Although the debtor had been foreclosed and the lender had won a writ of possession, a subsequent state court settlement order before bankruptcy was an executory contract that the debtor could assume to regain her home, according to an opinion by District Judge Robert C. Chambers of Huntington, W. Va., affirming Chief Bankruptcy Judge B. McKay Mignault.

The debtor had owned her home since 2000 but defaulted on the mortgage for the first time in 2016. The mortgage lender won a judgment of foreclosure, obtained title through a foreclosure sale and secured a writ of possession.

Before the lender evicted the debtor, the debtor and the lender entered into the first of three settlements that were incorporated into orders by the state court. However, the debtor defaulted on her payment obligations. Twice following the first settlement, the state court denied the lender’s motions to vacate a stay of eviction that was part of the settlement agreement. In both instances, the state court modified the settlement order.

The second amended settlement order required the debtor to make a lump-sum payment and specified monthly payments. Were she to comply, the state court order would require the lender to rescind the foreclosure, reinstate the mortgage and capitalize arrears.

In the pandemic, the debtor again defaulted on her payment obligations. This time, the lender sought a writ of mandamus from the West Virginia Supreme Court that would have required the trial court to give the lender possession of the home.

Before the state Supreme Court acted, the debtor filed a chapter 13 petition together with a motion to assume the state court’s revised order under Section 365(a) as an executory contract. The lender opposed on several grounds, primarily contending that the order from the state court was not an executory contract.

Bankruptcy Judge Mignault ruled in favor of the debtor, deciding that the state court order was an executory contract that the debtor had assumed in her chapter 13 plan. Judge Mignault also ordered the lender to rescind the foreclosure action, reinstate the mortgage and modify the loan by capitalizing arrears.

The lender appealed but failed to persuade District Judge Chambers, who affirmed Judge Mignault in his May 8 opinion.

On the merits, Judge Chambers first laid out the rules on executory contracts, including the so-called Countryman definition, which requires unperformed obligations on both sides such that a failure to perform would be a material breach. First, he held that the state court order was a contract under West Virginia law.

The lender argued that the debtor’s default before bankruptcy meant that the contract was terminated and was therefore no longer executory. Judge Chambers said that the argument was “inconsistent” with the “plain text” of Section 365(b), which allows a debtor to cure monetary breaches at assumption. In other words, “a contract is not terminated simply because a debtor defaults or breaches the contract prepetition,” he said.

Next, the lender proffered Section 365(c)(2) as a defense. The section bars a debtor from assuming an executory contract to make a loan or extend debt financing. The lender had not raised the argument below, so Judge Chambers refused to consider the idea on appeal.

Finally, the lender contended that the debtor had neither a possessory nor a legal interest in the home at the time of filing.

True, Judge Chambers said, a debtor loses redemption rights following a completed foreclosure sale. Referring to the state court orders laying out the settlement, he said that “a lot happened” after the lender won the writ of possession.

The debtor had payment obligations, and the lender could be required to reinstate the mortgage. Thus, Judge Chambers said that the debtor had both “a possessory and an equitable interest in her home — notwithstanding any foreclosure sale,” at the time of filing. He said that the debtor “did not lose these interests with her prepetition behavior. As a result, both interests entered her bankruptcy estate.”

Judge Chambers affirmed the bankruptcy court’s order granting the debtor’s motion for summary judgment and denying the lender’s cross motion.

Observations

Was the state court order a contract to make a loan or extend debt financing that could not be assumed under Section 365(c)(2)?

Arguably, the loan was made long before bankruptcy. The allegedly executory contract only changed some terms. On the other hand, capitalizing arrears could amount to a new loan precluding assumption.

Consider this hypothetical: To satisfy arrears on a defaulted mortgage, assume that the debtor and the lender sign a loan modification agreement to capitalize arrears before the debtor files a chapter 13 petition. If the debtor defaults before bankruptcy, can the modified mortgage be assumed? Does Section 365(c)(2) mean that mortgage defaults can only be compromised after filing? Can a lender renege on a deal just because the debtor files bankruptcy (and is probably in better financial condition as a result of bankruptcy)?