The Texas Supreme Court recently held that a loan modification agreement that lowers a borrower’s interest rate and reduces monthly payments by capitalizing past due amounts as principal does not violate the Texas home equity loan requirements in Article XVI, Section 50 of the Texas Constitution.
Specifically, the Court held that as long the original note is not satisfied and replaced, there is no additional extension of credit. Therefore, the restructuring of a borrower’s debt is valid and does not need to meet Texas’ constitutional requirements for a new loan as there is not a new extension of credit.
A copy of the opinion is available at: http://www.supreme.courts.state.tx.us/historical/2014/may/130638.pdf
In 2003, plaintiff homeowners (“Plaintiffs”) purchased a home in Texas via a 30 year home equity loan. In 2009, Plaintiffs fell behind in their monthly payments, and entered into a loan modification agreement with the defendant mortgage servicer. In 2011, Plaintiffs again fell behind in their monthly payments and sought another loan modification agreement. Instead of giving Plaintiffs a second loan modification, the defendant initiated a foreclose action. Plaintiffs defended against the foreclosure action by claiming the 2009 loan modification violated the home equity loan limitations in the Texas state constitution. The parties subsequently entered into a second loan modification.
Two months after entering into the second modification, Plaintiffs brought a class action in federal court in Texas claiming the defendant’s loan modification agreements violate Article XVI, Section 50 of the Texas Constitution.
The federal district court dismissed Plaintiffs’ class action for failure to state a claim, and Plaintiffs appealed. On appeal, the U.S. Court of Appeals for the Fifth Circuit certified the following 4 questions to the Texas Supreme Court:
1. After an initial extension of credit, if a home equity lender enters into a new agreement with the borrower that capitalizes past-due interest, fees, property taxes, or insurance premiums into the principal of the loan but neither satisfies nor replaces the original note, is the transaction a modification or a refinance for purposes of Section 50 of Article XVI of the Texas Constitution?
If the transaction is a modification rather than a refinance, the following questions also arise:
2. Does the capitalization of past due-due interest, fees, property taxes, or insurance premiums constitute an impermissible “advance of additional funds” under Section 153.14(2)(B) of the Texas Administrative Code?
3. Must such a modification comply with the requirements of Section 50(a)(6), including subsection (B), which mandates that a home equity loan have a maximum loan to value ratio of 80%?
4. Do repeated modifications like those in this case convert a home equity loan into an open-end account that must comply with section 50(t)?
The Texas Supreme Court began its analysis by stating that “because of Texas’ strong, historic protection of the homestead, home equity loans are regulated, not by statute as one might suppose, but by the elaborate, detailed provisions of Article XVI, of the Texas Constitution.”
The Court then examined the Fifth Circuit’s assumption that there is a distinction between a loan modification and a refinance. The Court stated the applicability of Section 50 does not depend on whether the transaction is a modification or a refinance, but whether there is an “extension of credit.”
Therefore, the Court rewrote the 5th Circuit’s initial certified question as:
After an initial extension of credit, if a home equity lender enters into a new agreement with the borrower that capitalizes past-due interest, fees, property taxes, or insurance premiums into the principal of the loan but neither satisfies nor replaces the original note, is the transaction a new extension of credit for purposes of Section 50 of Article XVI of the Texas Constitution?
The Court then examined how to define “extension of credit.” It stated that “credit is simply the ability to assume a debt a repayable over time, and an extension of credit affords the right to do so in a particular situation.”
Plaintiffs argued any increase in the principal amount of a loan is a new extension of credit within the meaning of section 50(a)(6), and thus Defendant’s loan modifications are extensions of credit. The Texas Supreme Court rejected Plaintiffs’ argument, holding that an extension of credit as defined by section 50(a)(6) does not merely consist of the creation of a principal debt, but also includes all terms of the original loan transaction. Thus, a loan’s terms that require a “borrower to pay taxes, insurance premiums, and other such expenses when due protect the lender’s security and are as much part of the extension of credit as the terms requiring timely payments of principal and interest.”
Plaintiffs next argued that restructuring a loan to capitalized on past due amounts and interest is a new extension of credit. The Texas Supreme Court again disagreed, holding “the borrower’s obligation for such amounts and the lender’s right to pay them to protect its security were all terms of the original extension of credit.” Thus, the Court held that no new extension of credit was created.
Similarly, Plaintiffs argued that requiring interest on capitalized, past due amounts is a new extension of credit. However, the Texas Supreme Court held this is simply a way to defer payment of obligations already owed so that a borrower can remain in his or her home.
Plaintiffs next attempted to claim that a loan cannot be restructured by changing the periodic payment amount without violating section 50(a)(6)(L)(i) which states all loans must be “scheduled to be repaid… in substantially equal successive period installments.” The Court held that section 50(a)(6)(L)(i) does not prevent a revision of the initial repayment schedule if it simply adjusts the regular installment amount.
The Texas Supreme Court next determined what test to use to determine when restructuring a loan constitutes a new extension of credit. The Court held there is no new extension of credit when “the secured obligations are those incurred under the terms of the original loan.”
Thus, in regards to the first certified question, the Court provided the following answer:
The restructuring of a home equity loan that, as in the context from which the question arises, involves the capitalization of past due amounts owed under the terms of the initial loan and a lowering of the interest and the amount of installment payments, but does not involve the satisfaction or replacement of the original note, an advancement of new funds, or an increase in the obligations created by the original note, is not a new extension of credit that must meet the requirements of section 50.
The Texas Supreme Court proceeded to examine the Fifth Circuit’s remaining certified questions.
With regard to whether the capitalization of past-due interest, taxes, insurance premiums, and fees are an impermissible advancement of additional funds, the Court determined they are not impermissible if those amounts were assumed by the borrower under the terms of the original loan.
The Court next determined that the restructuring of a loan does not have to comply with section 50(a)(6) because it does not involve a new extension of credit.
Lastly, the Texas Supreme Court held a repeated loan modification does not convert a home equity loan into an open-end loan that has to comply with section 50(t). The Court stated the description of an open-end loan “does not remotely resemble a loan with a stated principle that is to be repaid as scheduled from the outset but must be restructured to avoid foreclosure.”
Thus, the Texas Supreme Court held that the Texas Constitution “does not prohibit the restructuring of a home equity loan that already meets its requirements in order to avoid foreclosure while maintaining the terms of the original extension of credit.”
Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
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