Time Is on Your Side: Timing Considerations in Application of 11 U.S.C. § 1322(b)(2)

The Bankruptcy Code allows a chapter 13 debtor to propose a plan that bifurcates undersecured claims into secured and unsecured claims except where the claim is one secured “only by a security interest in real property that is the debtor’s principal residence”.[1] If the sole collateral securing the claim is the debtor’s principal residence, then the Code prohibits the bifurcation of the claim and the plan must provide for payment in full. Recently, the Bankruptcy Court for the District of Connecticut had to determine the proper time frame for determining the creditor’s collateral status.

In In re Coyle,[2] the debtor proposed a plan which bifurcated Prime Bank’s second mortgage claim into a partially secured claim and a partially unsecured claim. Unsecured claims would receive nothing under the plan. Prime Bank objected on the basis that its claim was secured only by the debtor’s residence and, accordingly, was subject to the “anti-modification” provisions of section 1322(b)(2).

The parties agreed that, at the time the plan was proposed, the only collateral securing Prime Bank’s claim was the mortgage on the debtor’s residence. However, when the underlying loan was initially made, Prime Bank took other collateral in addition to the second mortgage on the debtor’s home. Prior to the debtor’s bankruptcy filing, some of the additional collateral was foreclosed upon by a senior lender and Prime Bank received no proceeds from the foreclosure sale. Prime Bank’s lien in the remaining additional collateral lapsed prior to the debtor’s bankruptcy filing. So, at the time of the filing, Prime Bank’s second mortgage on the debtor’s residence was the sole remaining collateral available to Prime Bank.

The debtor argued that the court should determine Prime Bank’s collateral position as of the time the loan was made. Prime Bank conversely argued that the petition date was the appropriate time for such a determination. The Bankruptcy Court determined that the question was one of first impression in its district. The court reviewed and ultimately adopted the rationale of several other courts, including the Bankruptcy Court for the Western District of Michigan and the Third Circuit Court of Appeals, each of which had determined, when faced with the same question, that “… [T]he critical moment [in determining whether Section 1322(b)(2) applies] is when the creditor takes a security interest in the collateral”.[3] The Coyle court was persuaded by the reasoning that it is at “that point in time that the underwriting decision is made and it is therefore at that point in time that the lender must know whether the loan it is making may be subject to modification in a chapter 13 proceeding at some later date.”[4] The court was unpersuaded by, and declined to follow, a contrary decision reached by another bankruptcy court.

The Coyle court concluded that at the time the debtor granted Prime Bank a second mortgage on his home, the loan was secured by addition collateral. Prime Bank clearly knew this fact and was on notice and should have known, if it did not, that its claim was subject to modification in a chapter 13 plan filed at a later date. The fact that the only collateral remaining at the time of the bankruptcy filing was the mortgage on the debtor’s residence did not qualify Prime Bank for the protections of section 1332(b)(2)’s anti-modification provisions.

Lenders should be aware that the majority of courts appear to adopt the Coyle court’s reasoning. Loans secured by collateral in addition to the debtor’s residence — even if that collateral is no longer available when a future chapter 13 case is filed — may be subject to bifurcation in a chapter 13 plan. Lenders should carefully evaluate the collateral package provided to them and determine whether the risk of bifurcation is adequately addressed when making the loan.