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Author: Michael R. Steinmark and Kristina A. Kiik
Last Friday, May 16, 2014, the Texas Supreme Court issued a landmark decision for banks and mortgage servicers. In Sims v. Carrington Mortgage Services, L.L.C. (full opinion available here), the Texas Supreme Court held that as long as a modification of a home equity loan only restructures the collection of monies already owed under the original loan (including principal, interest, escrow, and fees), and does not involve any new monies being loaned (i.e., no new “extension of credit”), the loan modification does not have to comply with the restrictions in Texas Constitution Article 16, Section 50(a)(6).
Texas has a long history of protecting the homestead, which led to home equity lending only being permitted in the state after constitutional protections were adopted. Specifically, Texas Constitution Article 16, Section 50(a)(6) provides a number of requirements for home equity loans, such as the well-known “80% rule” and “3% rule” limiting, respectively, the original principal amount of a home equity loan and certain fees on the loan. Until now, however, it has been unclear whether those requirements apply to modifications of home equity loans.
Homeowners and lenders or mortgage servicers often enter into loan modification agreements before and during litigation to avoid foreclosure and help get borrowers back on track toward repayment of their financial obligations. That is exactly what happened between Frankie and Patsy Sims and Carrington Mortgage Services, L.L.C., when the borrowers fell behind on their mortgage payments. In 2009, the parties entered into a loan modification agreement that, among other things, capitalized past-due interest and other charges, including fees and unpaid taxes and insurance premiums, into the new unpaid principal balance. All other obligations and all other loan documents remained unchanged. The modification reduced the interest rate and monthly payments on the loan and kept the borrowers out of foreclosure.
Two years later, in 2011, the borrowers again fell behind on their payments and entered into another loan modification to avoid foreclosure. Two months after entering into that modification, the borrowers brought a class-action suit in federal court alleging their loan modification, along with others similarly situated, violated the home equity loan requirements in Section 50(a)(6) of the Texas Constitution.
The federal district court dismissed the action, and the borrowers appealed to the U.S. Court of Appeals for the Fifth Circuit. Because the appeal involved an issue of first impression under Texas state law, the Fifth Circuit utilized a procedural vehicle allowing it to obtain a decision from the Texas Supreme Court on the legal questions involved, including whether a modification of an existing home equity loan is a new “extension of credit” subject to the restrictions of Section 50(a)(6).
Adopting a textual approach to constitutional interpretation, Texas Supreme Court Chief Justice Nathan Hecht distinguished the word “refinance” from the word “modification.” Unlike a refinance, which involves a new extension of credit satisfying and replacing the original loan, a modification of a home equity loan does not involve a satisfaction or replacement of the original loan. Rather, modifications which, for example, capitalize interest on past-due amounts, unpaid escrow balances, and unpaid fees, simply defer or restructure payment obligations already owed under the original loan, generally in a way that allows the borrower to keep his home.The Texas Supreme Court thus found that modifications of home equity loans actually support the intent behind Section 50(a)(6) in protecting the homestead, and that same intent would be frustrated by requiring modifications to comply with Section 50(a)(6), as lenders would not be able or willing to enter into modifications under those conditions. Accordingly, because a modification is not a refinance, the Texas Supreme Court held the requirements of Section 50(a)(6) do not apply to apply to loan modifications of home equity loans so long as no new amounts are loaned and the modification only restructures payments of sums owed under the original loan.