CHAPTER 26: BANKRUPTCY 1
Chapter 26Bankruptcy
Introduction
Bankruptcy law is designed to accomplish two main goals: to provide relief and protection to debtors who have “gotten in over their heads” and to provide a fair means of distributing a debtor’s assets among creditors. Thus, the law attempts to protect the rights of debtor and creditor, with an emphasis on requiring debtors to pay as many of their debts as they can.
Because many debtors end up in bankruptcy because they can no longer afford to make the payments on their homes, this chapter begins with an introduction to mortgages and the foreclosure process. The chapter also looks at laws that assist debtors by providing exemptions that protect certain property from creditors.
Chapter Outline
I.Mortgages
An individual who buys real property typically borrows the funds from a financial institution to pay for it. A mortgage is a written instrument that gives the creditor an interest in, or a line on, the property as security for the payment. A mortgage loan is a contract.
Additional Background—The Sale of Real Estate
Transfers of ownership interests in real property are frequently accomplished by means of a sale. The sale of real estate is similar to the sale of goods, because it involves a transfer of ownership, often with specific warranties. In the sale of real estate, however, certain formalities such as the execution of a deed are observed that are not required in the sale of goods.
Several steps are involved in any sale of real property. The first step is the formation of the land sales contract. A title search (to verify that the seller has good title to the property and that no other claims to the property exist) follows, along with, usually, negotiations to obtain financing for the purchase. The final step is the closing.
Brokers. Buyers and sellers of real property frequently enlist the services of a real estate agent, or broker. Real estate agents are information brokers. They provide buyers and sellers of real estate with information and specialize in matching the wants of buyers with the property being offered for sale by sellers. The broker is usually retained by the seller and acts as the seller’s agent in the sale of the property. As compensation for their services, brokers usually receive a commission (which can vary between 1 to 10 percent of the purchase price) from the seller when the sale is concluded. A broker can also simultaneously act as an agent of the buyer, in which case a dual agency exists. Generally, a broker may not act as an agent for more than one party without the consent of all parties involved. (There exist some buyer-only brokers.) Most states require real estate brokers to be licensed, and, in some states, brokers may be required to meet continuing-education or other requirements. A seller engages the services of a broker through a written listing agreement. In an open listing, the seller contracts for the services of more than one broker, and the first broker to produce a buyer receives the commission. In an exclusive listing, the seller contracts with just one broker, who receives the exclusive right to find a buyer and receive the commission from the seller. Under an exclusive listing agreement, the broker is entitled to a commission even if another broker sells the property.
Sales Contract. Generally, when someone decides to purchase real estate, he or she makes a written offer to purchase the property and puts up earnest money to show that an earnest, or serious, offer is being made. (If the offeror decides to withdraw the offer, the earnest money, or deposit binder money, will often be forfeited to the seller.) The offer states in some detail the exact offering price for the property and lists any other conditions that may be appropriate. The offer may be conditioned on the offeror’s ability to obtain financing, for example. Within a specified time period, the seller of the property either accepts or rejects the offer. If the offer is accepted, then a contract of sale is drawn up. The signing of the sales contract is usually accompanied by a deposit, which may be 10 percent of the purchase price paid to the seller. The buyer can then add to the existing earnest money to bring it up to the desired amount.
Deposits toward the purchase price normally are held in a special account, called an escrow account, until all of the conditions of sale have been met and the closing takes place, at which time the money is transferred to the seller. The escrow agent,which may be a title company, bank, or special escrow company, acts as a neutral party in the sales transaction and facilitates the sale by allowing the buyer and seller to close the transaction without having to exchange documents and funds. An escrow agent is an agent of all of the parties involved in the sales transaction. When a conflict between the parties results in conflicting duties on the part of the agent, normally the agent will have a court resolve the conflict.
Sometimes, an arrangement is made in which a potential buyer is given the right to purchase property in the future, within a specified period of time and for a specific price. This is called an option contract. To be enforceable, the contract must be in writing, and consideration must be given to the seller. Essentially, payment to the seller compensates the seller for taking the property off the market until the end of the time specified in the option contract. Potential buyers may also obtain a right of first refusal. Frequently, those who lease property with the intention of possibly buying it in the future will have such a clause added to the lease contract. This right means that the lessee, or tenant, has first priority if the seller decides to sell the property. In other words, if the seller receives an offer from a third party, the seller cannot accept the offer until the tenant indicates that he or she does not intend to purchase the property.
Title Examination. After the sales contract has been negotiated, the buyer or buyer’s attorney (or the broker, escrow agent, title insurance company, or lending institution from which the purchase price is being borrowed) will begin the title examination, which entails examining at the county recording office the history of all past transfers and sales of the property in question. The title examiner will generally obtain an abstract from a private abstract company. This document lists all the records relating to a particular parcel of land. After reading the abstract, the examiner will give an opinion as to the validity of the title. Title examinations are not foolproof, and buyers of real property generally purchase title insurance to protect their interests in the event that some defect in the title was not discovered during the examination. A title insurance policy insures against loss resulting from any defects in the title and guarantees that, if any defects do arise, the title company issuing the policy will defend the owner’s interests and pay all legal expenses involved.
Financing. Unless a buyer pays cash for the property, the buyer must obtain financing for the purchase with a mortgage loan. A mortgage loan is a loan made by a banking institution or trust company for which the property is given as security. In some states, the mortgagor (the borrower) holds title to the property; in others, the mortgagee (the lender) holds title until the loan is completely repaid. In several states, a trustee—a third party—holds title on behalf of the lender. The trustee then deeds the property back to the borrower when the loan is repaid. If the payments are not made, the trustee can deed the property to the lender or dispose of it by auction, depending on state law.
There are numerous ways of financing the purchase of real property, some of which are quite creative. Frequently, financing is obtained through a conventional long-term mortgage loan in which the payment schedule extends over a period of twenty-five to thirty years. Traditionally, the interest rate for long-term loans was fixed—that is, the interest rate did not change over the period of the loan. Today, long-term loans often have variable rates of interest. In a variable-rate loan, the interest rate is pegged to a specified standard, such as the prime rate—the rate of interest offered by lending institutions to their most creditworthy customers—and adjusted at specified intervals, such as six months or a year. In some situations, the seller may be willing to finance the purchase for a buyer. That is, the buyer will pay, say, 10 percent of the price as a down payment and make periodic (usually monthly) payments to the seller until the balance of the purchase price is paid. In other situations, a wraparound mortgage may be used.
Several terms used in mortgage transactions merit special mention and clarification. Obtaining a mortgage normally involves paying a fee to the lender in the form of points. A point is a charge of 1 percent on the amount of a loan. Therefore, if the lender’s fee is two points and the amount of the loan is $80,000, the fee amounts to $1,600. This charge may be assessed against the buyer, the seller, or both.
If the mortgage terms allow for prepayment privileges, then the borrower can prepay the mortgage before the maturity date without penalty. Prepayment privileges may be especially important if market interest rates fall below the interest rate of the mortgage loan—in which case the loan could be refinanced to the advantage of the borrower.
An amortization schedule shows what portions of each monthly payment on a loan-term loan, such as a mortgage loan, go to the interest and to the principal on the loan, respectively. In the first several years of the loan, the borrower pays primarily interest on the mortgage, so the amount owing on the principal of the loan declines very slowly. By the end of the payment schedule, however, the payments are mostly on the principal. An amortization schedule is usually given to the borrower by the lending institution; if not, the borrower can request one.
Closing. The final step in the sale of real estate is the closing—also called settlement or closing escrow. The escrow agent coordinates the closing with the recording of deeds, the obtaining of title insurance, and other concurrent closing activities. Several costs must be paid, in cash, at the time of closing. These costs comprise fees for services, including those performed by the lender, escrow agent, and title company, and they can range from several hundred to several thousand dollars, depending on the amount of the mortgage loan and other conditions of sale. Lending institutions are required by law to notify—within a specified time period—each applicant for a mortgage loan of the specific costs that must be paid at the closing.
Warranty of Habitability. The common law rule of caveat emptor (“let the buyer beware”) held that the seller of a home made no warranties with respect to its soundness or fitness unless such a warranty was specifically included in the deed or contract of sale. Although caveat emptor is still the rule of law in a minority of states, there is currently a strong trend against it and in favor of an implied warranty of habitability. Under this new approach, the courts hold that the seller of a new house warrants that it will be fit for human habitation regardless of whether any such warranty is included in the deed or contract of sale. This warranty is similar to the UCC’s implied warranty of merchantability for sales of personal property. In recent years, some states, such as Virginia, have passed legislation creating such warranties for newly constructed residences. Under an implied warranty of habitability, the seller warrants that the house is in reasonable working order and is of reasonably sound construction. To recover damages for breach of the implied warranty of habitability, the purchaser is only required to prove that the home he or she purchased was somehow defective and to prove the damages caused by the defect. Under the warranty of habitability theory, the seller of a new home may be in effect a guarantor of the home’s fitness.
Seller’s Duty to Disclose. Traditionally, under the rule of caveat emptor, a seller had no duty to disclose to the buyer defects in the property, even if the seller knew about the defects and the buyer had no reasonable way to discover them. Currently, in many jurisdictions, courts have placed on sellers a duty to disclose any known defect such as a rotted roof that materially affects the value of the property and that the buyer could not reasonably discover. Under these circumstances, nondisclosure is similar to representing that the defect does not exist, and the buyer may have grounds for a successful lawsuit based on fraud or misrepresentation.
A.Fixed-Rate v. Adjustable-Rate Mortgages
1.Fixed-Rate Mortgages
A fixed-rate mortgage is a standard mortgage with a fixed rate of interest. Payments are the same for its duration. The interest rate may be based on the borrower’s credit history, credit score, income, and debts.
2.Adjustable-Rate Mortgages (ARMs)
The interest rate on an adjustable-rate mortgage changes periodically. The rate may begin relatively low and fixed. After a certain time, and at certain intervals, the rate adjusts. The adjustment consists of a specified number of points added to an index rate. Most ARMs limit the amount that the rate can increase over the duration of the loan.
B.Mortgage Provisions
Terms may include—
•Loan terms—the amount, the interest rate, the period of repayment, and others.
•A prepayment penalty clause.
•Provisions for the maintenance of the property.
•A statement obligating the borrower to maintain homeowners’ insurance.
•A list of the borrower’s non-loan financial obligations—property taxes and so on.
•A provision for the borrower’s payment of regular and ordinary expenses associated with the property—taxes, insurance, and other assessments—through the lender.
•Creditor protection, such as—
Mortgage insurance—If the debtor defaults, the insurer reimburses the creditor for part of the loan.
Recording the mortgage—Recording a mortgage in the appropriate county office perfects the creditor’s interest in the property. On the debtor’s default, a creditor who has not perfected his or her interest may have the priority of an unsecured creditor.
Additional Background—Recording the Mortgage
Recording statutesare in force in every jurisdiction. Their purpose is to provide prospective buyers with a way to check whether there has been an earlier transaction. Hence, recording a deed gives constructive notice to the world that a certain person is now the owner of a particular parcel of real estate.
There are three basic types of recording statutes—
•Race statutesprovide that the first purchaser to record a deed has superior rights to the property, regardless of whether he or she knew that someone else had already bought it but had failed to record the deed.
•Pure notice statutes provide that, regardless of who files first, a person who knows that someone else has already bought the property cannot claim priority.
•Race-notice statutes provide that a purchaser who does not know that someone else has already bought the property and who records his or her deed first can claim priority.
Irrespective of the particular type of recording statute adopted by a state, recording a deed involves a fee. The grantee typically pays this fee, because he or she is the one who will be protected by recording the deed.
C.Mortgage Foreclosure
If a borrower defaults, or fails to pay a loan, the lender can foreclose on the mortgaged property. The foreclosure process allows a lender to repossess and auction the property. A foreclosure can be expensive and remains on a borrower’s credit report for seven years.
1.Ways to Avoid Foreclosure
•Forbearance—The postponement of part or all of the payments of a loan in danger of foreclosure. This may be based on a borrower’s securing a new job, selling the property, or some other factor.
•Workout—A voluntary attempt to cure a default. A workout agreement sets out the parties’ rights and responsibilities—for example, a lender may agree to delay foreclosure in exchange for a borrower’s financial information.
•Short sale—A sale of the property for less than the balance due on a mortgage loan. A borrower—who typically must show some hardship—sells the property with the lender’s consent.
2.Foreclosure Procedure
A lender must strictly comply with the terms of the state statute governing foreclosures.
Case Synopsis—Case 26.1: McLean v. JP Morgan Chase Bank N.A.
JP Morgan Chase Bank, N.A., filed a foreclosure action in a Florida state court against Robert McLean. The mortgage attached to the complaint identified a different mortgagee and lender, however. Later, Chase provided an assignment of McLean’s mortgage that was dated three days after the filing of the suit and a note with an undated indorsement. From a judgment in Chase’s favor, McLean appealed.
A state intermediate appellate court reversed. A party seeking foreclosure must have standing to foreclose when it files its complaint. In this case, the mortgage was assigned after Chase filed its complaint, and the indorsement on the note was undated. To succeed, on remand Chase would have to prove that it owned the note at the time of the complaint or file a new complaint.
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Notes and Questions
What might the lender have done to avoid an unfavorable result in this case? The lender should have been more careful with the paperwork and its dates. The mortgage and its assignment should have been more easily traceable and should have been verified before the complaint was filed. The indorsement on the note should have been dated. Separate records proving the dates of the assignment and indorsement might also have been kept. Otherwise, how would the lender know that it was filing a complaint against the right defendant?
Additional Cases Addressing this Issue —
Mortgage Foreclosure
Recent cases focusing on notice, service, and other requirements in foreclosure proceedings include the following.
•Kersey v. PHH Mortgage Corp., 682 F.Supp.2d 588 (E.D.Va. 2010) (when a mortgagee was obligated to have, or reasonably attempt to have, a face-to-face meeting with the mortgagor before it could commence foreclosure, the mortgagee’s failure to comply gave rise to a cognizable breach of contract claim).
•ABN AMRO Mortgage Group, Inc., v. McGahan, __ Ill.2d __, __ N.E.2d __, 2010 WL 2222126 (2010) (a mortgagee must name a personal representative for a deceased mortgagor in a foreclosure proceeding for the court to acquire jurisdiction—there must be personal service because the mortgagor is a necessary party to the action).
•First National Bank of Chicago v. Silver, 73 A.D.3d 162, 899 N.Y.S.2d 256 (2 Dept. 2010) (a summary judgment in a foreclosure action in the mortgagee’s favor must be reversed and the complaint dismissed when the mortgagee did not deliver statutory-specific notice to the homeowner, together with the summons and complaint, as required by state law).
•Rabinowitz v. Deutsche Bank, __ Misc.2d __, __ N.Y.S.2d __, 2010 WL 2106217 (Sup. 2010) (a mortgagee gave adequate notice of a foreclosure sale when notice of a first auction was published for four successive weeks and—after the successful bidder refused to sign a memorandum of sale and decided not to buy the property—the mortgagee published notice of a postponement of sale and scheduled a second auction).
D.Redemption Rights