Court Nixes Cram Downs But Exceptions Remain

Attorneys Ben-Ezra and Perlin take lenders on a tour of the Supreme Court's decisions that protect lenders from a "cram down" of mortgages in bankruptcy proceedings - and look at some of the exceptions that might allow a homeowner to obtain a "cram down."

The United States Supreme Court's decision in Nobelman v. American Savings Bank, 508 U.S. 324, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993), held that a Chapter 13 debtor may not modify (or "strip down") a partially secured home loan. This is a significant case for residential mortgage lenders because it carves out a significant exception to the general bankruptcy rule allowing debtors to modify secured debts. We have discussed Nobelman and some of the subsequent cases previously. However, a recent court of appeals decision compels us to revisit this subject.

To review, Section 1322(b)(2) of The Bankruptcy Code permits a Chapter 13 debtor's plan to modify the rights of holders of secured claims. That statute, however, includes an "anti-modification" provision that prohibits modification of claims "secured only by a security interest in ...debtor's principal residence." Clearly, the anti-modification provision prohibits modification of wholly secured claims. The question in Nobelman was whether it also prohibits modification of the under-secured portion of a partially secured claim.

In Nobelman, the debtors had borrowed $68,000 to purchase their home. Six years later they declared bankruptcy. The lender filed a claim with the bankruptcy court for $71,000, the amount then due. At the time of the bankruptcy, the debtors claimed that the value of the apartment had declined to a mere $23,000. Technically speaking, the lender's claim was "secured" only up to the value of the apartment, the sole collateral for the loan. The lender's claim was under-secured by $48,000. The debtors argued that to the extent the claim was under-secured, it was not protected by the anti-modification provision of Section 1322(b)(2).

The Supreme Court disagreed. It said that where a mortgage is only partially secured, Section 1322(b)(2) would nonetheless, exempt the entire loan from modification. Thus, the debtors were not permitted to modify the claim. In a concurring opinion, one justice explained that in enacting Section 1322, Congress intended to give residential mortgages favorable treatment. The goal was "to encourage the flow of capital into the home lending market." This goal was accomplished, at least in part, by disallowing modification of debt secured exclusively by a borrower's residence.

Two years ago, the Eleventh Circuit Court of Appeals limited the reach of the anti-modification provision. In Tanner v. Firstplus Financial, Inc., 217 F.3d 1357 (11th Cir. 2000), the court restricted the modification exemption to cases, like Nobelman, in which the mortgage remained partially secured. Tanner held that where a second mortgage is wholly unsecured (for example, if the amount due on a prior mortgage exceeds the value of the home), the debtor may modify the claim. By way of illustration, if under the Nobelman facts, there had been a second mortgage also secured by the debtor's apartment, that second mortgage would have been wholly unsecured because the value of the home was less than that owed under the first mortgage. Under the rule of the Tanner court, Section 1322(b) would allow modification of this second mortgage.

This August, the Eleventh Circuit recognized another exception to the anti-modification provision. American General Finance, Inc. v. Paschen, 296 F.3d 1203 (11th Cir. 2002). In Paschen, the court interpreted another subsection of Section 1322. Subsection (c) was enacted in 1994. It provides, in part:

"Notwithstanding subsection (b)(2) ... in a case in which the last payment on the original payment schedule for a claim secured only by a security interest in real property that is the debtor's principal residence is due before the date on which the final payment under the plan is due, the plan may provide for the payment of the claim as modified..."

The debtors in Paschen argued that this new subsection allowed the modification of the unsecured portion of a partially secured short-term mortgage. As indicated by the quoted language from the statute, a short-term mortgage is one that matures prior to the completion of the proposed Chapter 13 plan. The court agreed with the debtors, and held that in enacting subsection (c), Congress partially overruled Nobelman.

Again, applying this holding to the Nobelman facts, if the mortgage in Nobelman were to have matured prior to the completion of the proposed Chapter 13 plan, the debtors would have been allowed to modify the unsecured portion of the debt - that is the total amount of the debt beyond the $23,000 value of the apartment. While Nobelman explicitly held that this unsecured portion was not modifiable, it was not dealing with a short-term mortgage. And, to the extent that Nobelman did not distinguish between short-term and long-term mortgages, Paschen says that Congress overruled the Supreme Court's holding.

To summarize, Section 1322(b)(2) unambiguously provides that a wholly secured mortgage on a debtor's principal residence may not be modified by the debtor's Chapter 13 plan. The rule of Nobelman extends the anti-modification provision to partially secured mortgages on a debtor's primary residence. Tanner prevented the further expansion of the anti-modification provision. It held that even if a mortgage is "secured" by the debtor's principal residence, the debtor can modify the lender's claim if that claim is wholly unsecured (for example where the amount secured by prior mortgages exceeds the value of the residence). Finally, Paschen recognized that Congress rolled back Nobelman, and held that the anti-modification provision would not protect any unsecured portion of a partially secured short-term mortgage.

One final caveat: The Tanner decision preceded Paschen by two years, almost to the day. In a footnote, Tanner anticipated the holding of Paschen, and at the same time, indicated that under the new subsection (c), balloon mortgages would receive similar treatment to short-term mortgages. This portion of the opinion is not binding, however, it is a clear signal as to how courts should treat partially secured balloon mortgages.

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