Late Mortgage Claims in Chapter 13 Practice after Pajian and Matteson

The summer of 2014 brought two interesting decisions from appellate courts that impact the treatment of secured mortgages in chapter 13 plans: In re Pajian[1] and In re Matteson.[2] As the ability to cure mortgage arrears is a unique aspect of chapter 13, these cases highlight important issues in chapter 13 practice.

Pajian came to the Seventh Circuit on direct appeal from the bankruptcy court after Lisle Savings Bank filed a claim more than three months after the claims bar date imposed by Rule 3002(c). The claim was filed for two debts: a secured first mortgage on a commercial property, and an unsecured deficiency judgment from a foreclosure proceeding. The bankruptcy court sustained the debtor’s objection to the unsecured portion of the claim, but deemed the secured portion allowed.[3] The Seventh Circuit, adopting a bright-line approach, held that Rule 3002(c) requires that a late-filed proof of claim, even a secured claim, must be disallowed if an objection is filed.[4]

The Sixth Circuit BAP in Matteson reversed a bankruptcy court decision[5] wherein the debtors filed an adversary proceeding to avoid mortgages on two parcels of real estate due to Bank of America’s failure to file a claim regarding the debts for these two mortgages in the underlying chapter 13 case. The bankruptcy court held that the amount due on the mortgage would be reduced by the amount that the creditor would have received but for its failure to file a proof of claim. An excerpt is as follows:

[Bank of America] still ha[s] a lien; there’s no question about it. But whatever amount is secured by that lien is reduced by the amounts that they precluded themselves from receiving through this confirmed plan. That’s what they lose. That’s what happens when a secured claim holder decides to disable itself to receive payments under a confirmed plan when they have a debt that’s provided for under [§] 1322(b)(5) by curing default and maintaining payments through the plan. They don’t lose their lien, they just simply can’t collect the amounts the plan calls for that will be paid. That’s what happens. They don’t, in other words, get to disable the plan and then come back later and get their cake and eat it, too.[6]

The Sixth Circuit BAP reversed the ruling as to the reduction of the debt owed and affirmed that the liens were not voided.[7] The ruling noted that waiver of the right to receive payment under the plan does not waive the right to payment on the debt, and also noted that the debtors or trustee had an option to file a claim on behalf of the creditor. The debtors were required to “service the debt” regardless of the creditor’s actions. [8]

Repercussions for Mortgage Creditors

Mortgage creditors in the Seventh Circuit now face a steep challenge: filing valid proofs of claim prior to the expiration of the claims bar date. Given that many mortgages that are serviced by third parties have trouble gathering the necessary documents[9] for a valid proof of claim due to multiple transfers, meeting this deadline may be particularly challenging. However, secured creditors do have valuable tools that many other creditors do not: §§ 506 and 1328. 11 U.S.C. § 506(d)(2) states that the failure of a secured creditor to file a proof of claim is not grounds to avoid the secured creditor's lien. Additionally, mortgage creditors are further protected from having the debt discharged, regardless of whether a proof of claim is filed. Mortgages permitted to be subject to cure-and-maintain treatment are long-term debts pursuant to 11 U.S.C. § 1322(b)(5) and are therefore nondischargeable pursuant to 11 U.S.C. § 1328(a).[10]

This does not mean that mortgage servicers may ignore the bankruptcy proceedings entirely and rely upon lien rights to fully protect their property interests. “Creditors, especially lending institutions ..., must follow the administration of the bankruptcy estate to determine what aspects of the proceeding they may want to challenge.... [The bank] was not entitled to stick its head in the sand and pretend it would not lose any rights by not participating in the proceedings.”[11] While the lien remains intact, the amount that the debtor owes on it may be altered through a chapter 13 proceeding.[12] As such, the filing of a timely proof of claim remains the best way to preserve a creditor’s complete rights.

Furthermore, “this is not to say that the lien is sure to escape unscathed from the bankruptcy.”[13] Rule 3012 confirms that a creditor’s secured status may be raised separately from other issues in a bankruptcy proceeding. While secured status is typically more often thought of in a § 502 context,[14] it is possible that Rule 3012 may be invoked in determining the value of a mortgage when the arrears are uncollectable through the chapter 13 plan.[15] Additionally, the Matteson panel raised the idea that, had the plan included a provision waiving the creditor’s rights if no proof of claim was filed, the provision might have been binding but did not explicitly rule on the point. “If the plan had explicitly provided for reduction of the debt without any payments, such a provision might have conflicted with the plan's treatment of the debt as a non-dischargeable long term debt, and may have been an unlawful provision.”[16] Regardless, unlawful provisions are binding absent objection,[17] and such provisions may proliferate in the months to come.

Repercussions for Debtors

Debtors are put in a precarious position with the outcome of Pajian and Matteson. Pajian requires a claim to be filed timely in order to be allowed — and the claim must be allowed in order for the trustee to disburse. “[T]he weight of authority … concludes [that] the failure to file a proof of claim does not impact a creditor's lien rights. It is distribution that is impacted by a lack of claim.”[18] Matteson makes it clear that the debtor’s duty to pay the cured mortgage is not abrogated by the creditor’s failure to file a claim, and that if the creditor fails to act and the debtor wishes to pay the mortgage pursuant to the plan through the trustee conduit, the debtor should file a claim for the creditor. This means that debtors’ counsel should closely monitor chapter 13 cases around the time of the claims bar date and file a proof of claim if necessary so as to alleviate “the concern that other creditors might swoop in at the last minute and upend a carefully constructed repayment schedule.”[19]

Since most debtors probably do not want to pay more than necessary to cure a mortgage arrearage or may not honestly know the correct amount of the arrearage, caution should be exercised by debtors’ counsel who file claims on behalf of the mortgage company. Stating that the mortgage is $0.00 in arrears when that is known to be untrue may land counsel in ethical hot water. Anyone who files a proof of claim “has an affirmative obligation to conduct a reasonable investigation into both the law and the facts before doing so and that inquiry must lead to the conclusion that the presenter's position is warranted by existing law or a non-frivolous argument.”[20]

On the other hand, debtors’ counsel have a duty of loyalty to their clients and may want to avail debtors of all available legal positions. It may also be prudent to have the debtor sign a proof of claim form, as the debtor stands in the best position to have the necessary knowledge, relative to debtors’ counsel and trustee. The relief afforded in Rule 3002.1(f-i) may result in a court order barring the collection of pre-petition arrears that have not been paid if the creditor chooses to not fully participate in the bankruptcy claims process.

One important factual difference between the claim disallowed in Pajian and the typical cure-and-maintain residential mortgage claim is that the claim in Pajian was a bifurcated claim: There was an unsecured portion for one judgment and a secured portion for a second commercial property. The bankruptcy court allowed the secured portion and was reversed at the Seventh Circuit, which held that the entire claim should have been disallowed.[21] Most mortgage claims, especially primary residential liens, are fully secured and do not contain an unsecured portion. Under § 1322(b)(2), such a mortgage cannot be altered, and bankruptcy courts may not have the authority to pick and choose which parts of the claim may be allowed. This is particularly true of pre-petition mortgage arrears, which are not a separate claim or class of creditor, but are included in the secured balance. A debtor may face a choice between paying a late-filed claim of questionable validity, or not being allowed to pay the mortgage through the bankruptcy whatsoever.

Practical Considerations

Creditors’ counsel will undoubtedly want to inform their clients of the growing body of case law that seeks to require secured creditors to participate in the bankruptcy process in a similar fashion as all other creditors. This may involve the balancing of risks, such as filing an incomplete claim before the claims bar date and adding in required documentation or amending the proof of claim as necessary later, versus potentially being required to waive arrearages if documentation issues prove to be too troublesome. Creditors and their counsel will also want to closely review plans to ensure that arrears or ongoing payments are not deemed waived entirely in Espinosa-type additional plan provisions and fight the issue at confirmation. However, the argument may be somewhat circular, as the simple solution is to timely file a proof of claim.

Debtors’ counsel may wish to exercise caution in the filing of objections to late mortgage claims. If Pajian is to be read on its face, the claim must be allowed or disallowed in its entirety, and once disallowed, the trustee may no longer disburse. This then puts the burden of making payments and potentially litigating mortgage issues solely upon the debtor, rather than through the trustee conduit and possibly with the trustee as a powerful ally. This may further confuse matters after discharge: Issues such as escrow accounting, fees due and the principal mortgage balance may be further complicated due to incomplete accounting on the debtor’s part when compared to trustee disbursement ledgers. Debtors’ counsel may also wish to include plan provisions that require the mortgage creditor to timely file a proof of claim or reduce the amount due on the mortgage, although this is a case of “know your court” in order to assess the risks and benefits for how such provisions will be viewed.[22]

Questions for the Future

Chapter 13 will probably continue to be a lively forum for mortgage litigation in the coming years. Whether mortgage servicers begin to file claims in a more timely fashion or the furor over arrearages in late or unfiled mortgage claims dies down has yet to be seen. It may become particularly interesting to see whether unsecured creditors become more involved in mortgage litigation by seeking to disallow late-filed mortgage claims, with the intent of increasing the unsecured distribution by rerouting plan funds once earmarked for mortgage arrears to the unsecured pool.