In re Mortgage Store

MEMORANDUM OF DECISION ON HSBC BANK’S MOTION FOR DISBURSEMENT OF PROCEEDS

ROBERT J. FARIS, Bankruptcy Judge.

HSBC¹ claims a first mortgage, and the bankruptcy trustee of The Mortgage Store (“TMS”) claims a second mortgage on property formerly owned by Mr. and Mrs. Abatie. The TMS trustee sold the property and is holding a portion of the proceeds pending resolution of his objections to HSBC’s claims. HSBC seeks disbursement of all the remaining proceeds. For the following reasons, I will grant HSBC’s motion in large part but will allow a reduced amount of attorneys’ fees to HSBC.

Facts

In 2003, IndyMac Bank, F.S.B. (“Indy-Mac”), agreed to make a construction loan to Lawrence and Kathy Abatie in the amount of $524,000. The Abatíes signed a promissory note and a mortgage that encumbered the Abatíes’ property in La-haina.² The mortgage secures “the repayment of the Loan [including ‘the debt evidenced by the Note’], and all renewals, extensions, and modifications of the Note.”³

The note provided an initial interest rate of six percent per annum, subject to annual change based on an index. The interest rate could not exceed twelve percent and would never change by more than two percentage points at any one time. The note further provided for adjustable monthly payments of principal and interest based on a thirty-year amortization period.

The note gives HSBC “the right to be paid back by [the obligor] for all of its costs and expenses in enforcing this Note to the extent not prohibited by applicable law. Those expenses include, for example, reasonable attorneys’ fees.”⁴ The mortgage provides that “Lender may charge Borrower fees for services performed in connection with Borrower’s default, for the purpose of protecting Lender’s interest in the Property and rights under this Security Instrument, including, but not limited to, attorneys’ fees.... Lender may not charge fees that are expressly prohibited by ... Applicable Law.”⁵ Section 22 of the mortgage also provides that, if the borrower defaults, “Lender shall be entitled to collect all expenses incurred in pursuing the remedies provided in this Section 22, including, but not limited to, reasonable attorneys’ fees.... ”

In 2006, The Mortgage Store lent the Abatíes $220,000, secured by a second mortgage on the Lahaina property.⁶

In 2007, IndyMac and the Abatíes entered into a Modification Agreement.⁷ The modification agreement says that it “MODIFIES THAT NOTE [i.e., the Aba-tíes’ 2003 note] TO CHANGE THE INTEREST RATE AND MONTHLY PAYMENT.” ⁸ IndyMac and the Abatíes agreed that the principal balance was $524,000. The interest rate calculation was changed in many respects. Among other things, the maximum interest rate was reduced from twelve percent to 9.95 percent. The payment schedule was also revised to permit “negative amortization”; subject to various complicated limitations, the Abatíes could pay less than the monthly accrual of interest, and the unpaid interest would be added to the principal amount of the loan. The mortgage was not amended and no new mortgage was recorded.

At some point, through a series of intermediate transfers, HSBC succeeded to the interest of IndyMac in the Abatíes’ loan. HSBC has possession of the original promissory note, which is endorsed in blank.

Mrs. Abatie filed a chapter 13 bankruptcy case in 2008 that was dismissed in 2009. She filed another chapter 13 case in 2009 that was dismissed in 2010.

In 2010, TMS filed this chapter 7 case.

In 2011, Mrs. Abatie filed her third bankruptcy case, this time under chapter 7. Both HSBC and the TMS trustee obtained relief from the stay to foreclose their respective mortgages. The TMS trustee commenced a judicial foreclosure proceeding. HSBC could have sought foreclosure of its mortgage in that proceeding but inexplicably did not. The TMS trustee obtained a decree of foreclosure and was the successful bidder at the foreclosure sale. Thus, the TMS trustee became the owner of the property, subject to the HSBC mortgage.

In 2013,1 authorized the TMS trustee to sell the property for $840,000, to pay the costs of sale, to pay HSBC the then undisputed part of the HSBC debt ($524,000), and to retain the remaining proceeds until the HSBC debt could be determined.

The parties exchanged information about HSBC’s claim. Both parties are dissatisfied with the other’s performance in this process. The TMS trustee complains that HSBC produced documents and information too slowly, and HSBC complains that the TMS trustee took too long to review the information that HSBC produced.

In December 2013, HSBC filed the motion that is before me now. The TMS trustee objects to the motion on numerous grounds and argues, not only that HSBC should receive none of the additional sale proceeds, but that it should also refund the $524,000 it received at closing.

Discussion

1. HSBC’s Right to Enforce the Note and Mortgage

The TMS trustee argues that HSBC has not established that it is entitled to enforce the loan and mortgage. I disagree.

The TMS trustee acknowledges that the promissory note is a negotiable instrument and that it was endorsed in blank. HSBC has established that its counsel has possession of it. Thus, HSBC is a person entitled to enforce the note.⁹

The TMS trustee argues that the recorded assignment of the mortgage does not also transfer the note. This is correct but irrelevant. Under Hawaii law (and the law of most other states), the collateral follows the obligation.¹⁰ A transfer of a promissory note automatically transfers any security for that note.¹¹ HSBC is therefore also entitled to the benefit of the mortgage without a separate assignment of the mortgage.

The TMS trustee argues that “[t]he assignment of a security interest, without a concomitant assignment of the underlying obligation, severs the security from the obligation it secured.”¹² The premise of this argument — that the mortgage was transferred but the note was not — is false. The note was transferred to HSBC (by endorsement in blank and delivery of the original instrument). Therefore, there was no such separate transfer of the mortgage. Even if the premise were true, the conclusion would not follow. Assuming that HSBC acquired the mortgage but not the note, the claim would not necessarily become unsecured. Because the obligation and the collateral are inseparable, one cannot assign a mortgage without also transferring the note. An attempt to transfer the mortgage apart from the note does not, however, invalidate the mortgage. Rather, such an assignment is ineffective.¹³

2. Effect of the 2007 Modification Agreement

The trustee’s argues that “[t]he 2007 Modification Agreement was essentially a new note,” and that the 2003 mortgage does not secure the “new note” or any additional principal or other charges arising from that modification. I disagree.

There is only one obligation of the Aba-tíes to HSBC and its predecessors. HSBC’s predecessor lent money to the Abatíes and the Abatíes promised to pay it back. The modification agreement changed the interest rate and repayment terms of that existing debt. This change did not create a new obligation or destroy the existing security for that obligation.

The 2003 mortgage secures the debt under the note as modified by the 2007 modification agreement. The mortgage says that it secures modifications of the original note. TMS had constructive notice of this provision of the recorded mortgage when it made its second mortgage loan. The lender was not required to record a new mortgage or an amendment to the existing mortgage due to the modification agreement.

The trustee argues that the 2007 amendment cannot be enforced against him because the negative amortization feature of the modification materially jeopardized his second lien position. He cites only one court decision in support of his argument, Remodeling & Const. Corp. v. Melker.¹⁴ The Melker decision is a trial court decision based on New York law that cites no authority and contains almost no analysis. A later decision of the same court, citing substantial authority, holds that “[t]he consent of a second mortgage is not required in order to validate a modification of the terms of a first mortgage” and limits the rule of Melker to modifications that “render the junior lien practically valueless.”¹⁵

Neither the trustee nor HSBC cites any Hawaii law on point. I predict that a Hawaii court would hold that, in the absence of an agreement between the senior and junior lienholder, the junior lienholder cannot challenge a change of the interest rate or payment schedule for the debt secured by the senior mortgage, where the first mortgage expressly states that it secures “modifications” of the original note. This is consistent with the Restatement (Third) of Property.¹⁶ A lender that makes a loan secured by a junior mortgage should not be allowed to force the senior lender to protect the junior lender’s interests, particularly where the first mortgage puts the junior lender on notice that the first mortgage secures modifications of the debt. Junior lenders desiring such protection should negotiate for it with the senior lender. (Even assuming that a Hawaii court would follow the New York rule, the modifications in this case — effectively an increase in the interest rate — did not render TMS’ second mortgage lien practically valueless.)

The TMS trustee argues that Hawaii law disfavors negative amortization. I disagree. Nothing in Hawaii law precludes “negative amortization,” “interest on interest,” or the capitalization of accrued but unpaid interest. Prior to 1986, Hawaii law forbade compound interest in most circumstances.¹⁷ But in 1986, the legislature amended the statute so the prohibition applies only to certain kinds of credit transactions, none of which matches the Abatíes’ first mortgage loan.¹⁸

The trustee says that the negative amortization feature of the modified note was unconscionable. But the Hawaii legislature legalized compound interest (in most circumstances) nearly thirty years ago. I will not employ the unconscionability doctrine to invalidate a term that the legislature has approved.¹⁹

Therefore, HSBC correctly used the 2007 modification agreement to compute the interest, late fees, and other amounts due to it and secured by its first mortgage.

3. Amount of HSBC’s Claim

HSBC argues that the TMS trustee is a non-party to the loan and therefore lacks standing to object to the amount of HSBC’s claim. HSBC is wrong under both federal and state law.

First, under bankruptcy law, the trustee has the right, and “if a purpose would be served” the statutory duty, to object to claims against the estate.²⁰ Although HSBC has not filed a proof of claim, it has asserted a secured claim against property which the trustee now owns. The trustee has the right and the duty to ensure that HSBC does not get more than its proper share of the estate’s assets.

Second, under Hawaii state law, “[t]he mortgagor, or any subsequent mortgagee, may defend the action for foreclosure, and may show any matter in legal or equitable avoidance of the mortgage.”²¹ Where the mortgaged property is not worth enough to cover all liens on the property, the amount of the senior liens has a direct effect on the junior lienors’ economic interest. A junior lienor, such as the TMS trustee, is entitled to protect his economic interests in court.

The trustee challenges HSBC’s computation of its claim on various grounds.

The trustee argues that HSBC has not established that it advanced the full amount of the construction loan, and that HSBC must establish the date of each advance in order to substantiate its calculation of interest. I disagree. In the 2007 modification agreement, the Abatíes agreed that the principal amount of the debt was $524,000.²² The loan ledger says the same thing.²³ This is sufficient to prove the principal amount of the debt as of 2007. Similarly, the loan ledger indicates that there was no unpaid interest as of the modification agreement.²⁴ Because the claim apparently does not include any interest accrued during the construction loan phase, the trustee’s question about the date of the advances is irrelevant.

The trustee argues that HSBC has not adequately documented its calculation of the escrow balance. Although HSBC’s documentation is confusing and hard to read, I find that the claim is adequately substantiated.

At the hearing on this motion, the trustee argued for the first time that HSBC’s evidence was inadmissible because HSBC did not provide a foundational declaration by an HSBC employee. I overrule this objection as untimely. The TMS trustee filed an objection to the motion and a supplemental reply but did not object to the lack of a declaration.

4. HSBC’s Attorneys’ Fees

The trustee objects to HSBC’s claim for attorneys’ fees on several grounds.

The TMS trustee objects to the heavy redaction of the billing information supporting the attorneys’ fees request. At the hearing on HSBC’s motion, I agreed with HSBC’s suggestion that I review the unredacted billing statements in camera. I also encouraged HSBC’s counsel to review the redactions because I found it hard to believe that so much material in the bills was truly privileged.

HSBC has now submitted unredacted statements for in camera review and revised redacted statements. The dramatic change in the amount of redaction confirms that the original redaction was grossly excessive. Particularly egregious is the redaction of the hourly rates charged by the Alston Hunt firm, a fact which could not conceivably be privileged.

The remaining redaction is still excessive. Most of the redacted information describes the general subject matter of a communication. This is not privileged and must usually be revealed in a privilege log.

I will not waste further time on this collateral issue, however. The TMS trustee has had a fair opportunity to object to HSBC’s claim and I can independently review the redacted entries.

The TMS trustee objects to all of the fees and costs charged before HSBC acquired the note and mortgage. I do not accept this contention. The holder of a note is entitled to collect all amounts owed under the note. It does not matter that a prior holder actually incurred and paid the collection costs that are included in the claim, just as it does not matter that a prior holder actually made the loan evidenced by the note.

HSBC seeks reimbursement for $57,188.02 of attorneys’ fees incurred by six law firms. One would expect higher than normal fees because the lender had to deal with four bankruptcy proceedings spanning a six year period. But a significant portion of the fees are unsubstantiated, unreasonable, or both.

Rush Moore, LLP, $9,481.88. In support of this claim, HSBC has submitted documents²⁵ which do not include time records or any meaningful description of the work done. They do not even look like a law firm’s billing statements, but instead appear to be summaries of the attorneys’ bills, prepared for the lender’s internal accounting purposes. (Note that the documents supporting the claims of two other firms are in identical format.²⁶) Because of the lack of information, HSBC has not carried its burden of establishing that this is a reasonable fee for the work done. Thus, HSBC’s claim for attorneys’ fees must be reduced by $9,481.88.

Barrett, Daffin, et al., $950.00. Although the documentation for this claim is scanty,²⁷ it appears that the firm filed a proof of claim and a motion for relief from the stay in one of Ms. Abatie’s bankruptcy cases. This claim is reasonable.

RCO Legal, $2,974-64- Of this amount, $1,832.64 is adequately described as being for filing a proof of claim, reviewing a plan, filing a motion for relief from stay, and proper out of pocket expenses such as a litigation guarantee and court filing fees. The remaining $1,642.00 is described only as “Attorneys Fees—Allowable” or “Attorneys Fees—Civil Litigation.” This description is not sufficient to allow me to judge the reasonableness of the fee. Therefore, I will reduce this portion of the claim by $1,642.00.

Law Office of David Rosen, $24,758.27. I do not doubt that HSBC should pay this firm the amounts billed, but HSBC is not entitled to charge its borrower for three categories of work done by this firm.

First, the Rosen firm spent time getting information from RCO Legal and learning about the case, and then transferring the case to Alston Hunt. This work was only necessary because HSBC chose to replace the RCO firm and then chose to replace the Rosen firm. HSBC’s debtor and the junior lienholder should not have to pay extra because the senior lender decided to change lawyers. (The relevant time entries are underlined in black on exhibit “A” to this decision.)

Second, the Rosen firm spent substantial time preparing pleadings and motions which were never filed. HSBC has never explained why it did not seek foreclosure of its own mortgage. I do not intend to be critical of the Rosen firm, because I do not doubt that the firm did the work at the request and for the benefit of its client, but HSBC is not entitled to add these charges to the debt. (The relevant time entries are underlined in red on exhibit “A.”)

Third, the Rosen firm spent substantial time identifying the holder of the mortgage and preparing mortgage assignment instruments for recording. Nothing in the loan documents permits HSBC to shift these costs to its borrower. (The relevant time entries are underlined in blue on exhibit “A.”)

I will reduce this portion of the claim by $14,997.60.

Alston Hunt Floyd & Ing, $4,518.85. For the reasons given above, HSBC is not entitled to reimbursement for transition work caused by HSBC’s decision to hire new counsel. The Alston firm had to do this work and its client should pay it, but the debtor and the junior lienor should not bear this burden. (The relevant time entries are underlined in black on exhibit “A.”)

I will reduce this portion of the claim by $1,574.00.

Allen Matkins Leek Gamble Mallory & Natsis, LLP, $14,499.38. The time-sheets indicate that this firm’s sole role was to act as an intermediary between the loan servicer and the attorneys who actually did the work. Evidently the servicer has chosen to outsource work which could be done by the servicer’s employees. This may or may not be a rational business decision, but the borrower and junior lender’s burden should not be increased as a result. This case was not so large or complex as to justify the lender’s retention of both mainland and local counsel. Therefore, all of the Allen Matkins bills are disallowed.

HSBC’s reasonable attorneys’ fees and costs are $14,988.16.

5. TMS Trustee’s Attorneys’ Fees

The TMS trustee argues that the attorneys’ fees he incurred in challenging HSBC’s claim should be deducted from HSBC’s distribution.

HSBC argues that there is no authority for such a deduction. I disagree. Two theories might support such a recovery.

The first is the Hawaii statute which permits the prevailing party “in all actions on a promissory note or other contract in writing” to recover a reasonable attorneys’ fee.²⁸ Only the party that prevails on the “disputed main issue” can recover under this statute.²⁹ I have awarded the bulk of the amounts requested by HSBC and have rejected most of the trustee’s arguments. I cannot say that the TMS trustee prevailed on the disputed main issue.

Second, in my view, a lender who demands payment of a debt, including foreclosure of a lien, has an implied duty to respond promptly to reasonable requests about the validity and amount of that debt.³⁰ HSBC took far too long to produce basic loan documents. For example, the trustee demanded production of the original promissory note in July 2013,³¹ but HSBC’s counsel did not receive it until February 25, 2014,³² about two months after HSBC filed this motion. It is also true, however, that, due to the press of business, the TMS trustee’s counsel took some time to review the materials that HSBC did produce.³³

Considering that both parties are responsible, to some extent, for the delay, the fair remedy is to deny the trustee’s claim for attorneys’ fees and HSBC’s claim for attorneys’ fees incurred after the closing of the sale. It is worth noting that HSBC is not claiming interest after April 29, 2013.

Conclusion

HSBC is entitled to disbursement of $172,819.48 of the sale proceeds. Counsel for HSBC shall prepare an appropriate separate order.

SO ORDERED.

EXHIBIT “A”

DISALLOWED ATTORNEYS’ FEES

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1 .More precisely, HSBC Bank USA, N. A., as trustee for the holders of Deutsche Alt-A Securities Mortgage Loan Trust, Series 2007-OA2 Mortgage Pass-Through Certificates pursuant to the Pooling and Servicing Agreement, dated as of March 1, 2007, a/k/a HSBC Bank USA, N.A. as Trustee for DALT 2007-OA2.

2 . Dkt. 892-2, -3.

3 . Dkt. 892-3 at 3, 4.

4 . Dkt. 892-2 at 4.

5 . Dkt. 892-3 at 11.

6 . Dkt. 903 at 148.

7 . Dkt. 892-4 at 2.

8 . Dkt. 892-4 at 2 (capitalization in original).

9 . Haw.Rev.Stat. §§ 490:3-309,490:1-201.

10 . S.N. Castle Estate v. Haneberg, 20 Haw. 123, 130 (Haw.1910) ("The assignment of the notes, however, of itself operated as a matter of law as an assignment of the mortgage and of the mortgagee’s powers under it.”).

11 . See id.; see also James M. Davis, The Mortgage-Follows-the-Note Rule, Norton Bankr.L. Advisor, September 2013.

12 . Dkt. 903 at 39.

13 . See, e.g., 55 Am.Jur.2d Mortgages § 927 (2014). 7

14 . 65 N.Y.S.2d 738 (Sup.Ct.), aff'd without opinion, 270 App.Div. 1053, 64 N.Y.S.2d 175 (App.Div.1946).

15 . 100 Eighth Ave. Corp. v. Morgenstern, 3 Misc.2d 410, 150 N.Y.S.2d 471 (Sup.Ct.1956), aff'd, 4 A.D.2d 754, 164 N.Y.S.2d 812 (App.Div.1957).

16 . Restatement (Third) of Property (Mortgages) § 7.3(c) (1997). Hawaii courts frequently follow the relevant Restatement. See, e.g., McIntosh v. Murphy, 52 Haw. 29, 469 P.2d 177 (Haw. 1970) (citing the Restatement (Second) of Contracts); see also Bynum v. Magno, 106 Hawai'i 81, 101 P.3d 1149 (Haw.2004) (citing the Restatement (Second) of Torts); see also In re Estate of Damon, 109 Hawai'i 502, 128 P.3d 815 (Haw.2006) (citing the Restatement (Second) of Property); see also Lahaina Fashions v. Bank of Hawaii, 131 Hawai'i 437, 319 P.3d 356 (Haw.2014) (citing the Restatement (Third) of Trusts).

17 .Haw.Rev.Stat. § 478-7 (1985).

18 . Haw.Rev.Stat. § 478-7 (2012). HSBC’s loan, to the Abatíes is neither a "consumer credit transaction” nor a “credit card agreement.” Id. § 478-1.

19 . Id. at 14.

20 . 11 U.S.C. § 704(5).

21 . Haw.Rev.Stat. § 667-4.

22 . Dkt. 892-4 at 2, para. 1.

23 . Dkt. 892-8.

24 . Id. The ledger records the "loan setup” on February 15, 2007, and lists a principal balance of $524,000 as of that date. The ledger then records a payment on February 23, 2007, most of which was applied to interest, but a portion of which was applied to principal. This implies that there was no significant amount of accrued but unpaid interest as of the modification date.

25 . Dkt. 892-11 at 68-75.

26 . Dkt. 892-11 at 61-67, 76-77.

27 .Dkt. 892-11 at 76-77.

28 . Haw.Rev.Stat. § 607-14.

29 . In re Hoopai, 369 B.R. 506, 510 (9th Cir. BAP 2007), reversed on other grounds, 581 F.3d 1090 (9th Cir.2009).

30 . I have awarded fees on this theory against another creditor in this case. Dkt. 705.

31 . Dkt. 823 at 11.

32 . Dkt. 930-9 at 2.

33 . Dkt. 930-8 at 1.