Mortgage Can Be Modified By Ch. 11 Plan, Even If Debtor Is Not Indebted, But Cram-Down Limited

By Andrew C. Kassner and Joseph N. Argentina Jr.

As the old saying goes — interesting facts make interesting law. In this post-great recession era where mortgage lenders are carefully scrutinizing borrowers for credit worthiness and have tightened underwriting criteria, the assumption is that they know the identity of their borrowers, and if the mortgaged property is transferred, the lender can demand payment of its loan.
Today we review a situation where a 50% interest in mortgaged commercial real estate was transferred without the consent of the lender, and the new tenant-in-common owner subsequently filed a Chapter 11 case and attempted to modify the payment terms of the mortgage loan to which he is not a party. Can this be done in bankruptcy? And what happens to the nondebtor 50% tenant-in-common borrower under the loan?
In a recent decision in In re Taing, Case No. 22-40896-CJP, the U.S. Bankruptcy Court for the District of Massachusetts held that a mortgagee holds a claim that could be modified by a Chapter 11 plan even if the debtor was not indebted under the mortgage, but limited the ability to “cram down” the plan terms against the lender to the extent it modified the lender’s rights against the nondebtor obligor.
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The Debtor Was a Partial Owner of Properties Secured by Mortgages Given by Third Parties

According to the opinion, the debtor owned a partial interest in properties located in Lowell, Massachusetts. Each of the properties was encumbered by mortgages given by third parties. The debtor was not a signatory to the mortgages or obligated under the notes secured by the mortgages. The mortgages contained due-on-sale clauses that restricted the transfer of the original owners’ interests in the properties. Nevertheless, the debtor had acquired 50% interest in the properties and subsequently filed for bankruptcy under Subchapter V of Chapter 11 of the Bankruptcy Code.
The debtor proposed a plan that sought to restructure the mortgage loan obligations on the properties. The mortgagees objected to the plan, arguing that because the debtor was not an obligor under the mortgage or note, they did not hold claims in the bankruptcy case that could be restructured under the plan. The mortgagees also objected to the plan on the basis that it had not been filed in good faith. One of the mortgagees also argued that the proposed cram-down treatment of its interest in the property could not be approved because it modified its interest in a non-debtor’s interest in the property.
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The Court Ruled the Mortgagees Held Claims In the Case

The court began its analysis by noting that Section 101(5) of the Bankruptcy Code defines the term “claim” as a “right to payment” or a “right to an equitable remedy.” Section 102(2) defines a “claim against a debtor” as a claim against property of the debtor. The U.S. Supreme Court, in Johnson v. Home State Bank, 501 U.S. 78 (1991), ruled that a “right to payment” includes a “right to the proceeds from the sale of the debtor’s property,” even if the debtor is not liable on the underlying mortgage. The Johnson decision involved a debtor whose personal liability on a nonrecourse mortgage had been discharged in a Chapter 7 bankruptcy case. The Supreme Court ruled that the mortgagee held a claim in the debtor’s subsequent Chapter 13 case because its in rem rights in the debtor’s property survived the Chapter 7 discharge.
According to the Massachusetts court, “the majority of courts apply the Supreme Court’s broad interpretation of “claim” in Johnson to permit confirmation of Chapter 13 plans that cure arrears where there are only in rem rights and no contractual privity between the debtor and creditor.” A minority of courts have ruled that the Bankruptcy Code does not permit a debtor to modify a debt on which the debtor is not personally liable. These courts have distinguished Johnson, where the debtor had been personally liable on the mortgage prior to its Chapter 7 discharge.
The opinion also cites a number of cases that have relied on Johnson to hold that secured claims may be restructured in Chapter 11 even where debtors lack privity with the secured creditor. The court further reasoned that contract privity concerns present in a Chapter 13 case are “somewhat mitigated” in Chapter 11, where nonrecourse secured creditors are able elect to be treated as recourse creditors under Section 1111(b) of the Bankruptcy Code. Moreover, the court distinguished cases that did not follow Johnson by noting they found that “no claim existed in lieu of deciding on good faith to avoid absurd results where debtor acted in a manner antithetical to the Bankruptcy Code.”
In this case, the court ruled that the mortgagees did hold claims in the bankruptcy case that could be treated and modified under the plan of reorganization despite a lack of privity with the debtor, and cautioned that the Supreme Court in Johnson instructed courts not to attempt to use the definition of “claim” to police the bankruptcy process for abuse. Here, the court expressly reserved for adjudication the issue of whether the debtor’s plan had been proposed in good faith.
One of the mortgagees also objected to the debtor’s plan because it sought to cram-down the mortgagee’s claim on the debtor’s share of the property and modify the mortgagee’s existing rights against the third-party co-owner. The original mortgage on the property provided for a fixed interest rate of 7.723%. The plan proposed to cancel the loan “as to the debtor’s interest,” and create a new debt owed by the debtor secured by a mortgage amortized over 40 years at 6.5%. The opinion notes that under that proposal, the new maturity date would be extended for “approximately 27 years.” The mortgagee would retain its existing claim against the third-party co-owner, secured by the existing mortgage on the third-party co-owner’s interest.
The court noted that a Chapter 11 plan can modify the rights of secured claimants, and a debtor may also modify a mortgage on its undivided interest. However, the opinion notes that courts have denied confirmation of plans that proposed to modify the lender’s rights against nondebtor co-owners or the rights of the non-debtor co-owner. For example, plans may not substantively consolidate a debtor and unwilling tenant-in-common co-owners or force them to restructure their secured obligations. The court determined that the Debtor’s plan would modify the mortgagee’s rights in the pre-existing mortgage and against the co-owner, including restricting foreclosure if the co-owner defaulted but the debtor did not. The court cited the Supreme Court’s recent ruling in Harrington v. Purdue Pharma, 144 S. Ct. 2071 (2024), that “plan injunctions affecting the rights and remedies of creditors as to nondebtor third parties are granted only in extraordinary circumstances.” The court ordered the debtor to file an amended plan within 21 days that did not affect the mortgagee’s rights against the co-owner.
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Conclusion: Interesting But Unanticipated Complex Result

The results of this opinion and other court decisions involving similar situations are interesting but complex. First, lender’s counsel should not confuse the fact that a nonborrower filed the case at all with whether the facts surrounding the transfer and bankruptcy filing demonstrate that the case or plan was not filed in good faith. The good faith issue should be front and center. Second, assuming the case is allowed to proceed, the result could be, in essence, two mortgages with different terms and enforcement rights — one against the debtor and the other against the non-debtor tenant-in-common. Of course, this scenario is not anticipated by lenders when originating mortgage loans, but many possible bankruptcy scenarios are not anticipated. This decision, and the number of similar cases cited in the opinion demonstrates that lenders’ counsel must add another scenario to the list.