By Alan Steven Wolf of The Wolf Firm and Richard Miller,
Metmor Financial(Mortgage Finance Magazine, August 1993)
By Alan Steven Wolf of The Wolf Firm and Richard Miller,
Metmor Financial
(Mortgage Finance Magazine, August 1993)
Mortgage servicers are always looking for new sources of income. One servicing fee which
may be overlooked by some servicers is the income generated from interest paid on
prepetition arrearages over the term of a Chapter 13 Plan. This article explores the
Chapter 13 plan in general, the recent United States Supreme Court case of Rake vs.
Wade (93 Daily Journal D.A.R. 7024 - Decided June 7 , 1993) which now requires that
interest be paid on prepetition arrearages paid through Chapter 13 plans, and the
relationship of that interest payment to mortgage loan servicing.
Chapter 13 provides a vehicle for debtors to restructure their debt under a "plan of arrangement" devised by Congress. Under this plan, mortgage debt is divided into two parts; (1) the arrearages that exist as of the date of the filing of the bankruptcy petition ("prepetition arrearages"), and (2) all payments that fall due after the petition date ("regular post petition payments" or "maintenance payments").
A Chapter 13 plan allows the debtor to pay the prepetition arrearages over a reasonable period of time (generally 12-36 months) provided that all regular post petition payments are made. The broad concepts is that at the completion of the plan, the debtor will be contractually current.
A concrete example puts this into focus. Assume the mortgage lender holds a $100,000
note with payments of $1,000 per month. If the Debtor files bankruptcy after missing eight
payments, the prepetition arrearages would be $8,000 (plus late charges and other
prepetition
costs, fees and charges). From the time of the Chapter 13 bankruptcy filing, the Debtor
would be required to make regular monthly payments of $1,000 per month. The Debtor would
also have to confirm a plan calling for payment on the prepetition arrearages within a
reasonable term to be 36 months, the Debtor would have to make 36 payments to the servicer
(through the Chapter 13 trustee) of $222.22 per month ($8,000/ 36=$222.22) in addition to
the regular monthly payment of $1,000. Under this payment scheme, at the end of 36
months,the Debtor would be contractually current.
The proposal to make payments is contained in a pleading known as a Chapter 13 plan.
This plan, which must be filed with the court and served upon creditors within 15 days of
the date of the filing of the petition, is reviewed by the Chapter 13 trustee at the
"First Meeting of Creditors" (also known as the "341(a) meeting"). At
this meeting, the Chapter 13 trustee assesses, among other things, whether or not
the debtor can afford to make the payments contained in the plan, i.e., whether the plan
is feasible.
The meeting of creditors is soon followed by a hearing on confirmation of the plan. At that hearing the judge will decide whether or not the plan was proposed in good faith, is reasonable and is otherwise allowed by law. Should the plan not comply with these requirements, a servicer may file an objection to confirmation of the plan or dismissal of the bankruptcy case.
If a plan is confirmed, regular payments are paid directly by the Debtor to the services. However, prepetition arrearages are not paid directly by the Debtor; instead, the debtor makes monthly plan payments to the Chapter 13 Trustee who then forwards the appropriated payment to each creditor named in the plan. As compensation, the Chapter 13 Trustee earns an "administrative" fee of approximately 8-10% for all disbursed funds. In the above example, the debtor would have to pay the trustees $8,800 ($8,000 plus 10%) for the trustee to disburse the $8,000 to the servicer over a 36 month period.
INTEREST ON ARREARAGES PAID
Under the standard Fannie Mae/ Freddie Mac fully amortized note, a missed payment does not accrue additional interest. Instead, a late charge is assessed as liquidated damage to offset the harm caused by the late payment. Thus, if the borrower failed to make eight payments of $1,000, each untimely payment would entitle the services to a late charge (generally 6% of the payment), but no additional interest would accrue on the unpaid debt. In other words, the payment of $8,000 plus late charges would reinstate the loan irrespective of when the $8,000 was paid.
Since the California foreclosure process generally takes only four months, the loss of interest has had little impact on services or investors. However, once a Chapter 13 case is filed, the possibility of payment on the arrearages over an extended term far in excess of four months raises the question of whether or not interest should be allowed on the prepetition arrearages. To deny interest while imposing an extended repayment term denies the lender the full present value of the amount owed.
Until 1991, the bankruptcy courts of the Ninth Circuit (which covers the states of Alaska, Arizona, California, Hawaii, Idaho, Montana,Washington) were split on whether or not a lender was entitled to interest on the prepetition arrearages paid through the Chapter 13 plan. Then in August 1991, the Ninth Circuit of Appeals in the case of In Re Laguna (944 F.2d 542 (9th Cir. 1991) determined that a mortgage lender was not entitled to interest on the prepetition arrearages. Since that time, and until recently, Chapter 13 plans were routinely confirmed without requiring the payment of additional interest.
THE RAKE DECISION
On June 7 , 1993, the United States Supreme Court in a landmark unanimous decision entitled Rake vs. Wade (93 Daily Journal D.A.R. 7 042) overturned Laguna and held that over-secured mortgage lenders are entitled to interest on arrearages paid through a Chapter 13 plan. The consolidated case involved three separate Chapter 13 bankruptcies, in which the lender held a note secured by the first mortgage on the principal residence of each Debtor. Each note allowed a $5 late payment fee but did not have any provision allowing for interest on arrearages. The Debtors each proposed to pay directly to the lender all regular post petition payments. The Chapter 13 plans each provided that the debtors would cure the prepetition arrearages, without interest, over the terms of the plans.
The Bankruptcy Court confirmed the Chapter 13 plans over the lender's objections and the District Court affirmed that decision on appeal. In a further appeal, the Tenth Circuit Court of Appeals then reversed the holding of the District Court and required the payment of interest. Due to a split in authority between the Circuit Court of Appeals, the United States Supreme Court accepted the case, eventually holding for the mortgage lender and requiring interest to be paid on prepetition arrearages paid over time where the value of the property exceeds the lender's debt. Now servicers servicing loans in Alabama, Alaska, Arizona, California, Delaware, Florida, Georgia, Hawaii, Idaho, Maryland, Montana, Nevada, New Jersey, Oregon, Pennsylvania, North Carolina, South Carolina, Virginia, Washington, all of which states previously denied interest on Chapter 13 Plans, will enjoy the benefits (and burdens) of Chapter 13 interest.
HOW IT WORKS
To understand the implications of the Supreme Court's ruling it is important to note that the payment of interest in the prepetition arrearages results in compound interest, a result that could not otherwise be achieved on a simple interest amortized loan. The interest compounds because the prepetition arrearages are comprised of the missed payments which include both a principal and interest component. Receiving interest on the full payment amount results in a double bonus, interest on interest as well as additional interest on principal As set forth below, the economic value of this sum is significant.
A concrete example puts these factors into focus. Assume the lender hold the same $100,000 note with payments of $1,000 per month, the same $8,000 prepetition arrearages (plus late charges and other prepetition costs, fees and charges), and assume the same Chapter 13 payment term of 36 months. Without interest, and as calculated above, the Debtor cures the arrearages over 36 months through the Chapter 13 plan by paying $222.22 per month (in addition to making regular monthly payments). However, if the arrearages were to be paid in amortized payments over the same term at 10% interest per annum, the Debtor would have to make payment to the services (through the Chapter 13 trustee) of $258.14 per month.
THE CASH COW
As opposed to the interest component of the regular post petition payments, the interest component of the payment on the prepetition arrearages is not to be applied to the loan; instead it is additional income to either the servicer or investor. By the end of the term, the Debtor will have paid $1,293.12 more that the $8,000 necessary to reinstate the $8,000 of arrearages. These funds are profit to either the servicer or lender. Moreover, due to the amortization, in the first year alone the servicer would receive $692 of the $1,293.12.
The income derived from Chapter 13 plan payments far exceeds most other sources of servicing income. For example, the Chapter 13 interest income of $692 the first year is almost twice what would be received as a normal servicing fee (assuming a relatively high average weighted servicing fee of 37 1/2 basis points, the total servicing fee on a loan with an unpaid principal balance of $100,000 would only be $375 per year), and greatly exceeds what could be derived from ancillary income. In fact, annual interest received on a Chapter13 plan approximately equals the late charges that could accrue over that same time period..
THE CHAPTER 13 PLAN INTEREST RATE
The interest rate adopted for Chapter13 plan payments obviously has a significant impact on the possible return through the plan. Those Courts which allowed interest prior to Rake were split on the index to be used. Most courts, for the lack of a better analysis, chose the mortgage contract rate. Thus if the mortgage called for interest at 8% per annum, the Chapter 13 plan provided this same interest for payment of the arrearages over time. Other courts focused on the risk associated with the Chapter 13 plan and reasoned that since the interest component of the amortized payments made on the arrearages really were unsecured (there is no contractual provision allowing for this interest), a higher unsecured rate was more appropriate.Whatever the rate used, a servicer allowed interest on prepetition arrearages has a substantial source of new income.
THE SMALLER SERVICER
Since interest on Chapter 13 plans had been relatively rare prior to the Supreme Court
ruling, most smaller servicers did not take the time to develop systems and procedures for
the capture of this profit; the numbers simply did not justify the investment of
resources. Instead, these servicers simply applied all of the plan payments to the debt.
Thus, even though amortized payments were made on the prepetition
arrearages, the entire amount was applied to the arrearages and continued to make extra
payments each month as called for under the plan.
As described above, the income which may be derived from Chapter 13 plans is substantial. Last year alone, when only a minority of courts allowed for interest on prepetition arrearages paid through Chapter 13 plans, one California based servicer earned over $130,000 from such interest. Now that all Chapter 13 plans must provide interest on prepetition arrearages, investing in systems and procedures to capture Chapter 13 interest seems prudent in even the smaller servicing shops.
SPECIAL SERVICING RESPONSIBILITIES
A servicer intent on capturing Chapter 13 interest should consider several issues. First, how the interest component is determined generally depends on local custom and practice. For example, in some jurisdictions, the Proof of Claim must claim interest at a set rate. In other districts, a Chapter 13 plan will be confirmed without a provision for interest unless the lender objects to the plan. Accordingly, special attention must be paid to local custom and practice and to the terms of the Plan to assure that proper interest is paid.
Where the proper procedures are followed, arrearage remittances should begin from the Trustees approximately 30-60 days after confirmation of the Chapter 13 plan. Trustees normally designate either on the check or on a separate disbursement sheet how the funds should be divided between the interest and principal component. However, some Trustees merely pay a lump sum and shift the accounting burden to the servicer. In these cases, close attention must be paid to the actual terms of the plan and a separate amortization schedule should be established for the plan payments.
Finally, servicers must establish appropriate accounting procedures for the receipt and reporting of interest income. Mortgage servicers have a wide array of technology to assist in the segregation of arrearage remittances. Service bureaus such as CPI and Lomas have the facilities available to split funds. These procedures should also include appropriate reporting requirements for state and federal taxing authorities including a method for including the interest paid as part of the Form 1098 and 1099.
THE FUTURE BATTLEGROUND-WHOSE INCOME IS IT?
Investor servicing contracts may or may not provide whether the servicer or the investor are entitled to interest paid on prepetition arrearages. At present FNMA and FHMLC have no general provision for the disposition of these funds. Servicers are advised to review their current agreements to determine if provisions presently exist regarding these funds. While interest is normally passed on to the investor, late charges are not. Whether or not interest on prepetition arrearages is construed as "interest" or a "late charge" will likely be a hot subject of negotiation between servicers and investors now that the Supreme Court has made interest applicable in all oversecured cases.
THE WORKOUT ADVANTAGES
The Supreme Court's ruling has also created a unique incentive for the borrower to attempt a workout of the loan without the filing of a bankruptcy. Because interest must now be paid on prepetition arrearages paid through the Chapter 13 plan, a borrower may be able to cut a better deal with the servicer outside of bankruptcy; the normal workout does not call for this interest. Such a workout is a win/win situation since both the borrower and lender save attorney's fees and other costs associated with the bankruptcy filing.
CONCLUSION
In the past, interest on Chapter 13 plans had been largely ignored by servicers; many of whom unknowingly applied the interest to the loan. Shrewd servicers discovered that this interest need not be applied to the loan and is a rich source of additional servicing fee income. Now that the United States Supreme Court has required interest to be paid on all Chapter 13 Plans where the lender is oversecured, servicers should carefully tailor their bankruptcy programs to capture this source of income derived from Chapter 13 plans is income to the servicer and not to be passed on to the investor. Also, borrowers should be made aware that there is an added incentive for them to workout the loan with the servicer rather than suffer the interest and other charges that would occur through the Chapter 13 plan. In short, the Supreme Court has properly made a Chapter 13 bankruptcy a matter of last resort.
For further information please contact:
The Wolf Firm, A Law Corporation, is an "AV" rated law firm which concentrates on providing superior legal services to the mortgage banking industry. The firm's national clientele includes many of the largest mortgage bankers in the country, as well as a variety of savings banks, commercial banks, commercial finance companies, credit unions, and the Resolution Trust Corporation. With a staff of approximately forty individuals, including attorneys, certified paralegals, legal secretaries, administrators, clerical personnel, and a full time computer systems analyst, the firm represents its clients on a wide range of matters including all aspects of both residential and commercial/multifamily mortgage loan origination and servicing, securitization, regulatory compliance, bankruptcy, and litigation related to the foregoing in both federal and state courts throughout California. For more routine matters, such as residential bankruptcies, evictions and receiverships, The Wolf Firm has developed extremely cost-effective and efficient programs using specially trained paralegals and computer technology to assist its attorneys in handling these matters at rates that are the most competitive in the State of California and, through its membership in the USFN, the Firm is able to arrange similar services in virtually every state in the nation.
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