Mortgage Loan Modification Does Not Alter Lien Priority

By Scott F. Waterman, Chapter 13 Standing Trustee for the Eastern District of Pennsylvania (Reading)

Modifying a first mortgage is one of the most common loss mitigation tools available to bring a loan current to prevent foreclosure. In this case the first mortgage was modified twice by capitalizing the unpaid interest, reducing the interest rate, and reducing the monthly payments from $2,048 to $1,693 and transforming the loan from being in default to one that was deemed current. Fraction v. Jacklily, LLC (In re Fraction), No. 19-121 (Bankr. E.D. Pa. 2020)(per Frank, J).

This issue arose in bankruptcy because when the case was filed the first mortgage lien exceeded the fair market value of the real estate rendering the second mortgage lender’s secured claim valued at zero. The debtors sought to avoid the second mortgage in full as it was wholly unsecured, under 11 U.S.C. §506 (a) and (d). See also In re McDonald, 205 F.3d 606 (3rd Cir. 2000), which states that in a chapter 13 bankruptcy junior liens that are unsupported by any equity in a property can be stripped off and discharged.

The second mortgage lender defended arguing that the bankruptcy court should apply the Equitable Subordination Doctrine to reorder the priority of its mortgage over the modified residential mortgage, claiming that it was prejudiced when the first lender modified its mortgage to make the debtors current.

In Pennsylvania, liens against real property generally have priority over each other on whichever lien was recorded first. See 42 Pa.C.S.§ 8141. Mortgage priority is not limited to the principal balance of the loan that the mortgage secures. In addition, certain advances made by the mortgagee for the purpose of protecting the mortgage’s secured position along with unpaid interest are secured with the same priority as the loan principal.

Recently in Hamilton v. Pennsylvania Housing Finance Agency, 614 B.R. 48 (E.D. Pa. 2020), the United States District Court declined to adopt either § 7.3 of the Restatement (Third) of Property or the “Equitable Subordination Doctrine” outside of bankruptcy.

In Fraction, Bankruptcy Judge Eric L. Frank refused to sidestep the issue and addressed it head on, by holding that the Equitable Subordination Doctrine is inapplicable because the loan modifications did not prejudice the second lender. Specifically, he found that the modifications did not add “new debt”, i.e. they did not create new liabilities for the first time. The loan modifications merely recapitalized interest and costs that were already owed and secured under the original Note. Even accounting for the increased principal added to the balance of the Note, both loan modifications had the effect of reducing that amount of Debtors’ indebtedness under the first mortgage over time. Finally, the Court concluded that the loan modification were not required to be recorded as they did not create “new interest” in Property. As a consequence the Court granted summary judgment for the debtors holding that the second lender secured claim was valued at zero.

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watermanScott F. Waterman, Esq. graduated from Tufts University in 1991 with a dual major in history and political science. He received his J.D. from Temple University School of Law in 1994. He is a Chapter 13 Bankruptcy Trustee for the Eastern District of Pennsylvania, and his office is located in Reading, Pennsylvania. Previously, he had his own private law practice focusing on consumer bankruptcy and commercial collection matters. Mr. Waterman is a former Chair of the Eastern District of Pennsylvania Bankruptcy Conference and is a Fellow of the American College of Bankruptcy. He is a member of the National Association of Chapter 13 Trustees and the Berks County Bar Association. Mr. Waterman volunteers his time as a current board member of the Consumer Bankruptcy Assistance Project which provides free legal assistance to indigent bankruptcy clients. In 2014 Mr. Waterman was appointed to be a member of the Local Rules Advisory Committee of the United States Bankruptcy Court for the Eastern District of Pennsylvania in helping to draft new and updated local bankruptcy rules. That same year he served on the Bankruptcy Judge Merit Selection Committee for the Eastern District of Pennsylvania to which he was appointed by the United States Court of Appeals for the Third Circuit. Mr. Waterman has two sons and enjoys sailing, playing softball and watching baseball. He spends his free time driving his kids back and forth to their various sporting activities.

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