STRIPPING OFF A WHOLLY UNSECURED MORTGAGE LIEN IN A CHAPTER 7 BANKRUPTCY REVISITING THE DEWSNUP AND NOBELMAN DECISIONS

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1 STRIPPING OFF A WHOLLY UNSECURED MORTGAGE LIEN IN A CHAPTER 7 BANKRUPTCY REVISITING THE DEWSNUP AND NOBELMAN DECISIONS Sharanya Gururajan Ralph, Schwab & Schiever, Chtd. 175 E Hawthorn Pkwy, #345 Vernon Hills, IL sgururajan@rss-chtd.com A majority of individuals filing for bankruptcy relief do so in the wake of mounting mortgage debt and collapsing home values. In such circumstances, the ability to strip off a wholly unsecured mortgage lien could bring tremendous relief to debtors who are homeowners. Stripping off an unsecured mortgage lien requires it to be treated as an unsecured claim in the bankruptcy case. Such a claim would be discharged in a Chapter 7 bankruptcy or be paid as a pro-rata distribution under a Chapter 13 Plan in conjunction with unsecured creditors. While a majority of courts have allowed the strip off of an unsecured mortgage lien secured solely by a debtor s principal residence in a Chapter 13 bankruptcy, only a handful of courts have been willing to extend this remedy to Chapter 7 debtors, despite the fact that the legal analysis involved in a strip off remains largely the same between the two. Relevant Provisions of the Bankruptcy Code: Section 506 provides in relevant part: (a)(1) An allowed 1 claim of a creditor secured by a lien on property in which the estate has an interest is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property and is an unsecured claim to the extent that the value of such creditor's interest is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, 1 See 11 U.S.C. 502(a) 1

2 and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor's interest. (d) To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless-(1) such claim was disallowed only under section 502(b)(5) or 502(e) of this title; or (2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title. Under 11 U.S.C. 506(a)(1), a claim is secured only to the extent of the value of the property on which the lien is fixed; the remainder of that claim is considered unsecured. United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, (1989) 2. Therefore, under 506(d), the unsecured portion of a creditor s lien should be voided. 3 Thus, a $100,000 claim, secured by a lien on property worth $60,000, is considered to be a secured claim to the extent of $60,000, and to be an unsecured claim to the extent of $40,000. See 3 Collier on Bankruptcy , p (15th ed. 1988) ( [S]ection 506(a) requires a bifurcation of a partially secured or undersecured claim into separate and independent secured claim and unsecured claim components ) (Footnote No. 3 to U.S. v. Ron Pair Enterprises, Inc., 489 U.S. at 254). The Nobelman Decision and Stripping Off Unsecured Mortgages in a Chapter 13 Bankruptcy: The Nobelman case held that a Chapter 13 debtor could not bifurcate or strip down an undersecured mortgage lien secured solely by a debtor s principal residence, into secured and unsecured components, due to the anti-modification restriction placed by 1322(b)(2) prohibiting the modification of claims secured by the debtor s principal residence. 4 The Nobelman case also held that Chapter 13 debtors should look to 2 See also In re Smith, 247 B.R.191, 195 (W.D.Va.2000) quoting Crossroads of Hillside v. Payne, 179 B.R.486, 490 (W.D.Va.1995) 3 See In re Folendore, 862 F.2d 1537 (11 th Cir. 1989); In re Mays, 85 B.R. 955 (Bankr. E.D.Pa.1988); In re Lindsey, 823 F.2d 189 (7 th Cir. 1987) 4 See 11 U.S.C. 1322(b)(2) 2

3 506(a) to determine if a claim was secured for purposes of 11 U.S.C. 1322(b)(2). Nobelman v. Am. Sav. Bank, 508 U.S. 324, (1993). It followed that as long as there was some equity to which the creditor s lien attaches, the claim was secured under 506(a), and therefore the partially secured lien could not be stripped down under the anti-modification clause of 1322(b)(2). Id. Nobelman did not specifically address the issue of whether wholly unsecured mortgage liens secured by primary residences could be stripped off in a Chapter 13 bankruptcy. 5 However, since Nobelman asserted that Chapter 13 debtors could look to 506(a) for the definition of a secured claim, several courts have reasoned that a junior mortgage lien unsupported by any equity in the residence, is an unsecured claim under 506(a). Therefore, under Nobelman, the anti-modification restriction of 1322(b)(2) would not apply to such an unsecured claim and the rights of the holder of such claim may be modified even though the lien may encumber a debtor s primary residence. See In re Geyer, 203 B.R. 726, 729 (Bankr. S.D. Cal. 1996) 6 which stated that: The Nobelman court's concern does not apply here when the creditor's claim is totally unsecured. Where the estate's interest in property is zero, the claim under section 506(a) is completely unsecured and is not entitled to the protection of section 1322(b)(2). 5 See A Brief Survey of Lien Stripping and Modifications in Chapter 13 Plans, By Hon. John H. Squires, Journal of the DuPage County Bar Association, December See also, In re Woodhouse, 172 B.R. 1 (Bankr.D.R.I.1994); In re Sette, 164 B.R. 453, 456 (Bankr.E.D.N.Y.1994); In re Moncrief, 163 B.R. 492 (Bankr.E.D.N.Y.1994); In re Williams, 161 B.R. 27 (Bankr.E.D.Ky.1993); In re Lee, 161 B.R. 271 (Bankr.W.D.Okla.1993); In re Kidd, 161 B.R. 769, 771 (Bankr.E.D.N.C.1993); In re Hornes, 160 B.R. 709 (Bankr.D.Conn.1993); and In re Plouffe, 157 B.R. 198 (Bankr.D.Conn.1993);Matter of Sanders, 202 B.R. 986 (Bankr.D.Neb.1996); In re Lee, 177 B.R. 715 (Bankr.N.D.Ala.1995) 3

4 The Dewsnup Decision and Stripping Off Unsecured Mortgages in a Chapter 7 Bankruptcy: The Dewsnup case preceded the Nobelman case in a Chapter 7 context, wherein the Petitioner argued that the $120,000 lien should be reduced to the fair market value of the land 7 under 506(a) and that the unsecured portion of the lien should be voided under 506(d). 502 U.S. 410 (1992). The Dewsnup court stated that the application of 506(d) is not rigidly tied to 506(a). The term allowed secured claim in 506(d) should.not be read as an indivisible term of art defined by reference to 506(a), but should be read term-by-term to refer to any claim that is, first, allowed, and, second, secured generally Id. at 411. In determining whether a claim could be voided, the Dewsnup court reasoned that under 506(d), the questions are twofold: (a) Is the lien allowed under 502?; and if so (b) Is the lien secured with recourse to the underlying collateral? If the answers to both these questions is affirmative, then the lien is an allowed secured claim for purposes of 506(d), and could not be voided. Id. at 417. Therefore, we hold that 506(d) does not allow petitioner to strip down respondents lien, because respondents claim is secured by a lien and has been fully allowed pursuant to 502. However, the Dewsnup court prefaced its ruling stating: Were we writing on a clean slate, we might be inclined to agree with petitioner that the words allowed secured claim must take the meaning in 506(d) as it does in 506(a). But, given the ambiguity in the text 8, we are not convinced that 7 The value of the land in question was determined to be $39, See Justice Scalia s dissent where he points out, inter alia, that there is in fact no ambiguity in the Code with regards to the meaning of allowed secured claim in 506(a) and 506(d) where he states: Congress did not leave the meaning of allowed secured claim to speculation. Section 506(a) says that an allowed claim (the meaning of which is obvious) is also a secured claim to the extent of the value of [the] creditor s interest in the estate s interest in [the securing] property. (This means, generally speaking, that an allowed secured claim is 4

5 Id. Congress intended to depart from the pre-code rule that liens pass through bankruptcy unaffected. The ability to strip off an unsecured junior mortgage in a Chapter 13 bankruptcy case with relative ease has evaded debtors in a Chapter 7 bankruptcy case, primarily due to the Dewsnup decision. The question becomes what is the requirement for a claim to be secured under 506(d). There are two possibilities: (a) Is there a lien that is at least partially secured by value in the collateral? Or (b) Is it sufficient that there exists a properly perfected mortgage lien on the collateral irrespective of whether there is equity to cover even a portion of the lien? Even though the facts of Dewsnup involved a lien that was partially supported by value in the property, the majority of courts interpret Dewsnup s definition of a secured claim under 506(d) as the latter of the two possibilities described above 9. See In re Cook, 432 B.R. 519, 523 (Bankr. D. NJ. 2010) which stated Under Dewsnup, an allowed claim is secured for purposes of 506(d) simply because the claim is subject to a lien with recourse to collateral. Valuation is not a factor in the determination. As long as a claim is secured by a mortgage on a residence, irrespective of whether it is wholly unsecured or partially secured, courts take the position that the secured only to the extent of the value of the property on which the lien is fixed; the remainder of that claim is considered unsecured). When 506(d) refers to an allowed secured claim, it can only be referring to that allowed secured claim so carefully described two brief subsections earlier. 502 U.S. at See In re Hernandez, 175 B.R. 962, 964 (N.D.Ill. 1994) which stated, In Dewsnup the Supreme Court decided that the phrase allowed secured claim in Section 506(d) meant a claim which was both allowed and secured, regardless of the extent of the security; See In re Cunningham, 264 B.R. 241, 245 (Bankr. N.D.Md. 2000) which stated by concluding that secured claim merely refers to a claim secured by a lien, the Court effectively negated any argument that allowed secured claim means the same in 506(d) as in 506(a) 5

6 claim is secured for purposes of 506(d). Therefore, according to these courts, Dewsnup s prohibition against stripping down an undersecured lien also applies as a prohibition to a strip off of an unsecured mortgage lien 10. While the determination of a mortgage lien as unsecured in both a Chapter 7 bankruptcy and a Chapter 13 bankruptcy is made pursuant to 506(a), the ensuing strip off is allowed in a Chapter 13 bankruptcy pursuant to 1322(b)(2). However, with no corresponding code provision in Chapter 7, a lien strip off has generally been disallowed owing to the narrow reading of Dewsnup which defines secured differently in 506(a) compared to 506(d). Under Dewsnup, 506(a) defines a secured claim as one that is secured only to the extent of the value of the property on which the lien is fixed, whereas 506(d) defines a secured claim as one that is secured by a mortgage or security interest in collateral irrespective of whether there is value in the property to support the lien claim. If courts limited the application of the Dewsnup ruling to partially secured liens, similar to the Nobelman ruling, they may be more willing to consider a strip off of a fully unsecured mortgage lien in a Chapter 7 bankruptcy case. Judge Dorothy T. Eisenberg of the Eastern District of NY, in November, 2009, allowed the strip off of a wholly unsecured mortgage lien in a Chapter 7 bankruptcy case. In re Lavelle, 2009 WL Judge Eisenberg considered the Dewsnup case and narrowly construed the decision whereby limiting the ruling to partially secured liens. Therefore, to the extent that the lien was worthless and not supported by any value in the collateral, the lien was 10 See In re Talbert, 344 F. 3d 555, 562 (6 th Cir. 2003); Ryan v. Homecoming Fin. Network, 253 F. 3d 778, 783 (4 th Cir. 2001); In re Laskin, 222 B.R. 872, 876 (9 th Cir. BAP 1998); In re Caliguri, 431 B.R. 324 (Bankr. E.D.N.Y 2010); In re Pomilio, 425 B.R. 11, 18 (Bankr. E.D.N.Y. 2010); In re Cunningham, 246 B.R. 241, 247 (Bankr. D. Md.2000); In re Virello, 236 B.R.199 (Bankr. D.S.C.1999). 6

7 unsecured under 506(a) and thus not an allowed secured claim under 506(d) which permitted the court to void the lien. Judge Eisenberg stated that: Id. at 5...[the] holdings in a Chapter 13 context clearly demonstrate that under the Code it is appropriate under 506(a) and 506(d) to distinguish partially secured liens from wholly unsecured liens. Once it is established that Dewsnup is distinguished, there is no reason why in a Chapter 7 context the same language in 506(a) and (d) should not void the lien of a wholly unsecured claim. The policy reasons underlying the Dewsnup decision were: (a) liens pass through bankruptcy unaffected; (b) the mortgagee and mortgagor bargained for a consensual lien which would remain against real property until foreclosure; (c) any increase in value of the real property collateral should accrue to the benefit of the mortgagee creditor, not the debtor or other unsecured creditors, and (d) the fresh start principles of bankruptcy relate to a discharge of the debtor from personal deficiency, and not to an in rem deficiency. Dewsnup, 502 U.S. at 417. While these concerns are valid, they similarly exist in a Chapter 13 bankruptcy case. However, wholly unsecured junior liens are routinely avoided in Chapter 13 bankruptcy cases. There is no legitimate reason to isolate these so called policy concerns solely to Chapter 7 debtors when the strip off relief is available to Chapter 13 debtors. As Judge Eisenberg states in the Lavelle case, the possibility that debtors will receive windfalls from avoided liens is not persuasive since markets are uncertain, and it is not certain that such a scenario will ever occur. In re Lavelle, 2009 WL at 6. If a creditor with a wholly unsecured mortgage were to foreclose on the property, it will receive no monetary gain since there is no value in the property. Id. Under such circumstances, it makes sense to provide the debtor with the requisite fresh start, whether in a Chapter 7 or Chapter 13 bankruptcy case, especially 7

8 in the current economic climate, where it is beneficial for debtors to retain ownership of their homes rather than abandon their properties and cause further dimunition of home prices. Allowing bankruptcy judges to determine the validity and existence of liens in a streamlined and consistent manner may be more cost efficient than having borrowers and lenders wade through a loan modification process that is neither streamlined nor monitored in any meaningful way. In light of the foregoing, it may be worthwhile to revisit the Dewsnup decision and its legal inconsistencies, as further highlighted by the current economic conditions. 8