The Demise of the Wholly Unsecured Lien on Residential Property
The controversy has now resulted in three circuit court and two bankruptcy appellate panel decisions in the past three years (four within the last eight months).5 All five decisions have found that stripping off a wholly unsecured junior lien on residential property is permissible. This column discusses the antecedents of lienstripping as found in Dewsnup v. Timm, 502 U.S. 410 (1992), and Nobelman v. American Sav. Bank, 508 U.S. 324 (1993), as they relate to the appellate decisions regarding lienstripping. The overriding conclusion of the appellate courts is that lienstripping is a viable option to chapter 11, 12 and 13 debtors. Only chapter 7 provides a safe haven for under secured liens.
Dewsnup and Nobelman
The Supreme Court's decision in Dewsnup focused on the interplay between §§506(a) and 506(d) and whether both sections could be harmonized in determining the value of a lien that was undersecured on real property. The debtor in Dewsnup had argued that §506(a) and (d) compelled both a reduction of the value of the creditor's lien in the property and an avoidance of the creditor's lien to the value of the creditor's interest in the property. Dewsnup, 502 U.S. at 413. The bankruptcy court declined the debtor's arguments, finding that because the chapter 7 trustee had abandoned the property (it was fully encumbered), §506(a) could not be used to bifurcate the claim and lien because the estate did not have an interest in the property. Id. at 414. The district court and Tenth Circuit affirmed.
In sum, the Supreme Court found that the "avoidance powers" under §506(d) do not come into play when a claim has been allowed as a secured claim under §502(a). Id. at 414-15. The court reasoned that because the creditor's claim had been allowed as a secured claim under §506(a), the lien could not be avoided as to the value of the property under §506(d) because the claim was allowed as fully secured. Id. Moreover, the court had previously held that because liens pass through bankruptcy unaffected, an allowed secured claim under §502(a) could not be stripped down to its secured and unsecured components. Id. at 417-18; see Farrey v. Sanderfoot, 500 U.S. 291 (1991). The court expressly left open the issue of whether lienstripping could occur under other chapters of the Bankruptcy Code.
In Nobelman, the Supreme Court was again faced with the issue of lienstripping as it related to residential mortgages. Analyzing whether §502(a) or 1322(b)(2) should determine the ability to strip-off liens on residential mortgages, the court found that §1322(b)(2) discusses the "rights" of holders of secured claims as opposed to the value of the claim. Nobelman, 508 U.S. at 328. The court determined that the secured creditor's "rights" in the residential property were state law rights, which included the right to retain the creditor's lien until the debt is paid off or accelerate the loan upon default and proceed to foreclosure. Id. at 329-30.
The court found that §1322(b)(2) prohibits a debtor from modifying the creditor's mortgage rights under state law on residential property. In Nobelman, the protection of the rights (or claim) was different than in cases involving wholly unsecured claims because the lender in Nobelman had equity securing its claim. As such, there was a lien position to protect. The Supreme Court held that Congress intended to protect residential mortgages from strip down when it promulgated §1322(b)(2). As such, the court held that where a lien is partially secured by residential property, it cannot be stripped down into secured and unsecured components.
Wholly Unsecured Claims
As noted herein, there was considerable debate post-Nobelman as to whether a chapter 13 debtor could avoid a lien that was wholly unsecured. The Ninth Circuit Bankruptcy Appeals Panel in In re Lam was the first appellate court to consider the issue. Lam involved a fourth deed of trust that was clearly unsecured. The bankruptcy court in Lam concluded that "even wholly unsecured creditors with a security interest in real property...have state law rights which cannot be modified in a chapter 13 plan." Lam, 211 B.R. at 39. The Lam court decided that the determinative feature of the Supreme Court's ruling in Nobelman was the protection of rights and the existence of a lien, not the presence of value to support it. Id. at 40.
The Ninth Circuit Bankruptcy Appeals Panel was unpersuaded by the lower court's analysis, noting that Nobelman only dealt with partially secured claims on residential property, not wholly unsecured claims. Moreover, the Lam court found that there are no "state rights" implicated in a wholly unsecured claim analysis under §1322(b)(2) because the rights are empty if not illusory. Simply put, a junior unsecured lien would receive nothing at foreclosure; thus, there are no "rights" to protect. Id. The court further noted that Nobelman itself suggests that unsecured liens on property should be voided because the lienholder would not be the holder of a secured claim under §1322(b)(2). The Lam court found that the policy behind §1322(b)(2) was to protect secured claims, not secured creditors. Such a reading of §1322(b)(2) comports with the Code's emphasis on creditor rights that are supported by valuable estate property. Id. at 41.
The Third Circuit in In re McDonald, 205 F.3d 606 (3d Cir. 2000), held that §103(a) provides that §506(a) applies to all chapters under the Bankruptcy Code and sorts creditor's allowed claims into secured and unsecured claims. The Third Circuit found that once §506(a) applies to chapter 13, a rational reading of §506(a) supports the conclusion that a wholly unsecured claim is not a secured claim. Id. at 611. The Third Circuit reconciled §§506 and 1322 by finding that §1322's anti-modification clause uses the term "claim" rather than "secured claim," and, therefore, applies to both the secured and unsecured part of the mortgage. The Third Circuit observed that the anti-modification clause further states that the claim must be "secured only by a security interest in...the debtor's principal residence." Id.
The Third Circuit reasoned that if a mortgageholder's claim is wholly unsecured, the debtors could apply §506(a), which would result in the lienholder not having a claim secured by the debtor's residence. As such, the lienholder would have an unsecured claim, and the anti-modification provision of §1322 would not apply because the lienholder would not have a security interest in the property to protect from modification. Id.
As to the issue of Congress's intent to protect mortgage lenders, the Third Circuit found that §1322 was designed to protect mortgage lending and, because second mortgages are rarely used to purchase a home, making second or junior mortgages subject to the anti-modification clause would not impair that goal. Id. at 613. Conversely, the Third Circuit appeared unconcerned with the lender's argument that a junior lienholder with $1 in value on residential real property could invoke Nobelman to retain its lien, but a wholly unsecured creditor could not. The court responded to this argument by noting that bright-line rules of construction are common in the law, with potentially harsh effects. Id.
The lienstripping issue in In re Bartee, 212 F.3d at 283 (5th Cir. 2000), involved the consideration of whether a homeowners association's lien could be stripped off where there was no equity in the home to give the claim value. Homeowners association liens under Texas law run with the land, giving the association the right to foreclose on the residence to enforce unpaid maintenance fees or other costs. Bartee, 212 at 283. As in Lam and McDonald, the debtor argued that because the association did not have a secured claim, §1322(b)(2) could not protect it from cramdown. The homeowners association similarly argued that the Fifth Circuit should focus on the association's "rights" under §1322(b)(2), and, therefore, protect its rights just as the Supreme Court had done in Nobelman.
The Fifth Circuit recognized that the problem in understanding the Nobelman decision was the Supreme Court's ambiguity in focusing on the "rights" of holders of secured claims as opposed to applying the bifurcation of claims with insufficient value in property under §506(a). Further, the Fifth Circuit did acknowledge that although the Supreme Court did analyze the practical effect of bifurcation under §506(a) where there is insufficient equity to secure more than one claim, the court nonetheless held that the lienholder's rights under §1322(b)(2) trumped §506(a)'s application. Id. 289-90.
The Fifth Circuit held that once a court applies §506(a) and the lien is found to be wholly unsecured, the end result is that the mortgageholder does not have a secured claim. Moreover, "in the case of a wholly unsecured junior mortgage, the valuation function of §506(a) obviates the need to even consult §1322(b)(2)." Id. The Fifth Circuit reasoned that those courts holding otherwise "are unable to explain how §506(a) can apply and yet not actually serve the valuation and claim determination purpose for which it was crafted." Id. Finally, as to the issue of protecting mortgage lenders, the court dryly observed that many times junior mortgages are obtained and targeted at personal spending. The holder of a junior mortgage is apt to be much like other unsecured creditors in chapter 13—a claim for consumer debt. Id. at 293.6 Section 1322(b)(2)'s anti-modification provision does not apply to liens obtained for non-housing lending.
Bartee has been quickly followed by two other appellate decisions: In re Mann by the First Circuit Bankruptcy Appeals Panel and In re Tanner by the Eleventh Circuit. Both decisions adopted the reasoning of McDonald and Bartee, finding that §506(a) required that if a lien was wholly unsecured, §1322(b)(2) did not apply.
The appellate majority on lienstripping of residential property leaves chapter 77 as the only chapter where lienstripping is not allowed. At least two bankruptcy courts have allowed lienstripping in chapter 11, going so far as to void the liens of the IRS. See Dever v. Internal Revenue Service (In re Dever), 164 B.R. 132 (Bankr. C.D. Cal. 1994); Bowen v. United States (In re Bowen), 174 B.R. 840 (Bankr. S.D. Ga. 1994). Courts have uniformly allowed lienstripping in chapter 12, finding that Dewsnup does not apply to chapter 12. See, e.g., Harmon v. United States, 101 F.3d 574 (8th Cir. 1996); In re Zabel, 249 B.R. 764 (E.D. Wis. 2000); In re Leverett, 145 B.R. 709 (Bankr. W.D. Okla. 1992).
The acceptance of lienstripping poses serious consequences for lenders and the federal and state governments. Tax liens can arguably be stripped where there is no underlying value to secure the tax lien. As such, taxing authorities as non-consensual creditors are at risk because collection against collateral is being reduced. Federal agencies such as the Small Business Administration, Farm Service Agency and Department of Housing and Urban Development either insure or provide secondary lending. These agencies, who provide loans to entities or individuals that may not be eligible for conventional financing, will also absorb the risks should their liens be avoided.
2 See In re Bartee, 212 F.3d 277, 288-89, n.15-16 (5th Cir. 2000), for an accounting of the numerous opinions on the subject. Return to article
3 Section 506(a) provides, in relevant part, that "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 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." Return to article
4 Section 1322(b) provides that a debtor's 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." Return to article
5 Lam v. Investors Thrift (In re Lam), 211 B.R. 36 (9th BAP 1997); In re McDonald, 205 F.3d 606 (3d Cir.); petition for cert. filed, 68 U.S.L.W. 3775 (U.S. June 7, 2000) (No. 99-1993); In re Bartee, 212 F.3d 277 (5th Cir. 2000); In re Mann, 249 B.R. 831 (1st BAP 2000); and In re Tanner, 2000 WL 966700 (11th Cir. 2000). Return to article
6 What is somewhat curious about the Fifth Circuit's opinion is that under Texas law as recently as three years ago, homestead property could not be encumbered but for a purchase money lien, taxes or material and mechanic's lien. Texans could not obtain secondary liens on their homesteads until the Texas Constitution was amended in 1998. Return to article