by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

BANKRUPTCY; CHAPTER 13; CLAIMS SECURED BY PRINCIPAL RESIDENCE: Mortgage on owner-occupied triplex does not qualify as a claim "secured only by a security interest in real property that is the debtor's principal residence" and therefore can be "stripped down" as part of a Chapter 13 plan. Lomas Mortgage, inc. v. Louis, F2d , (1st Cir., No 95-1956, 4/18/96). Under certain circumstances, a bankruptcy court may "strip down" the claim of a secured creditor so that the portion of the debt treated as "secured" is limited to the current value of the property, while the rest of the claim is treated as an unesecured claim. This, of course, provides the bankruptcy planners with considerably greater flexibility in fashioning a plan that will be be most acceptable to all the various creditors (other than the victim of the "strip"). It also means that the secured lender may get less than full value on its loan even when unsecured creditors are getting paid.

When the Bankruptcy Code was revised in 1978, Mortgage creditors argued to Congress that bankruptcy practices that reduced their expected level of security protection would deterred them from making real estate loans at all. They were not able to prevail completely, but they were able to convince the Congress to make a special exception for home lenders, embodied in Section 1322 (b) (2). The language states that, subject to certain other restrictions, a Chapter 13 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 debtors principal residence. . . " The 1994 Bankruptcy Reform Act extended this protection to Chapter 11 secured creditors. (Section 1123(b)(5).

It was uncertain whether this language restricted the power of a bankruptcy court to "strip down" home loans in Chapter 13 cases, but in the Nobleman case in 1993, the Supreme Court decided that the restriction did apply to strip down practices. Home lenders were protected.

But the protections have been short lived. Bankruptcy courts set right to work narrowly defining the types of loans protected by the section 1322 language. Cases have held, for instance, that loans that were secured by a home and by furniture and other personal property of the borrower were not within the protected class. See, e.g., Hammond v. Commonwealth Mortgage Corp. of America, 27 F.3d 52, (3rd Cir. Pa. 1994). Other cases have held that the inclusion of an assignment of rents clause is the creation of a second security interest, so that the claim in question was not secured "only" by the residential real estate, even when no rents were being generated or anticipated. See, e.g. In re Tallo, 168 B.R. 573 (Bankr. M.D. Pa. 1994).

This case is in the now well established tradition of bankruptcy courts whittling away at secured creditor protections in order to "fatten up" the estate to make a reorganization happen.

The property in question was a "triplex" residence. The mortgage covered the entire property, but the mortgagor resided in only one of the three units. One of the other units was occupied by the debtor's brother, and the third unit was rented out. The lender argued that triplex units are common forms of residential ownership, that the mortgage market treats one-to-four family residences as "single family residential" for purposes of mortgage lending, and that the exception for residential loans ought to apply. Lender also pointed out that to eliminate coverage for such units would deter lenders from making loans in the inner city and favor suburban home lending, a result probably not intended by Congress.

The court responded that the statute does not contain any express numerical limit, and consequently if the court were to find that a single owner occupied unit triggered the protection, then it might be required to apply the protection for lenders on 100 unit apartment complexes if the mortgagor occupied one of the units. It further relied upon an apparent Congressional approval of its reading of the statute in a report regarding the 1994 amendments, which appeared to cite with approval an earlier lower court case reaching the same conclusion.

Comment: The court's point concerning the "slippery slope" application of the statute is well taken. But in other parts of the opinion, the court attempts a "plain language" interpretation of the statute that may prove problematic in other cases. The argument is that the term "only" modifies the entire phrase "by a security interest in real property that is the "debtor's principal residence," and that the word "is" requires complete and exclusive identity bwetween "real property" and "principal residence."

In other words, if the security property is not "only" the principal residence of the debtor, then the protections would not apply. Consider the case of a home office. Does the presence of such an office prevent the premises from being "only" the principal residence of the debtor? What if the debtor engages in child care in the home for compensation? What if the debtor raises prize pansies in the back yard and sells them to local decorators?

Even more to the point, consider the fact that it might be in the best interest of a debtor to initiate such a "non-residential" use prior to declaring bankruptcy, thus undercutting the protections of the statute. Is the lender helpless to protect against such a practice? Is this the Congressional intent?

The court's answer may be simply that Congress should have made its intent more clear. Perhaps it will, ultimately, but not before Section 1322 experiences continued undercutting from judicial interpretation. The "plain language" approach has a "slippery slope" of its own.

Wouldn't it be better to leave to further interpretation the question of what joint uses could occur without defeating the lender's protection, and to restrict the application of the term "only" to the issue of whether the home is the sole security for the loan?

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