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CLIENT ADVISORY - August 22, 2007

Nosek Revisited- Courts are Continuing To Impose Additional Duties On Mortgage Lenders
 
by John L. Day, Jr., Esq.

Most lenders and servicers have become very aware of the need to apply payments from debtors in a chapter 13 bankruptcy exactly as required by the confirmed plan. As you may recall, the seriousness of this problem was highlighted earlier this year in the Nosek case when one court sanctioned a lender for apparently applying post petition payments to the oldest contractually due installment¹. The lender's accounting system did not permit them to distinguish between pre-petition arrears payments and post petition regular payments. To determine the exact status of an account, the lender needed to manually prepare a ledger showing the correct application of payments. When the debtor wanted to refinance her loan, she requested a payment history, which showed that some payments were held in suspense and that payments were applied to the oldest contractual due date, even where they were designated for a post petition installment.

A confirmed chapter 13 bankruptcy plan binds both the debtors and the creditors. The provisions in the confirmed plan will replace the terms in a note and mortgage to the extent that they are inconsistent. A typical chapter 13 plan permits debtors to gradually cure a default on a mortgage debt. The plan also requires that debtors stay current on payments which come due after the bankruptcy is filed. Once a plan is confirmed, it acts like a court-approved contract or consent decree that binds the debtors and all of the creditors. Therefore, it is extremely important to always carefully review chapter 13 plans and to object when necessary.

Courts are interpreting the portion of the bankruptcy code which permits debtors to cure mortgage arrears as also imposing a duty on the lender to essentially create and track two accounts for each loan. One account tracks the payments received on the pre-petition arrears and one account tracks the post petition payments made by the debtors. However, the vast majority of lender's accounting systems do not provide for accounts to be divided in this manner. For example, if the debtor is post petition current, this must be reported even though there remains a substantial pre-petition arrears that has not been paid.

The Nosek court was very critical of the use of suspense accounts, especially where accumulated payments were not immediately disbursed as soon as funds equivalent to a full payment were received. The court also scrutinized payment histories that apparently apply payments to the oldest contractual due date even where the payment was meant to cover a current post petition payment. The failure of a lender or servicer to maintain accounts consistent with a chapter 13 plan and the failure to provide an account status to the court, to the debtors, and to third parties (such as refinancing lenders), which is consistent with the plan's terms, could result in significant sanctions. While Nosek may be an extreme example of the sanctions that may be awarded, it places a significant accounting, programming and administrative burden on lenders and servicers.

Recently, cases are expanding the burden on lenders and servicers even more so. Debtors are adding special provisions to the plans, sometimes without legal basis, making it even more crucial to carefully review proposed plans. In one recent Tennessee case, the debtor proposed a plan imposing many extra duties on the lender. Even though the court struck down some of those provisions, the court did (1) reaffirm the duty of the creditor to apply the payments as pre-petition or post petition as dictated by the plan, (2) require the creditor to show the pre-petition arrears as –0- when the discharge was issued, (3) require the creditor to deem the pre-petition arrears as contractually current upon confirmation (which eliminates late fees on timely post petition payments) and (4) require the creditor to notify the debtors, trustee and debtors' counsel in writing of any payment change in advance of the effective date of the change².

These decisions reinforce the need for lenders and servicers to quickly adapt their accounting and other procedures to both apply payments as required by plans and to report to others an account's status that is consistent with the plan's terms. Lenders and servicers need to make sure that changes in monthly payment amounts due to escrow changes and interest rate fluctuations are reported to the debtor and the court or trustee, when necessary. The failure to report payment changes could create a waiver of the right to collect the increased payments or liability for over collecting, if the payment went down. Lenders should consider whether they need to audit their files on a periodic basis to verify their records are consistent with the chapter 13 trustees' records. More courts are ordering that lender's accounts be shown as contractually current when the chapter 13 plan is complete. An audit, which is not made until the case is ready to close, may be too late. The Tennessee decision further highlights the importance of always reviewing a chapter 13 plan very carefully and objecting when necessary.

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(1)Nosek v. Ameriquest Mortgage Co., 363 B.R. 643 (In re Nosek)(Bankr. D. Mass. Mar. 6, 2007) (awarding $250,000.00 in emotional distress damages and $500,000.00 in punitive damages pursuant to 11 U.S.C. § 105(a) (2005) for violating § 1322(b) of the Bankruptcy Code. The case is on appeal to the First Circuit Court of Appeals, however the debtor recently asked the bankruptcy court to award a judgment against the lender for $1,000,000, which includes the $750,000 already awarded plus accrued interest and legal fees.)

(2)In re Collins, 2007 Bankr. Lexis 2487 (Bankr. E.D.Tenn July 19, 2007)