4th Cir. Holds Escrow, Other Principal Residence Mortgage Loan Items Not Subject to Chapter 13 Bifurcation

The U.S. Court of Appeals for the Fourth Circuit recently held that “escrow funds, insurance proceeds, or miscellaneous proceeds” are protected by the anti-modification provisions for Chapter 13 bankruptcies as “incidental property” under the definition of “debtor’s principal residence” in the federal Bankruptcy Code.

A copy of the opinion in In re Birmingham is available at:  Link to Opinion.

A debtor filed a voluntary petition for Chapter 13 bankruptcy. One of the claims against the debtor was a mortgage loan secured by a deed of trust on the debtor’s primary residence.  When the debtor filed his original Chapter 13 bankruptcy plan his property was valued at $206,400 and there was an arrearage on the mortgage of $93,386.58.

The debtor’s bankruptcy plan included a cram-down of the mortgagee’s interest in the property.  After a series of objections and amendments to the debtor’s bankruptcy plan, the debtor filed an adversary complaint requesting a declaration that the mortgagee’s claim be treated as a partially unsecured claim subject to modification and bifurcation in his Chapter 13 bankruptcy.

The debtor argued that certain provisions of the deed of trust required collateral other than real property, which the debtor argued would remove the claim from the Bankruptcy Code’s anti-modification protection for mortgage loans secured by the debtor’s principal residence at 11 U.S.C. § 1322(b)(2).

The debtor cited provisions of the deed of trust, involving escrow items, property insurance proceeds, and miscellaneous proceeds.

The mortgagee filed a motion to dismiss the debtor’s adversary complaint, contending that the items referred to in the deed of trust cited by the debtor constituted “incidental property,” which were part of the “debtor’s principal residence” under 11 U.S.C. § 101(13A)(A), and which would not expose the mortgagee’s mortgage loan to a Chapter 13 modification.

The bankruptcy court granted the mortgagee’s motion to dismiss.  The debtor appealed the bankruptcy court’s decision to the U.S. District Court for the District of Maryland, raising the same arguments on appeal, namely that the inclusion of miscellaneous proceeds, escrow funds, and insurance proceeds in the deed of trust constituted a waiver of the anti-modification provision of 11 U.S.C. § 1322(b)(2).

The district court affirmed the bankruptcy court’s ruling, holding that the miscellaneous proceeds, escrow funds, and insurance proceeds provisions described benefits that were merely incidental to an interest in real property and generally were not additional security for purposes of § 1322(b)(2).

The district court further noted that the items at issue did not have any value of their own separate and apart from the property and the deed of trust.  In fact, to the contrary, these items all existed only to give effect to the mortgagee’s security interest, which otherwise could have been frustrated by a superior lien or by destruction or condemnation of the property.

The debtor appealed to the Fourth Circuit.

As you may recall, under Chapter 13 of the Bankruptcy Code, individual debtors may obtain adjustment of their indebtedness through a flexible repayment plan approved by a bankruptcy court. See Nobelman v. Am. Sav. Bank, 508 U.S. 324, 327, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993).  Section 506(a) of the Bankruptcy Code is used in conjunction with § 1322 of the Bankruptcy Code to allow modification, or bifurcation, of a secured creditor’s claim into secured and unsecured portions when the claim exceeds the value of the secured property. Id.

Under Section 506(a), “an allowed claim secured by a lien on the debtor’s property is a secured claim to the extent of the value of the property; to the extent the claim exceeds the value of the property, it is an unsecured claim.” See Nobelman, 508 U.S. at 328.

However, Section 1322(b)(2) provides that a bankruptcy 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 debtor’s principal residence.”  11 U.S.C. § 1322(b)(2).

Thus, the anti-modification clause in 11 U.S.C. § 1322(b)(2) of the Bankruptcy Code protects a mortgagee from having its claim in a Chapter 13 bankruptcy proceeding modified, if the mortgage is secured “only by a security interest in real property that is the debtor’s principal residence.” 11 U.S.C. § 1322(b)(2). In other words, a claimant’s interest in real property that is secured solely by the debtor’s principal residence may not be modified or bifurcated in a Chapter 13 bankruptcy.

Congress clarified the meaning of “debtor’s principal residence” in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). The Bankruptcy Code now defines the term as “a residential structure if used as the principal residence by the debtor, including incidental property, without regard to whether that structure is attached to real property.” 11 U.S.C. § 101(13A)(A).

The BAPCPA also defined “incidental property,” as it relates to a debtor’s principal residence, as “(A) property commonly conveyed with a principal residence in the area where the real property is located; (B) all easements, rights, appurtenances, fixtures, rents, royalties, mineral rights, oil or gas rights or profits, water rights, escrow funds, or insurance proceeds; (C) all replacements or additions.”  11 U.S.C. § 101(27B).

With this framework in mind, the Fourth Circuit held that “escrow funds, insurance proceeds, or miscellaneous proceeds” are protected by the anti-modification provisions for Chapter 13 bankruptcies as “incidental property” under the definition of “debtor’s principal residence” in the federal Bankruptcy Code.

The debtor argued that provisions of the deed of trust, involving escrow items, property insurance proceeds, and miscellaneous proceeds constituted sufficient additional security for the mortgagee’s interest such that the mortgage loan was secured by more than just an interest in real property.

The Fourth Circuit disagreed, relying on a Sixth Circuit ruling. In Allied Credit Corp. v. Davis, 989 F.2d 208 (6th Cir. 1993), the Sixth Circuit found that “items which are inextricably bound to the real property itself as part of the possessory bundle of rights” did not extend a lender’s security beyond the real property. Id. at 213. On the topic of insurance, the Davis court explained that “hazard insurance is merely a contingent interest — an interest that is irrelevant until the occurrence of some triggering event and not an additional security interest for the purposes of § 1322(b)(2).In re Davis, 989 F.2d at 211.

The Fourth Circuit held that this reasoning similarly applied to the miscellaneous proceeds and escrow funds that were tied to the real property at issue here.

The Court also relied on Akwa v. Residential Credit Solutions, Inc., No. 14-cv-02703-Akwa, 530 B.R. 309 (D. Md. 2015), which involved the same standard Fannie Mae/Freddie Mac deed of trust that was at issue in this appeal. In Akwa, the court noted that the lender was entitled to collect funds for escrow which the lender could use to pay property-related payments, like taxes, rents, as well as repairs or restoration. Akwa, 530 B.R. at 313-14.

The Court found that, as in Akwa, the deed of trust did not create “separate or additional security interests, but merely contained provisions to protect the lender’s security interest in the real property.” Akwa, 530 B.R. at 314. Accordingly, it held that the district court properly found, as a matter of law, that escrow funds, insurance proceeds, and miscellaneous proceeds were incidental property that did not constitute separate security interests.

In short, the Fourth Circuit concluded that the anti-modification clause applied to the Fannie Mae/Freddie Mac Deed of Trust at issue in this case. The Fourth Circuit did not therefore consider the effect — if any — of additional language in a deed purporting to create a separate security interest in escrow funds, insurance proceeds, or miscellaneous proceeds, in light of its interpretation of § 1322(b)(2).

The debtor also argued that both the bankruptcy court and the district court should have looked to Maryland law to determine whether the deed of trust created additional security interests in escrow funds, insurance proceeds, and miscellaneous proceeds as “real property.”

The Fourth Circuit again disagreed, noting that the Bankruptcy Code explicitly defines “incidental property” to a debtor’s principal residence, which includes both escrow funds and insurance proceeds. 11 U.S.C. § 101(27B).

In addition, the Fourth Circuit noted that state laws are suspended if they conflict with the Bankruptcy Code. See Butner v. U.S., 440 U.S. 48, 54 n.9, 99 S. Ct. 914, 59 L. Ed. 2d 136 (1979). Thus, it was not necessary for the Court to examine Maryland law on this issue.

Even if Maryland law were to apply, the Fourth Circuit observed that it was far from clear that the resulting holding would have been favorable for the debtor.  The Court noted that a security interest is created under Maryland law when there is language present in the security instrument that leads to the logical conclusion that it was the intention of the parties to create a security interest. Here, however, the Fourth Circuit had already found that the deed of trust did not contain language granting a security interest in escrow funds, insurance proceeds, or miscellaneous proceeds. Therefore, the debtor’s argument with respect to the application of Maryland law was unavailing.

Finally, the policy arguments that the debtor put forth were similarly rejected. The debtor asked the Fourth Circuit to ignore various cases that characterize escrow funds, insurance proceeds, and miscellaneous proceeds as “part and parcel” of real property.

But the Court, again citing Akwa, observed that characterizing escrow funds, insurance proceeds, and miscellaneous proceeds as additional security for purposes of § 1322(b)(2) “would completely eviscerate the anti-modification exception of § 1322(b)(2) because many deeds of trust which encumber improved real property contain these provisions to protect the lender’s investment in the real property.” Akwa, 530 B.R. at 313.

Thus, the debtor’s position could not be squared with an interpretation that would render the anti-modification provision inapplicable to virtually all residential mortgages.

Accordingly, the Fourth Circuit held that the debtor’s complaint failed to state a plausible claim for relief, and affirmed the district court’s judgment in favor of the mortgagee.

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Eric Tsai practices in Maurice Wutscher’s Commercial Litigation and Consumer Credit Litigation groups, and in its Regulatory Compliance group. He concentrates his practice primarily on the defense of consumer and commercial financial services companies, including mortgage lenders and servicers, mortgage loan investors, third party debt collectors, and other financial services providers. He also counsels clients on regulatory compliance, licensing, and other consumer protection matters. Eric earned his undergraduate degree from the University of California, Irvine. Prior to attending law school, he worked as a loan officer for national direct lenders. He earned his Juris Doctor from California Western School of Law and thereafter obtained a Master of Laws (LLM) in Taxation from the University of San Diego School of Law. Eric publishes extensively on various issues affecting consumer lending and litigation, including both federal and California-specific developments. He is licensed to practice law in California, Nevada, and Oregon, and is admitted in all United States District Courts in the State of California, the United States District Court for the District of Oregon, the United States District Court for the District of Nevada, the U.S. Tax Court, and the Ninth Circuit Court of Appeals. He is also a licensed real estate broker in the State of California.