is required to treat the account as reinstated. The primary disadvantage of this method, rather than an annual disclosure requirement, is that the debtor may not have an ability to provide for payment (or plan modification) of any fees and charges which have accumulated by the end of the case if they are ultimately found permissible.
In conclusion, there are certainly different and better ways to address these issues than the sample plan provisions provided here. Importantly, though, a process should begin, if not started already, to formulate plans that avoid the problems that have plagued cure plans for the past 30 years. Courts that have approved model chapter 13 plans should convene local rules committees or working groups to consider modifications that will make cure plans work the way they were intended and carry out the intent of Congress in implementing §524(i).
1 There have been recent encouraging signs of progress. In addition to court approval of plan provisions implementing §524(i), the NACTT is also working with several major servicers to develop a set of best practices.
2 The House Report to the Bankruptcy Reform Act of 1994 reaffirms that this is the intent of Congress. see H.R. Rep. No. 835, 103d Cong., 2d Sess. 55 (1994) reprinted in 1994 U.S.C.C.A.N. 3340 (“It is the committee’s intention that a cure pursuant to a plan should operate to put the debtor in the same position as if the default had never occurred”).
3 Section 524(i) provides a response to decisions that had questioned whether bankruptcy court authonty exists to remedy a creditor’s failure to credit post-petition payments properly. For example, it provides a remedy found missing in Telfair v. First Union Mortgage Corp., 216 F.3d 1333 (11th Cir. 2000).
4 For post-January 2001 Fannie Mae/Freddie Mac uniform instruments, the order of application of payments is (1) interest, (2) principal, (3) escrow, (4) late fees and (5) any other charges due under the security Instrument.
5 See In re Perez, 339 B.R. 385 (Bankr. S.D. Tex. 2006) (finding that home mortgage payment procedures and uniform plans approved in districts that limit assessment of post-petition late fees was not impermissible modification of mortgage holder’s rights).
6 To avoid double payment, the principal amount should be based on the original amortization as if the account were current on the petition date since the arrearage amount typically includes the entire past due installment payments that provide for payment of principal. A similar analysis of the post-petition escrow payments must be done to avoid double payment of pre-petition escrow charges. see In re McCormack, 203 B.R. 521 (Bankr. D. N.H. 1996) (noting that escrow account must be “zeroed out” post-confirmation to exclude any pre-confirmation amounts being paid under the plan).
7 12 U.S.C. §2609.
8 Several courts have held that a servicer’s failure to notify debtors during the plan of escrow account shortages and deficiencies as required by RESPA amounts to a waiver of the servicer’s right to collect those amounts. see Chase Manhattan Mortg. Corp. v. Padgett, 268 B.R. 309 (S.D. Ra. 2001); In re Dominique, 368 B.R. 913 (Bankr. S.D. FIa. 2007).
9 12 C.F.R. §226.20(c).
10 In re Sanchez, 372 B.R. 289, 297 (Bankr. S.D. Tex. 2007) (“In order for the bankruptcy system to function, every entity Involved in a bankruptcy proceeding must fully disclose all relevant facts”); In re Jones, 366 B.R. 584,602-03 (Bankr. E.D. La. 2007) (“Bankruptcy courts cannot function if secured lenders are allowed to assess post-petition fees without disclosure and then divert estate funds to their satisfaction without court approval.”).
11 See, e.g., Fannie Mae/Freddie Mac Uniform Instruments, First Lien Security Instruments, at www.freddiemac.com/uniform/unifsecurity.html.
12 See also In re McDonald, 336 B.R. 380, 386 (Bankr. N.D. III. 2006) (referring to model plan approved in district which provides: “If the debtor pays the cure amount..while timely making all required post-petition payments, the mortgage will be reinstated according to its original terms, extinguishing any right of the mortgagee to recover any amount alleged to have arisen prior to the filing of the petition”).
13 See in re Padilla, 2007 WL 2264714 (Bankr. S.D. Tex. Aug. 3, 2007) (finding that court has authority under §105(a) to order disgorgement of post-confirmation fees charged to debtors without proper Rule 2016 application or in violation of the confirmed plan); In re Sanchez, 372 B.R. 289 (Bankr. S.D. Tex. 2007) (holding that creditor’s failure to disclose post-confirmation fees charged to debtor and to file fee application under Rule 2016 violated automatic stay).
National Consumer Law Center; Boston
About the Author
John Rao is an attorney with the National Consumer Law Center and focuses on consumer credit and bankruptcy issues.
Copyright American Bankruptcy Institute Feb 2008
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