In early June, the U.S. Supreme Court issued an opinion in two consolidated cases. These cases questioned whether a debtor in a Chapter 7 bankruptcy could void a secondary mortgage lien when the debt owed on the first-lien mortgage exceeded the property’s current market value.
The Supreme Court’s opinion seems to benefit credit unions.
The debtors each filed motions in their respective bankruptcy courts to “strip off”—or void—the subordinate mortgage liens under Section 506(d) of the Bankruptcy Code. In each case, the bankruptcy court granted the debtors’ motions and agreed the liens could be stripped. Both the District Court and the U.S. Eleventh Circuit Court of Appeals affirmed the decision.
The Eleventh Circuit had previously allowed numerous debtors to file motions and complaints challenging underwater subordinate mortgage liens.
Let’s address two terms often used in such cases. “Strip down” concerns reducing the value of the claim (loan amount) secured by a lien to the value of the collateral. “Strip off” defines voiding a subordinate lien secured by property that also secures the first lien.
In this situation, the value of the property is less than the claim (loan amount) on the first lien, and the debtor seeks to void, or strip off, the entire subordinate lien.
In a previous Supreme Court case, Dewsnup v. Timm, a Chapter 7 debtor wanted to strip down a partially underwater lien to the value of the property. The debtor sought to reduce her debt of approximately $120,000 to the value of her property, which at that time was $39,000.
The Supreme Court rejected her argument, holding that when property securing a loan is worth less than the current loan balance, the Bankruptcy Code doesn’t permit a Chapter 7 debtor to strip down the lien to the property’s current value.
The debtors in these cases argued that the Dewsnup decision should only apply to partially underwater liens. They suggested that Dewsnup should apply when the property value exceeds the first lien loan amount and partially secures the subordinate lien.
But the debtors argued that when the first lien exceeds the property value, and the subordinate lien is wholly unsecured, they should be permitted to void the entire subordinate lien.
The Supreme Court disagreed, pointing out that undesirable situations could develop.
For instance, if the property were valued at $1 more than the amount of the first lien loan, the debtor could not strip down a subordinate lien. But if the property were valued at $1 less than the amount of the first lien loan, the debtor could strip off the entire subordinate lien.
With the constantly changing value of real property, this view could lead to arbitrary results.
In addition, if the property ultimately sells for more than its appraised value, the excess goes to the debtor instead of the creditor.
In deciding these cases, the Supreme Court looked at Section 506(d) of the Bankruptcy Code, which provides, “To the extent that a lien secures a claim against a debtor that is not an allowed secured claim, such lien is void.”
So Section 506(d) would permit debtors to strip off a creditor’s subordinate mortgage lien only if the creditor’s claim—generally, its right to repayment from the debtor—isn’t an allowed secured claim.
But Bankruptcy Code Section 502 deems a claim filed by a creditor “allowed” if no party objects—or if, in the case of an objection, the Bankruptcy Court determines the claim should be allowed.
In these two cases, the court allowed the claims under Section 502. And the liens weren’t considered void.
The Supreme Court ultimately reversed the Eleventh Circuit decisions in both cases, deciding that when a first or senior mortgage lien debt exceeds the present value of the property, a debtor may not strip off the subordinate mortgage lien.
The Supreme Court’s decision resolved a split in Circuit Court decisions and reaffirmed what most courts have decided in Chapter 7 bankruptcies: Liens securing valid claims aren’t stripped in bankruptcy but remain in effect until the debt is paid in full or until foreclosure occurs.
Chapter 13 bankruptcy Differences
Chapter 13 bankruptcies generally treat strip-downs differently from Chapter 7 bankruptcies.
Section 1322(b)(2) of Section 13 permits a debtor to request a flexible repayment plan, approved by a bankruptcy court. The plan may also include modification of secured claims.
Sections 506(a) is used in tandem with Section 1322 to permit modification of a secured creditor’s claim into secured and unsecured portions when the claim (loan balance) exceeds the value of the secured property.
But a claim secured only by a security interest in the debtor’s principal residence cannot be bifurcated into secured and unsecured portions.
In other words, a strip-down may not be made if the property is the debtor’s principal residence.
MICHAEL McLAIN is CUNA’s senior federal compliance counsel. Contact him at 608-231-4185 or at firstname.lastname@example.org.