Daily Development for April 18, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri dirt@umkc.edu

This “occasional” DD is from Cheryl Kelly of the Thompson Coburn firm of St. Louis, Mo.

BANKRUPTCY; CHAPTER 13; CRAM DOWN; LIENS SECURED BY PRINCIPLE RESIDENCE: Third Circuit holds that the Bankruptcy Code’s protection against modification of a claim secured by a debtor's principal residence is not lost when the mortgage instrument includes as additional security an assignment of rents and a pledge of an escrow fund for taxes and insurance.

1st 2nd Mortgage Co. of NJ, Inc. v. Ferandos (In re Ferandos); 2005 WL 627747 (3rd Cir., 3/18/05)

Section 1322(b)(2) of the Bankruptcy Code authorizes a debtor to "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." (emphasis added).

The residence of the Chapter 13 debtor here was encumbered by first and second priority mortgages.  The junior mortgage included an assignment of rents were assigned as additional security for the indebtedness.  The junior mortgage also required the establishment and funding of an escrow account to pay property insurance premiums and taxes, and included a pledge of the funds deposited into the account as additional security for the mortgage indebtedness.  The fair market value of the debtor’s home did not exceed the outstanding balance of the indebtedness secured by the first mortgage.  The debtor argued that the assignment of rents provision in the junior mortgage and the pledge of the escrow account rendered the second mortgage loan ineligible for Section 1322(b)’s anti-modification protections, thereby permitting the debtor to “cram-down” the second mortgage loan (treat the undersecured portion of the claim as unsecured) under otherwise applicable provisions of the Bankru!

 ptcy C
The Bankruptcy Court for the District of New Jersey ruled in favor of the debtor, finding that because the second mortgagee’s claim was secured by property in addition to the residence, Section 1322(b)(2)’s protection respecting loans secured solely by “residential real property” did not apply.  The District Court affirmed the Bankruptcy Court.  The 3rd Circuit, in a decision considering issues of first impression in that Circuit,  reversed and remanded.

The Third Circuit panel noted a line of cases in which the "grant of [any] additional collateral sealed the mortgagee's fate”, insofar as qualification for the Section 1322(b) protections is concerned.  The Court distinguished those cases from the one at bar in that they involved loans secured not only by real property but also by personal property such as appliances, machinery, furniture, and equipment on the premises.

The Court additionally noted another line of cases attempting to categorize collateral for Section 1322(b)(2) purposes in an effort to give effect to the perceived intent of Congress that the expectations of home lenders not be thwarted.  To the court,  the "real inquiry," should be "whether the assignment of rents was a grant of a lien on real property, and whether a security interest in the escrow ever existed as a matter of law."  If the lender's claim is secured by assets other than the residential real property, Section 1322(b)(2)'s anti-modification protection clearly does not apply:  "Congress has written the provision in a way that leaves little room for disagreement as to its meaning, and when language granting additional personal property collateral is included in the mortgage, and is effective to grant an interest in such collateral, the mortgagee is at its peril in not deleting it".

Applying New Jersey law relevant to the question, the Court concluded that rents are real property, and that, consequently, the acceptance by the mortgagee here of an assignment of rents as additional security, did not disqualify it from Section 1322(b)’s protections.  With respect to the funds held in escrow, the Court described these as "simply not akin to property whose value is applied by mortgagees in the event of default to pay down the outstanding debt."  Further in the Court’s view, once funds are deposited into escrow, the mortgagor has no further interest in them under New Jersey law, such that a grant of a security interest in such funds is “meaningless and [as a matter of law] conveyed essentially no interest at all."

Reporter’s Comment 1: This case appears correctly decided given the characterization, under applicable state law, of “rents” as realty, and escrowed funds as no longer property of the debtor that can be subjected to a security interest.  Whether every state would characterize the property in question the same way as New Jersey apparently does is a matter for mortgagees to consider in “localizing” their forms of mortgage.

Mortgagees are additionally wise to heed the Court’s words of warning respecting the ease with which the anti-modification protections may be lost by inadvertently including collateral that is not “real property” under applicable state law.

Reporter’s Comment 2:  Query whether, as the Third Circuit suggests, mortgage lenders view funds held in escrow as not akin to property to which recourse would be expected in the event of a default.

Editor’s Comment: The editor hates cram downs as much as the next real estate lawyer, but how can we conclude that there is no interest of the debtor in tax and insurance escrows?  If the escrowed money earns interest (as required in some states) or if it otherwise contains a surplus after taxes and insurance are paid - such as when estimated tax or insurance premiums prove too high - isn’t this the mortgagor’s money?  If,  when such surplus arises, the mortgagor is otherwise in default on the mortgage, does the mortgagee expect to be able to apply such surplus as security?  That would appear to be the probable intent of the security language.

The opinion repudiates earlier decisions that hold that a merely “incidental” security interest in personal property will not disqualify the anti-modification protection.  It says that if there is any security interest in personal property, the protection is lost.

The mortgage said that the tax and insurance monies were “pledged as additional security for the sums secured by this mortgage.”  The court seems to have completely overlooked the possibility that these funds might contain monies that are not necessary to pay taxes and insurance.  But the mortgagee clearly did not overlook that possibility, and sought to reach these funds as additional security.  The next lender may not be so lucky as the lender here.

If lenders are interested in drafting a “modification proof” mortgage,  they ought to be restricting their interest in these escrowed funds to the right to apply them for the dedicated purpose of paying taxes and insurance.  The reasoning of the Third Circuit will not otherwise protect them.

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