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By Diane Davis
March 10 — An individual Chapter 11 debtor can divide a lender's mortgage claim into a secured and unsecured component, a district court in California held March 1.
Reversing the bankruptcy court's judgment and remanding the case, Judge Richard Seeborg of the U.S. District Court for the Northern District of California concluded that Bankruptcy Code Section 1123(b)(5)'s anti-modification exception doesn't apply in the debtor's case because the lender maintains an interest in the debtor's personal property in addition to his principal residence.
Under Section 1123(b)(5), a Chapter 11 plan is barred from modifying “a claim secured only by a security interest in real property that is the debtor's principal residence.” The restriction on modifying residential mortgages generally aligns Chapter 11's treatment of such mortgages with that of Chapter 13, according to Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 172 (D. Michael Lynn et al. eds., 2016).
Chapter 11 bankruptcy is for businesses or individuals whose debts exceed the statutory thresholds for Chapter 13. Chapter 13 bankruptcy allows individuals receiving regular income to obtain debt relief while retaining their property, but to do so, the debtor must propose a plan that uses future income to repay a portion of his or her debts over a three to five year period.
Courts are split, however, on whether an individual Chapter 11 debtor can strip down a residential mortgage when the property is also used to generate income.
The district court followed the Ninth Circuit Bankruptcy Appellate Panel's decision in In re Wages, 508 B.R. 161 (9th Cir. BAP 2014), which looked to the plain language of the text, rather than the Third Circuit's decision in Scarborough v. Chase Manhattan Mortgage Corporation, 461 F.3d 406 (3d Cir. 2006), which concluded that the real property that secures the mortgage must be only the debtor's principal residence in order for the anti-modification provision to apply.
Contrary to the debtors' interpretation of the statute, Section 1123(b)(5) doesn't require the real property to be used exclusively as the debtor's residence, but it does require the lender's claim to be secured “only by a security interest in real property,” the court said. Under the Residential Construction Rider (RCR) attached to the deed of trust, Suntrust Mortgage, Inc.'s claim doesn't meet that definition, the court concluded.
Suntrust's claim was secured by an interest in personal property because construction on the debtor's home was incomplete when the loan was made. As a result, Suntrust's claim falls outside of the confines of the protection Congress created in Section 1123(b)(5), the court said, citing In re Hammond, 27 F.3d 52 (3rd Cir. 1994).
Debtors Charles and Anna Utzman acquired two vacant lots in Mill Valley, California, with the intent of building a home. Suntrust loaned the debtors $1.3 million to construct a home, which was to include both a home office and a residential unit to rent out to third parties.
Later, the home became the debtors' principal residence. The deed of trust gave Suntrust a secured interest in the property where their home was located.
Subsequently, the debtors filed for Chapter 11 protection and proposed modifying Suntrust's rights under Section 506, which permits the bifurcation of a secured claim.
Suntrust objected, arguing that the anti-modification exception in Section 1123(b)(5) barred the bifurcation. The debtors, however, contended that because the deed of trust conveyed an interest in a multi-unit dwelling and personal property, the exception didn't apply because Suntrust's claim isn't secured “only by a security interest in real property” that serves only as “the debtor's principal residence.”
The bankruptcy court found that the anti-modification exception did apply and denied the debtors' motion to bifurcate Suntrust's claim. The bankruptcy court relied on the Ninth Circuit Bankruptcy Appellate Panel's case in In re Wages.
The district court rejected the Third Circuit's approach in favor of the Ninth Circuit BAP's interpretation in . Looking at the plain language, the word “only” is an adverb used to modify the word “secured,” and the clause “that is the debtor's principal residence” modifies the term “real property,” the court said. According to the court, the placement of “only” suggests that it limits the extent of the collateral for the secured debt, and not the use of the property deemed the “debtor's principal residence.”
The court said it wasn't necessary to look at the legislative history of the statute in light of its plain meaning.
The fact that the debtors rent out a small portion of their property doesn't defeat the applicability of the exception, the court said.
The statute also requires that the lender's claim be secured “only by a security interest in real property.” Under the RCR, Suntrust's claim doesn't meet that condition, the court said. Thus, the anti-modification exception doesn't apply in this case, the court said.
David N. Chandler, Law Offices of David N. Chandler, Santa Rosa, Calif., represented appellants Charles Henry Utzman, and Anna Kathryn Utzman; Peter Salvador Munoz of Reed Smith LLP, San Francisco; and Dennis Peter Maio of Reed Smith, San Francisco, represented appellee Suntrust Mortgage, Inc.
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