When a borrower files a bankruptcy case, for almost all purposes, what would commonly regarded as a single claim secured by collateral is subject to being treated as two claims: a “secured claim” in the amount of the value of the collateral securing the claim and an “unsecured claim” in the amount of the difference between the collateral value and the total amount of the claim. Thus, for bankruptcy purposes, a creditor holding a claim in the amount of $300,000 secured by collateral worth $200,000 has a $200,000 secured claim and a $100,000 unsecured claim that shares the same priority and right to payment as the claims of other creditors who have no collateral at all.
However, when Congress enacted the Bankruptcy Code in 1978, it provided one important exception to this concept in Chapter 13 cases, which are reorganization cases by debtors who are individuals. In Section 1322(b)(2) of the Code, Congress provided that Chapter 13 plans can 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.” Consequently, if our hypothetical creditor’s $300,000 claim was secured by a an investment property owned by the debtor and worth $200,000, the debtor’s plan could provide for the debtor to pay the creditor $200,000 over time, keep the property, pay pennies on the dollar, if that, on account of the $100,000 unsecured claim, and discharge any further obligations to the creditor. However, if the claim was secured only by the debtor’s principal residence worth $200,000, the Chapter 13 plan would need to provide for payment of the full $300,000 claim.
Over the years, bankruptcy courts, desiring to give debtors fresh starts, have focused on the words “only” and “real property” in Section 1322(b) and have allowed debtors to modify claims secured by their principal residences if the lien instruments also cover such things as awnings, satellite dishes, escrow accounts, and casualty insurance proceeds. When Congress overhauled the Bankruptcy Code in 2005, it attempted to overrule these kinds of cases, albeit in a somewhat awkward way. Although the cases allowing Chapter 13 debtors to modify claims secured by things other than “only real property that is the debtor’s principal residence” did so based on the language of Section 1322(b), Congress made no changes to that section. Instead, Congress added two new definitions to Section 101 of the Code in which many of the terms used in the Code are defined. First, it added a definition of “debtor’s principal residence” in Code Section 101(13A). That definition provides that debtor’s principal residence “means 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.” Second, in Section 101(27B) of the Code, Congress added a definition of “incidental property.” That term “means, with respect to a debtor’s principal residence, property commonly conveyed with a principal residence in the area where the real property is located.”
In a January 20, 2017 decision in the case of Birmingham v. PNC Bank, N.A., the United States Court of Appeals for the Fourth Circuit, whose decisions govern bankruptcy cases in Maryland, Virginia, West Virginia, North Carolina, and South Carolina, applied these definitions in rejecting an argument by a Chapter 13 debtor that he could modify the secured creditor’s claim because the creditor’s lien covered: (a) funds held in an escrow account to pay property taxes and insurance premiums; (b) casualty insurance payments and unearned insurance premiums; and (c) proceeds resulting from destruction or condemnation of the collateral. The debtor argued that since these items were not “real property,” the creditor’s claim was not secured “only by a security interest in real property that is used as the debtor’s principal residence” and thus could be modified.
The Fourth Circuit rejected the debtor’s arguments. Although there is no indication that any evidence was ever presented as to whether escrow funds, insurance proceeds, and condemnation proceeds are “commonly conveyed with a principal residence in the area where the real property is located,” the Fourth Circuit concluded that they were “incidental property” because they were “items which are inextricably bound to the real property itself as part of the possessory bundle of rights.” Because the new definition of “debtor’s principal residence” includes “incidental property,” the creditor had a security interest in “only” the debtor’s principal residence and its claim could not be modified. Any other holding, the Fourth Circuit said, “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.”
The Fourth Circuit’s decision in Birmingham is an important victory for residential mortgage lenders. Nevertheless, the decision does suggest that lenders can still deprive themselves of the protection of the anti-modification provisions of Section 1322(b) by using the wrong words in their mortgages and deeds of trust or covering too much in them. For example, the Fourth Circuit placed a great deal of emphasis on the fact that the lender’s mortgage did not describe the escrow funds, insurance proceeds, and condemnation proceeds as “additional collateral. The Fourth Circuit also specifically distinguished the case before it from cases in which creditors had obtained liens on such things as appliances and wall to wall carpeting. If lenders want to avoid having their residential loans modified by Chapter 13 plans, it is important that their forms only provide for collateral “commonly conveyed with a principal residence in the area where the real property is located.”