When borrower files a Chapter 13 Bankruptcy, mortgage lenders barred from increasing monthly mortgage payments to restore mortgage escrow "cushion", Third Circuit says.

Very commonly, home mortgages have provisions that require the homeowner to pay, as part of their monthly payment, an additional monthly amount in escrow to cover taxes and insurance and certain other expenses. Under the federal law governing this, the Real Estate Settlement Procedures Act [RESPA], the lender can calculate this amount by estimating the future taxes and insurance over the next 12 months, and add an additional two months’ payment as a cushion. This total, essentially 14 months worth of payments, is then divided by 12 to come up with the monthly escrow dollars added to the mortgage payment. If a borrower does not make mortgage payments which include the escrow portion, the lender is entitled to increase the future payments to make up the resulting shortfall.

In In re Rodriguez, 2010 WL 5191428, the homeowners filed a Chapter 13 bankruptcy, and proposed to pay the mortgage arrears including the unpaid escrow amount through their bankruptcy plan. When the bankruptcy was filed, the lender had already advanced $3869.91 for taxes, insurance and other charges, and in addition was entitled to an escrow cushion of $1787.69. There were two possible ways the total escrow shortfall including the cushion could be paid. One was to include the full amount including the cushion as part of the arrears in the lender’s proof of claim. In that case, the cushion would have been restored by the time the borrowers had completed all their payments, along with repayment of the $3869.91 the lender had paid out pre-bankruptcy. The lender chose the alternative. It included in the arrears it asked to be repaid through the bankruptcy only the $3869.91 it has already paid out, and increased the borrowers monthly payment going forward to get back its cushion.

The borrowers filed a motion saying what the lender had done was an illegal attempt to collect from them a debt or claim, ie the "cushion"  that was only collectible inside the bankruptcy process. The "automatic stay" imposed under 11 U.S.C. 362 prohibits (with certain exceptions not applicable in this case) post-bankruptcy collection on claims that existed when the bankruptcy was filed. The borrowers asked for sanctions against the lender.

The issue was thus whether the lender could collect the cushion directly from the borrowers outside of bankruptcy, or whether it had to collect inside the bankruptcy plan’s proposed payout. If the right to the "cushion" was a "claim" that was enforceable when the bankruptcy case was filed, what the lender had done was improper. The bankruptcy court and later the US District Court on appeal held that what the lender had done was legal and proper.

On further appeal, the Third Circuit reversed the lower courts.   The lender argued that the right to collect the cushion was not a "claim" that had to be paid through the bankruptcy, because the escrow account was only an asset and not a debt. It pointed out correctly that if they had foreclosed and gone to sheriff sale, the borrowers would not have had to repay the cushion. Instead, the lender said, it was required only to collect through the bankruptcy what it had already paid out. The Circuit Court disagreed and held that under its broad view of what constitutes a "claim" that must be included for payment in a bankruptcy, the lender’s right to demand and collect the cushion was no different than its right to get back what it had paid out. Since both were enforceable rights that existed when the borrowers filed their bankruptcy, the lender had to collect its cushion by payments through the bankruptcy plan. It made no difference, the Court said, that this would force the lender in effect to give an "interest free" loan for the cushion amount during the time it would take to get paid up.

The appeals court sent the case back for the lower courts to determine whether the lender had wilfully violated the automatic stay and could be sanctioned for doing so. However, it is unlikely given the novelty of the issue and their previous rulings for the lender that any sanctions are going to be imposed. Judge Sloviter filed a dissent pointing out that the decision improperly gave RESPA's procedures and requirements short shrift, and that the lender had in fact acted entirely as this law allowed. Whether in another court RESPA will be given precedence with a different result remains for the future.

Nevertheless, this decision is important guidance for lenders and borrowers alike. In Chapter 13 cases, the borrowers must stay current after bankruptcy on their mortgage payments if they want to keep the home. Any increase in those payments decreases the amount they have left to pay out under their bankruptcy plan, and can sink an otherwise feasible plan. Borrowers and their bankruptcy attorneys should always examine and question escrow calculations and demands by lender for repayment to make sure the amounts are correct. This decision makes that process easier and more predictable for both borrowers and lenders.

This decision also underscores how broad is the universe of "claims" that can be discharged in bankruptcy. The Court cited and relied on its previous ruling in In re Grossman’s Inc. 607 F.3d 114 (3d Cir. 2010) that a "claim" exists where the circumstances upon which a right to payment arises predated the bankruptcy, even though the right to collect or sue on that right might come sometime in the future and even though the creditor might only later be able to determine who owed it. The Grossman’s case is still the subject of controversy and in certain cases can be the result of enormous practical and legal difficulty. (Think of the person whose right to sue for injury is discharged because the accident happened before the bankruptcy but its effects including pain, suffering or disability become apparent only years later and  long after the bankruptcy) However, in this case, we think the Third Circuit properly applied its principles to achieve certainty and uniformity of treatment.