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Foreclosures Flood Bankruptcy Courts

By Sylvia Hsieh; originally published on LawyersWeeklyUSA.com on August 19, 2008

The foreclosure crisis is fueling an increase in bankruptcy litigation over a variety of issues between lenders and homeowners. According to a recent ABA teleconference, residential foreclosures rose 55 percent just in the last year, with an estimated 1 million foreclosures by the end of the year and $3.5 trillion in home equity wiped out.

"There is a boom in individual bankruptcy filings, despite changes in the law in 2005 that make it more difficult for an individual to get relief," said Patrick Mears, a partner at Barnes & Thornburg in Grand Rapids, Mich., who moderated the conference. wiped out.

Cleveland bankruptcy attorney Richard Nemeth said that filings are "back up to what they were just prior to the legislation going into effect and are headed up."

The new bankruptcy law took away a lot of discretion exercised by bankruptcy judges. But bankruptcy courts are now busier than ever hearing new consumer claims arising from the home mortgage debacle.

"It used to be that bankruptcy lawyers didn't have to spend a lot of time litigating. That has totally changed now, because there's a need to protect people from losing their homes," said April Charney, an attorney with Legal Aid in Jacksonville, Fla.

Bankruptcy judges are scrutinizing home mortgage loans very closely, and in many cases refusing to grant lenders relief from a stay.

"Bankruptcy courts are taking on a whole new role now as consumer guardians," said Traci Rollins, a partner at Squire, Sanders & Dempsey in West Palm Beach who represents lenders.

"Judges are much more skeptical of lenders' behavior and lenders have to be scrupulously careful. An error previously believed to be de minimus can bring a whole foreclosure to a screeching halt," Rollins said.

In some states that do not require judicial foreclosure, bankruptcy courts are becoming the "battleground" for various consumer defenses to foreclosure, said Stuart Rossman, a staff attorney with the National Consumer Law Center in Boston.

Challenging the loan

A large amount of litigation revolves around challenging ownership of the mortgage where a loan servicer is involved.

The issue is whether the mortgage servicer has standing based on whether it can show a chain of title for loans it purchased in bulk as securities.

A growing number of bankruptcy courts have denied relief from stays or issued standing orders because the mortgage servicer did not prove it owned the loan.

State courts have also dismissed foreclosure actions for the same reason. And at least one court has imposed sanctions against a mortgage servicer and its attorneys for collecting payments on a loan it did not own.

"Nobody was doing due diligence or looking at whether the loan was legally assigned," said Charney, noting that this issue has come up in every one of her cases.

Bankruptcy judges are now requiring "real proof" of ownership of a debt, such as original copies of the assignment, said Michael Robinson, an attorney in Castle Rock, Colo. who recently stopped a foreclosure by challenging the mortgage servicer's standing.

The problem, said Robinson, is that "everybody has moved to e-filing and is using PDFs so they are having a tough time finding originals. And with all the layoffs, they are having a hard time finding the person who signed it to show up in court."

The practical effect is that this provides leverage for negotiating the terms of the mortgage, he said.

"It's a way to negotiate. Once you challenge this and the servicers lose, they end up getting their act together and we've been very successful in getting great results for debtors," such as turning an adjustable rate mortgage into a 30-year fixed mortgage without any missed payments and "extremely low" interest rates, said Robinson.

Another burgeoning issue is how to discharge junior mortgages.

Because in most cases there is no equity attached to second mortgages, those can be stripped off.

But it's an open question how to do that, said Joan Grimes, a bankruptcy attorney in Walnut Creek, Calif., who represents debtors.

"Is it discharged by motion or by adversary proceeding? Once you've determined how to do it, is it avoided immediately in Chapter 13? Or can the lien only be avoided after the plan is completed? We'll see this come into play this year," Grimes said.

Creative argument

Debtors' attorneys have found another creative loophole to help debtors who are repeat filers.

Under the bankruptcy statute, if a debtor is a repeat filer in the same year, it is understood that the automatic stay goes away after 30 days.

However, "creative debtors' attorneys have done an excellent job of exploiting the poor draftsmanship of the reform legislation to help their clients," said Nemeth.

The portion of the statute that imposes the stay refers to "the debtor, the debtor's property, and the bankruptcy estate," but the portion of the statute that refers to termination of the stay for repeat filers refers only to termination "with respect to the debtor."

Debtors' lawyers have therefore argued that the stay does not terminate with respect to the debtor's property or the estate.

"Bankruptcy judges have accepted the argument on a 'plain meaning' ground even though the result is contrary to the pro-creditor thrust of the reform legislation," said Nemeth. He noted that the argument has been especially helpful in Chapter 13 consumer reorganization cases.

Recent cases

Here's a closer look at some recent cases:

• Arkansas. A bankruptcy court issued a preliminary injunction against America's Servicing Co. to stop it from continuing to collect "phantom debt" arising from mortgage payments it misapplied. (In re Moffitt, No. 3:04-bk-22708E (Bankr. E.D. Ark. 2008).)

• California. Calling the case a "poster child for some of the practices that have led to the current crisis in our housing market," a bankruptcy court discharged a $250,000 home equity line of credit. The court found that even though the homeowners lied about their income on their application, the lender did not rely on the misstatement because it relied solely on the value of the property. (In re Hill, No. 07-4106 AT (Bankr. N.D. Calif. 2008).)
• Massachusetts. A bankruptcy court sanctioned Wells Fargo and Ameriquest and their lawyers for misrepresenting their role as owners of the debtor's mortgage. (Nosek v. Ameriquest Mortgage Co., No. 04-4517 (Bankr. D. Mass. 2008).)
• New York. A state trial court dismissed a foreclosure proceeding with prejudice because the assignment of the mortgage was defective. (Wells Fargo Bank v. Farmer, No. 27296/07 (2008).)
• Ohio. A series of rulings by federal district courts in Ohio have resulted in the dismissal of dozens of foreclosure actions for lack of standing. (In re Foreclosure Cases, No. 3:07CV043 (S.D. Ohio 2007).) (27 foreclosure claims dismissed without prejudice).
  (In re Foreclosure Actions, No. 1:07CV1007 (N.D. Ohio 2007).) (32 foreclosures claims dismissed without prejudice for lack of documentation).
  (In re Foreclosure Cases, No. 07-Cv-166 (S. D. Ohio 2007).) (15 foreclosure actions dismissed without prejudice for lack of standing)

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