Thursday, March 19, 2009

The Bankruptcy Reform Rube Goldberg Device

The Bankruptcy Code of 1978 was intended to simplify the law and make it more functional. In most respects, it worked beautifully. The same cannot be said for the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Badly drafted is one of the kinder adjectives applied to it. Now history seems poised to repeat itself. On March 5, 2009, the House passed H.R. 1106, the Helping Families Save Their Homes Act. While the bill’s purposes are laudatory, its drafting is tortured. This article will walk you through the bankruptcy-related provisions of the bill section by section. If you want to skip ahead to the good stuff, start with Section 103.

Section 100 Definition

The first thing that the bill does is introduce a definition of “qualified loan modification.” We later learn that this definition has almost nothing to do with modifying mortgages in bankruptcy and amounts to little more than legislative clutter. To further complicate things, the definition of a “qualified loan modification” is tied to “the guidelines of the Obama Administration’s Homeowner Affordability and Stability Plan as implemented March 4, 2009.” Thus, a definition in the Bankruptcy Code is tied to a non-legislative document. However, it does get President Obama’s name permanently added to the Bankruptcy Code.

Section 101 Eligibility for Relief

The next thing that the bill does is eliminate certain home mortgage debts from the chapter 13 debt limits. The bill eliminates any home mortgage or debt that was previously secured by a home which was foreclosed upon if the value of the home was less than the applicable debt limits. While this provision isn’t entirely clear, I think that it means that if a home mortgage is less than $1,010,650, that debt is not included in calculating eligibility for chapter 13, so that a debtor can have an additional $1,010,650 in secured debts and still file for chapter 13. This is an interesting idea, but what problem is it solving? If the problem is that some homeowners don’t qualify for chapter 13 because their home mortgages exceed $1,010,650, wouldn’t it be easier just to raise the debt limits?

Section 102 Prohibiting Claims Arising from Violations of the Truth in Lending Act

The third substantive bankruptcy provision of the bill allows a claim to be denied if the debtor could have rescinded the loan based upon a truth in lending violation. While this is certainly a good result, how does this add anything to Sec. 502(b)(1) which allows a claim to be denied because it is unenforceable against the debtor?

Sections 103 and 105 Authority to Modify Certain Mortgages

Finally, six pages into the bill, we get to the heart of the matter. Section 103 contains the major terms allowing modification of home mortgages in chapter 13. The section modifies Sec. 1322, which is the permissive list of provisions which may be included in a chapter 13 plan by adding four new subsections. The new subsections go on for nearly seven pages and contain a lot of material to digest. Additionally, Section 105 modifies section 1325, which contains the requirements for confirmation of a plan.

Eligibility

In order to be eligible for modification, proposed Sec. 1322(b)(11) states that a loan must be “originated before the effective date of this paragraph and secured by a security interest in the debtor’s principal residence that is the subject of a notice that a foreclosure may be commenced with respect to such loan.” This provision reflects two interesting policy choices. First, it only applies to loan originated before the effective date of the bill. Thus, no future mortgages will be subject to modification. If mortgage modification is a good idea, why limit it to only pre-existing mortgages? One possible answer is that the bill is intended to encourage lenders to make new loans, secure in the knowledge that they will not be subject to modification. However, since Congress can always modify the provision, it seems like this is a bit illusory. The other curious choice about eligibility is that a mortgage must be the subject of a foreclosure notice before it can be modified in a bankruptcy. Thus, if a debtor has been keeping his mortgage current by borrowing against credit cards or from relatives and reaches the point where he can’t go on, he would not immediately be able to file chapter 13 and restructure the mortgage. On the other hand, a debtor who stopped paying his mortgage to finance a trip to Las Vegas would be able to secure a modification. It seems like a questionable decision to deny relief to someone who has made an honest effort to pay his debts, while granting it to his more profligate neighbor.

To make things more complicated, there is a second eligibility provision a few pages later in proposed Sec. 1322(h). For a case commenced more than 30 days after the effective date of the bill, the debtor must certify that that he contacted his lender and provided it with documentation equivalent to Schedules I and J and then “considered any qualified loan modification offered to the debtor by the holder of the claim.” Of course, all the debtor has to do is “consider” the offer so it doesn’t offer much protection to the lender. In the alternative, the debtor may certify that the property was subject to a foreclosure sale scheduled to be held within 30 days. Since the property already has to be subject to a foreclosure notice (as contrasted with a scheduled foreclosure sale) in order to be eligible under the first eligibility section, it is unlikely that the requirement to ask the lender for a pre-foreclosure modification contains any teeth. However, with regard to a case already pending, before the debtor may submit a plan proposing to modify a loan or propose to modify an existing plan to modify a loan, the debtor must certify that he “attempted to contact the holder of such claim (or the entity collecting payments on behalf of such holder) regarding modification of the loan that is the subject of such claim.” This requirement is pretty toothless as well, since all the debtor need do is certify that he attempted to contact the lender regarding modification. Thus, a debtor could certify that one hour prior to filing his motion to modify, he sent the lender an email requesting that the loan be modified to eliminate the requirement to make payments. That would comply with the technical language of the statute.

Why place the eligibility provisions in two different places? Cue up Avril Lavigne singing “Why do you have to make things so complicated?”

If a debtor is eligible, he can choose from the following menu of modifications:

Valuation

First, she can provide for payment of the secured claim as provided by Sec. 506(a)(1), that is, write the mortgage down to the value of the property. However, we learn in subsequent section 1322(i) that valuation under Sec. 506(a)(1) “shall be the fair market value of such residence on the date such value is determined and, if the issue of value is contested, the court shall determine such value in accordance with the appraisal rules used by the Federal Housing Administration.” Thus, we are using Sec. 506(a)(1) for valuation, but this section shall have a special meaning applicable only to valuing home mortgages.

If the property is sold during the life of the plan, the debtor must share any gain with the lender based upon a sliding scale. If the property is sold in the first year of the plan, then the lender receives 90% of the difference between the sales price (after subtracting cost of sale and the value of improvements made) and the amount of the secured claim as determined under Sec. 506(a)(1). By year 5, the lender’s share of the gain is limited to 10% of the excess.

Interest Rates

Second, a debtor may convert an adjustable rate loan into a fixed rate loan or make adjustments to the manner in which the adjustable rate is calculated. Additionally, another provision allows the debtor to adjust the interest rate to a fixed rate based on the “currently applicable average prime rate offer as of the date of the order for relief under this chapter corresponding to the repayment term determined under the preceding paragraph as published by the Federal Financial Institutions Examination Council in its table entitled ‘Average Prime Offer Rates—Fixed’ plus a reasonable premium for risk.” Why have two different sub-parts dealing with setting the interest rate, especially when the provision allowing tinkering with adjustable rates is completely unnecessary in light of the later provision allowing a fixed rate. By tying the interest rate to a rate announced in a specific table of a specific publication, Congress runs the risk that it will have to amend the bill if the publication ever goes away or is changed. For example, what happens if the Federal Financial Examination Council changes its name to the Federal Lending Institution Council? Is there still an applicable rate? Further, the use of a specified rate is undercut somewhat by allowing the addition of a “reasonable” risk premium. Wouldn’t it just be easier to use the Till standard for interest rates?

There is also a provision stating that on request of the debtor or a senior secured creditor, the court can confirm a plan which reduces the interest rate but does not reduce the principal amount of the debt “provided the total monthly mortgage payment is reduced to a percentage of the debtor’s income in accordance with the guidelines of the Obama Administration’s Homeowner Affordability and Stability Plan as implemented March 4, 2009 if, taking into account the debtor’s financial situation, after allowance of expenses that would be permitted for a debtor under this chapter subject to paragraph (3) of subsection 9b), regardless of whether the debtor is otherwise subject to such paragraph, and taking into account additional debts and fees that are to be paid in this chapter and thereafter, the debtor would be able to prevent foreclosure and pay a fully amortizing 3-year loan at such reduced interest rate without such reduction in principal.” Wouldn’t it just have been easier to say that a debtor cannot reduce principal if a reduction in the interest rate would be enough to grant relief to the debtor?

Reamortization

Third, the debtor may reamortize the loan to provide for a term not to exceed 40 years from its origination.

Trustee Payments

Proposed Sec. 1322(b)(11)(D) allows for a modified mortgage to be paid either directly to the lender or through the Chapter 13 trustee. If payments are made directly through the standing trustee, the trustee’s commission on the mortgage payments will be reduced to 4% or may be waived altogether if the debtor’s income is less than 150% of the poverty threshold.

Good Faith

Proposed Sec. 1325(a)(11) imposes a special good faith requirement applicable only to mortgage modifications in chapter 13. In order to confirm a plan providing for modification of a mortgage, the court must find that “such modification is in good faith.” Of course, Sec. 1325(a)(3) already requires that the entire plan be proposed in good faith, so that this requirement must require really good faith. The statute proceeds to tell us what really good faith is and is not. It is not good faith if the debtor proposes to modify a mortgage which he could afford to pay without modification. Additionally, in deciding whether the debtor acted in good faith “the court shall consider whether the holder of such claim (or the entity collecting payments on behalf of such holder) has offered to the debtor a qualified loan modification that would enable the debtor to pay such debts and such loan without reducing such principal amount.” Also, the court must find that “the debtor has not been convicted of obtaining by actual fraud the extension, renewal or refinancing of credit that gives rise to a modified claim.”

The new requirements for good faith modifications raise several issues. Good faith is a term which is not defined anywhere in the Code, but has an established meaning. By adding a definition here, is Congress intending to define good faith elsewhere in the Code or is this a special subset of good faith applicable only to this subsection? Considering whether the debtor rejected a reasonable proposal from the lender and whether the debtor needs to modify the loan in order to be able to pay his debts both make good sense. However, what to make of the provision that the debtor is not acting in good faith if he has been convicted of fraud with respect to the loan? Do we really need to put this in a statute or isn’t it obvious? Further, by providing that the debtor acted in bad faith if he was convicted of fraud, it suggests that it would not be bad faith if the debtor acted fraudulently but was never prosecuted or even was indicted but hadn’t been convicted yet.

Section 104 Combating Excessive Fees

Wedged inbetween sections 103 and 105, which contain the mortgage modification provisions, is section 104 which establishes a new procedure for establishing the reasonableness of post-petition fees and charges assessed to a debtor. Under this section, the debtor, the debtor’s property and the property of the estate are not liable for a fee, cost or charge incurred while the case is pending unless (i) the creditor serves a notice of the charges on the debtor, debtor’s attorney and chapter 13 trustee not later than one year after the charges are incurred or less than 60 days before the case is closed, (ii) the charges are law, reasonable and authorized by the applicable security agreement; and (iii) secured by property worth more than the amount of the claim. Failure to follow the procedure would result in waiver of the charge and any attempt to collect the charge would subject to the lender to liability for violation of the automatic stay or discharge. The section also provides for waiver of prepayment penalties on claims secured by the debtor’s principal residence.

Section 108 Effective Date

The statute would take effect upon enactment and would apply to cases filed before, on or after that date. As a result, debtors with pending cases could go back and modify their plans under this legislation.

What Are The Lessons Here?

What can we learn from this confusing bill? A few lessons for drafting emerge.

1. Don’t add unnecessary definitions to Sec. 101of the Bankruptcy Code. It is too long and confusing as it is.

2. Don’t tie definitions in Title 11 to executive branch documents. While H.R. 1106 does this with the Obama Administration’s Homeowner Affordability and Stability Plan and the Federal Financial Institutions Examination Council’s table entitled “Average Primate Offer Rates—Fixed,” BAPCPA made the same mistake when it incorporated the IRS collection standards. There are two problems here, one practical and one substantive. The practical problem is that tying legislation to outside sources requires the reader to consult another document in order to understand the legislation. The substantive problem is that the legislative branch is effectively allowing the executive branch to define the content of a statute. This raises important separation of powers issues.

3. Don’t rely on a complicated solution when a simple one will do because there may be unintended consequences. In Sec. 101, the bill excludes home mortgages from the chapter 13 eligibility limits. This means that a debtor could file chapter 13 even though he had a million dollar home and a million dollar vacation home. While that may benefit AIG executives who may face financial hardship from not receiving large bonuses anymore, it doesn’t really help the average homeowner.

4. Don’t add feel-good grounds for objecting to claims in Sec. 502(b) if they aren’t necessary. One of the reasons that the Bankruptcy Code is beginning to resemble the Internal Revenue Code (or the Los Angeles phone book) is that Congress keeps adding minutiae to existing statutes. BAPCPA did this to Sec. 362 and 523. Adding a definition of good faith applicable only to home mortgage modifications is confusing and could change the meaning of the term in other situations as well. Stating that value will be determined according to Sec. 506(a)(1) and then setting specific rules for determining value under that section is confusing and contradictory.

5. Keep similar provisions together. HR 1106 tosses rules for eligibility for mortgage modification and determining interest rates around randomly, requiring the reader to go to multiple locations to figure out how the statute works.

6. Don’t come up with a complicated solution when a simple one is available. The Supreme Court provided a standard for calculating interest rates in bankruptcy which was elegant in its simplicity. Rather than using the existing concept, HR 1106 requires the reader to look up a table published somewhere else and then requires the court to apply a “reasonable” risk premium. Why not just use the prime rate plus an appropriate risk premium. The effort to incorporate the Obama Administration’s Homeowner Affordability and Stability Plan is confusing at best. This Plan factors into the legislation in at least three places. First, it applies in determining eligibility for mortgage modification depending upon whether the lender made a proposal in compliance with the Obama Administration’s Plan and whether the debtor “considered” it. If all the debtor has to do is “consider” a proposal from the lender, wouldn’t it be easier to just say that the debtor has to consider any proposal offered by the lender in good faith? Second, the Obama Plan comes into play in determining whether the debtor’s proposal is made in good faith. Wouldn’t it be easier to just say that the debtor can’t modify the mortgage if the debtor rejected a plan which was at least as generous as the debtor could have obtained in bankruptcy? Finally, the Obama Plan is used in deciding whether the debtor should be allowed to propose a plan which reduces the interest rate but doesn’t reduce principal. Wouldn’t it be easier just to say that the debtor cannot reduce principal if an interest rate reduction would be enough to make the plan work?

7. Don’t include meaningless requirements. Requiring the debtor to “consider” an offer from the lender doesn’t impose a meaningful restriction, since the debtor is free to consider the proposal and then reject it. Similarly, does it really help to say that a debtor who has been convicted of fraud in connection with a loan is not acting in good faith? This will exclude very few debtors while potentially protecting fraudulent actors who managed to avoid a criminal conviction. Thus, the “restriction” lets in more people than it keeps out.

I haven’t had a chance to review the Senate Bill yet. However, if it is as quirky and complex as the House bill, the likelihood that a conference committee could sort out the difficulties or that the resulting product would make any sense are not cause for optimism.

3 comments:

Patches said...

Great post.

I have been following this intently here and on Creditslips.org. We have had quite a few fervent discussion on this subject. From what I gather the HR bill was watered down quite a bit by our "Blue Dog" Democrats. Good grief didn't the 2005 amendment give us enough "good faith tests"? The "Blue Dog" amendment raised the "clawbacks" as well. I like that we finally get to pass "primary" residences through the 506 valuation gate but the "reasonable" rate for risk can confuse things district by district. "Till" although for vehicles was a great way to do things. Vehicles though are exposed to depreciation as opposed to appreciation that most "brick and mortar" homes enjoy. I say just leave the LIBOR average out of it. IT'S London for goodness sake!

The sunset provision I think is fair and totally dispels the "LIE" that the amendment will cause banks to charge additional "risk" premiums to future Mortgages "because they can just run to Bankruptcy court and have them changed" (Republican talking point, such a lie!) Anyway...
As you can see that frustrates me a bit that and the fact that the lobbyists stalled much needed change with the the "hope" fiasco really gets my goat. I read an article that reported that all of the Banking and Mortgage/Servicing lobbyist toasted the "Hope for Homeowners" bill. Ahhhh! Stall, stall stall. It's their M.O.

That said, because of all of this I am seeing more workouts than I have before. As you know though Servicing Companies are not in the Biz of modifying mortgage contracts but to their credit they are doing so in increasing amounts. I think its because of the "stick" that the Bankruptcy amendment poses.

Just a legal assistants take on the whole subject. I like your post on the Judge Schmidt Dec. also. The firm I work for practices out of Corpus.

Patches said...

Oh, ya I forgot I know Katie Porter would like and I like the Excessive fees section. You know we have always had a problem with that stuff in 13s. I didn't really catch on until I read Katie Porters paper on the subject. I mean I have always thought something was up but the paper put two and two together for me. What I like especially is the penalty they assign for those excessive fees. Violation of Stay and Discharge. Awesome. I guess that takes care of the Campbell decision by the 5th cir. reversing the Violation of Stay and Punitive Damage award.

You know, I still see that Mortgage/Servicing Cos. trying to collect for the an Arrearage through the "conduit or Pass Thru" mortgage payment. You have to be really careful when reviewing those POCs. When you call them on it they always take like 2 months to research.

Malibupat said...

My daughter, who has been laid off twice in the last two years--most recently in April--contacted her lender, Wells Fargo, in April about modifying her loan under the Obama's Save Your Home plan. She meets eligibility requirements for the modification as she has a new job and did done everything Wells required to get this done, and has contacted them every week, as required, to find out the status of her loan. She was told not to make any payments while this is in review.

Last evening she made her weekly call to Wells and found out her house was put in foreclosure two days ago and is set for auction on Sept. 1. She has received nothing but statements from Wells over the last few months. Wells will not give her contact info for her case worker, and told her she should receive notification in a day or two of the foreclosure and auction. She can't get anyone to talk with her about the status of her modification except to say it's still in review.

She has $55,000 equity in the house.

According to the Obama program, banks cannot put a house in foreclosure while it is still in review and application for modification automatically puts foreclosure on hold. The bank admits the loan is still in review. What can she do, who can she contact to get this fixed? Is there someone in the government who can intervene on her behalf?

Thank you