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Lien Stripping Overview

Chapter 13 Lien Strip-Offs of 2nd Mortgages

Lien stripping is not permitted in Chapter 7 bankruptcy cases. That door was closed by the U.S. Supreme court in Dewsnup v. Timm, 502 U.S. 410 (1992). There, the Dewsnup court expressly prohibited lien stripping via §506(a) in Chapter 7 cases.

Prior to the Dewsnup decision, the Supreme Court had not addressed the issue of lien stripping in Chapter 13 bankruptcy cases, leaving unresolved the issues of (a) stripping an undersecured mortgage lien and (b) stripping a wholly unsecured junior mortgage lien.

One of those issues was resolved in 1993. The Supreme Court address the issue of lien stripping of undersecured mortgage liens in its seminal decision of Nobelman v. American Savings Bank, 508 U.S. 324 (1993). In Nobelman, the Supreme Court addressed the issue of whether a debtor’s attempt to “strip-down” an undersecured residential mortgage lien held by the senior lienholder was prohibited. More specifically, the court framed the issue as whether §1322(b)(2) prohibited a chapter 13 debtor from relying on §506(a) to reduce an undersecured homestead mortgage to the fair market value of the mortgaged residence. The Nobleman court then held that §1322(b)(2) does prohibit a debtor from stripping-down the undersecured home mortgage to its fair market value.

Left unanswered was the issue regarding “stripping-off” wholly unsecured second mortgage liens. Therefore, the issue remained unanswered whether §1322(b)(2) prohibited a chapter 13 debtor from relying on §506(a) to strip-off a wholly unsecured homestead mortgage.

Without Supreme Court direction, the issue of lien stripping wholly unsecured homestead mortgage liens has been hotly debated and frequently litigated. The majority of courts that have addressed this issue are in favor of allowing Chapter 13 debtors to strip-off wholly unsecured homestead mortgage liens, including Judge Squires of the US Bankruptcy Court for the Northern District of Illinois. See Waters v. The Money Store (In re Waters), 276 B.R. 879 (Bankr. N.D.IL 2002)(J. Squires). But, there is some authority rejecting the ability to strip-off these liens, including Judge Schmetterer in the US Bankruptcy Court for the Northern District of Illinois. See Barnes v. American General Finance (In re Barnes), 207 B.R. 588 (Bankr. N.D.IL 1997)(J. Schmetterer).

Regrettably, the Seventh Circuit Court of Appeals has not directly ruled on this issue. But all of the other Circuit Courts that have addressed this issue have been in unanimous support of the majority position of allowing lien stripping of wholly unsecured junior mortgage liens. The Second Circuit, Third Circuit, Fifth Circuit, Sixth Circuit, and Eleventh Circuit all agree that a lien strip-off of wholly unsecured junior mortgage is permissible after Nobelman. See Pond v. Farm Specialist Realty (In re Pond), 252 F.3d 122 (2nd Cir. 2001); McDonald v. Master Fin., Inc. (In re McDonald), 205 F.3d 606 (3rd Cir. 2000); In re Bartee, 212 F.3d 277 (5th Cir. 2000); In re Lane, 280 F.3d 663 (6th Cir. 2002); Zimmer v. PSB Lending Corp., 313 F.3d 1220 (9th Cir. 2002); and In re Tanner, 217 F.3d 1357 (11th Cir. 2000). See also two Bankruptcy Appellate Panels supporting lien strip-offs, Domestic Bank v. Mann, 249 B.R. 831 (1st Cir. BAP 2000); and Lam v. Investor Thrift, 211 B.R. 36 (9th Cir. BAP 1997).

Judge Squires’ Waters case illustrates the majority position. In re Waters, 276 B.R. 879 (Bankr. N.D.IL 2002). There the Waters court framed the issue as whether a Chapter 13 debtor can strip off a wholly unsecured junior mortgage pursuant to 11 U.S.C. §506(d), notwithstanding the anti-modification protection afforded holders of home mortgages in 11 U.S.C. §1322(b)(2). The court began its analysis by distinguishing between (a) attempts to “strip-down” undersecured mortgage liens and (b) attempts to “strip-off” wholly unsecured mortgage liens. The court immediately rejected any attempts to strip-down a mortgage lien because of the Supreme Court’s Nobelman decision. But the facts in Waters demonstrated that the uncontroverted fair market value of the debtor’s home was less than the amount of debt subject to the senior mortgage lien. Therefore, the court found that the second mortgage was wholly unsecured. The Waters court spent the remainder of the opinion resolving the “strip-off” issue. In the end, the Waters court stripped the wholly unsecured junior mortgage and avoided the lien.

A similar approach was taken in First Mariner Bank v. Johnson, 411 B.R. 221 (D. Md. 2009). There, the Johnson court began its discussion by examining Section 506 and Section 1322(b)(2). Section 506(a) generally permits a debtor to bifurcate a secured creditor’s claim into secured and unsecured portions if the amount of the claim exceeds the value of the collateral. Section 506(a) applies to bankruptcies under all chapter and sorts creditors’ allowed claims against the debtor into secured and unsecured claims:

"An allowed 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, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to setoff is less than the amount of such allowed claim… " 11 U.S.C. Section 506(a)(1).

Whereas, 11 U.S.C. Section 1322(b)(2) applies only to Chapter 13 bankruptcies. It states that a debtor’s Chapter 13 plan may:

"modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims." 11 U.S.C. Section 1322(b)(2).

The Johnson court rejected creditor’s argument that the Supreme Court’s Nobleman decision interpreted Section 1322(b)(2) as prohibiting the modification of any claim secured by a lien on real property that is the debtor’s principal residence. The court rejected creditor’s attempt to equate the phrases “secured by a lien on real property” and “secured claim.”

The Johnson court found that the anti-modification provision in Section 1322(b)(2) did not apply because junior lienholder’s lien was not a “secured claim” within the meaning of the Bankruptcy Code. The court believed that the proper starting point in its analysis is the valuation in Section 506(a), not the anti-modification exception contained in Section 132(b)(2). Therefore, the court found that a creditor cannot invoke the anti-modification protection in Section 1322(b)(2) without first demonstrating that it has an allowed secured claim.

The Johnson court also noted that lawyers and layperson often think of any claim for repayment of a mortgage loan as a “secured claim” whether or not the mortgagee could actually realize anything at a foreclosure sale. However, that is incorrect as a matter of bankruptcy law. Whether a lienholder has a “secured claim” or an “unsecured claim,” in the sense in which those terms are used in the Bankruptcy Code, depends on whether the lienholder’s interest in the collateral has economic value. Therefore, a junior mortgagee whose lien on a Chapter 13 debtor’s property is “completely under water” holds an unsecured claim regardless of the fact that the junior mortgage was secured by a lien on the debtor’s principal residence.

Therefore, the Johnson court stripped the junior lien after concluding that because the first lien on debtor’s property exceeded the fair market value in the home, the junior lien was wholly unsecured, and its interest could be modified by the Chapter 13 plan pursuant to Section 1322(b)(2).

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I am attorney Robert Schaller and have been practicing law for over 24 years. I have represented clients in almost 2,000 bankruptcy cases. I am eager to represent you in your next lien stripping case.

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