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Thursday, June 19, 2014

11th Circuit: §506(d) "Strip-Offs" Part Deux

What Has Gone Before

     Back in April, I posted about the U.S. Supreme Court's denial of certiorari on an unpublished order of the 11th Circuit Court of Appeals, in which the 11th Circuit followed a previous unpublished decision that allowed wholly unsecured liens to be "stripped off" in Chapter 7, using 11 U.S.C. §§506(a) & (e). As I discussed in that post, the 11th Circuit interpreted Dewsnup v. Timm, 502 U.S. 410 (1992) to be limited to partially secured first mortgages, and followed its own precedent  -- handed down before Dewsnup v. Timm --  in ruling that 11 U.S.C. §506 could be used to void wholly unsecured mortgages and liens in Chapter 7. See Folendore v. United States Small Bus. Admin., 862 F.2d 1537 (11th Cir. 1989).

     I also noted that the 11 Circuit stood as an outlier on this issue, and that the other circuits reaching the same issue had ruled that Dewsnup v. Timm controlled (and forbade)  the use of §506 against wholly unsecured liens in Chapter 7. My prior blog post is here:  http://impudentbankruptcylawyer.blogspot.com/2014/04/now-in-play-506d-strip-offs-in-chapter-7.html

  The 11th Circuit Speaks Again
     The 11th Circuit, on June 18, 2014, published a decision in which it adopted the majority view allowing debtors to use a "Chapter 20" to strip off liens. The decision is Wells Fargo Bank, N.A. v. Scantling (In re Scantling), ___ F.3d ____ (11th Cir. Docket No 13-10558, 6/18/14), and you can read it here: http://www.ca11.uscourts.gov/opinions/ops/201310558.pdf

     You won't find "Chapter 20" in the Bankruptcy Code; bankruptcy lawyers use it as a term of art to describe a two-step process used to strip off unsecured junior liens and mortgages. First, the debtor files a Chapter 7 bankruptcy and obtains a discharge of the underlying promissory note and other debt. Second, immediately after the Chapter 7 discharge, the debtor files a Chapter 13, in which the debtor files a plan (usually with token payments for lien creditors) and files a motion, under 11 U.S.C. §506, to determine that the liens remaining after the Chapter 7 are void because they are wholly unsecured.

     Here's the trick: the debtor in these circumstances does not care that he or she cannot get a "discharge" in Chapter 13; the debtor's sole purpose is to use his or her Chapter 13 case to void and "strip off" the unsecured mortgages. 11 U.S.C. §1328(f) mandates a four year waiting period (after the date the debtor filed the prior Chapter 7) for filing a Chapter 13 in which the debtor seeks a discharge. But -- nothing in the Bankruptcy Code prohibits the debtor from filing a Chapter 13 for another purpose in that four year waiting period, so long as the debtor can confirm a plan according to the dictates of Chapter 13.

     Wells Fargo argued that the Chapter 13 plan and discharge must go hand-in-hand. However, a Chapter 13 plan does more than secure a discharge after all its payments are completed: it allows the debtor to cure mortgage defaults; pay off income tax debt over five years, without further accrual of interest and penalties; and allows the avoidance of wholly unsecured mortgages, even on the debtor's primary residence. 11 U.S.C. §1322(b)(2) states that the 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." Although the SCOTUS has ruled that Chapter 13 debtors cannot use §506(a) to modify a partially secured mortgage on a residence,  Nobelman v. American Savings Bank, 508 U.S. 324 (1993), most circuits -- including the 11th Circuit -- have ruled that a §506(a) valuation can be combined with §1322(b)(2) provision in a plan to void a wholly unsecured mortgage. See Tanner v. Firstplus Financial, Inc. (In re Tanner), 217 F.3d 1357 (11th Cir. 2000). In other words, if there is no equity in the residence to secure any part of the mortgage, the mortgage becomes a wounded gazelle on the African savannah, and the Chapter 13 plan is the lion.

     The 11th Circuit recognized Chapter 13's versatility and thus followed the majority of bankruptcy courts, district courts and circuit courts in allowing Ms. Scantling's "Chapter 20" and her plan to void Well Fargo's second and third mortgages on her residence.

     Of particular interest is footnote 5 of the decision, in which the 11th Circuit stated:

      We are also mindful of the recent unpublished opinion in Wilmington Trust, National 5 Ass’n v. Malone (In re Malone), No. 13-13688, 2014 WL 1778982 (11th Cir. May 6, 2014), which was decided after oral argument in the instant case, in which a panel of this court recently found it was bound by prior published decisions and affirmed a decision by the bankruptcy court, in a Chapter 7 proceeding, that allowed a debtor to strip off a worthless second priority lien.

The Bottom Line

     Debtors in the 11th Circuit have the best of both worlds: if they are daring, they can try to strip off their wholly unsecured mortgages in their Chapter 7 case (and now, those debtors have a footnote in a published opinion to cite). If they are not daring (and have the funds for filing two bankruptcy cases), they can take the safer route of a "Chapter 20" to get rid of their second or third mortgage.

©Kevin C. McGee 2014

Monday, June 9, 2014


     This morning, on June 9, 2014, the U.S. Supreme Court issued its unanimous decision in Executive Benefits Agency  v. Arkinson, settling an issue that has plagued federal courts on all levels since the SCOTUS’s 2011 decision in Stern v. Marshall, 564 U.S. ___, 131 S. Ct. 2594 (2011):

Does the bankruptcy court violate Article III of the U.S. Constitution or Title 28 of the United States Code if it issues proposed findings and rulings on the type of issue identified in Stern v. Marshall as “core” under the bankruptcy statutory scheme, but beyond the tolerance of Article III if the bankruptcy court makes final findings of fact and rulings of law?

The Basics: Bankruptcy jurisdiction, since 1984, has divided issues into two categories: “core” matters spelled out in 28 U.S.C. §157(b)(2), which involve matters “arising in” a bankruptcy case and that a bankruptcy court would be expected to decide as part of the bankruptcy case (i.e., deciding whether proofs of claim are allowed, adjudicating the debtor’s discharge or the dischargeability of certain debts, confirming plans of reorganization); and “non-core” matters, which are matters “related to” the bankruptcy case. 

     Classic examples of “non-core” matters are disputes between non-parties, and the debtor’s pending state law claims against other persons.  28 U.S.C. §157 envisions that bankruptcy courts, as adjuncts of the U.S. District Courts to whom the District Courts “referred” all bankruptcy and related matters, can issue final findings of fact and final rulings of law on core matters. If the matter is “non-core”, 28 U.S.C. §157(c)(1) still allows the bankruptcy court to hear the case,  but issue only “proposed” findings and rulings for the U.S. District Court to either confirm or rehear.  28 U.S.C. §157(c)(2) allows bankruptcy courts, like U.S. magistrates, to finally determine any non-core matters if both parties to the matter consent.

     The difference between “core” and “non-core” has traditionally been on appeal. If the matter is core, then the U.S. District Court (or a Bankruptcy Appellate Panel) sits as an appellate court and its standard of review is “abuse of discretion” on factual findings and “de novo” (or “anew”) on rulings of law based on those facts (28 U.S.C. §158(a)). If the matter is non-core, the appellant gets another shot to try the case in front of the U.S. District Court, which looks at the proposed factual findings as suggested findings, and can rehear evidence to reach its own factual findings (28 U.S.C. §157(c)(1)).

The Effect of Stern v. Marshall: Stern v. Marshall, in effect, created a third category of matters for the bankruptcy court: “core” under the statutory definitions, but beyond the bankruptcy court’s power to finally decide under the U.S. Constitution. In Stern, the “core” matter was the debtor’s state law counterclaim to a proof of claim filed by a creditor. Because the counterclaim could not be decided based on the same facts and occurrences raised in the proof of claim, it was a “permissive” counterclaim instead of a “mandatory” counterclaim; however, 28 U.S.C. §157(b)(2)(C) provides that all “counterclaims by the estate against persons filing claims against the estate” fall into the “core” category, including the permissive state law counterclaims.

     The SCOTUS held that if the allowance of the debtor’s permissive state law counterclaim did not have the effect of directly offsetting the proof of claim amount, Article III prohibited the bankruptcy court’s decision of that counterclaim  as a “core” matter (with final findings and rulings). The SCOTUS majority (it was a 5-4 decision authored by Chief Justice Roberts) believed that “the removal of counterclaims such as [the debtor’s counterclaim] from core bankruptcy jurisdiction meaningfully changes the division of labor in the current statute; we agree with the Unite States that the question presented here is a “narrow” one.”

Post Stern v. Marshall ConfusionStern v. Marshall threw bankruptcy courts, U.S. District Courts, and U.S. Circuit Courts of Appeal into a jurisdictional tizzy. If the bankruptcy court’s “core” jurisdiction could be questioned for counterclaims to proofs of claim, then does the bankruptcy court’s final decision of other types of “core” matters implicate Article III?  Will the U.S. District Court be forced to withdraw its “reference”  of Stern “core, but really non-core” matters in every case, or can the bankruptcy court issue proposed findings and rulings in such matters as if they were non-core matters under the statute? Can the parties consent – or be deemed to consent – to the bankruptcy court’s final decision of Stern matters?  Does Article III allow bankruptcy courts to decide any Stern matter, regardless of consent of the parties?

   Lawyers in bankruptcy court were just as flummoxed. What the heck is a Stern matter? Do you commit malpractice if you don’t challenge the bankruptcy court’s “core” jurisdiction on any issue that might be beyond that jurisdiction per Article III, such as fraudulent transfers and preferences? Does filing a proof of claim still waive objections to bankruptcy court jurisdiction on Stern matters, as it does with jury trials on preferences and fraudulent transfers? Do you need to file a motion for withdrawal of the reference from the bankruptcy court as an automatic reflex?

     Local rules and orders from District Courts and bankruptcy courts tamed some of this chaos by: keeping the reference with the bankruptcy court; allowing for District Courts to second-guess bankruptcy court determinations that a Stern matter was or was not involved; and permitting U.S. District Court to treat bankruptcy court “final” findings and rulings as “proposed” if the bankruptcy court guessed wrong on a Stern issue.

Executive Benefits Agency  v. Arkinson Background: Executive Benefits Agency  v. Arkinson involved state law fraudulent transfer claims asserted under 11 U.S.C. §544; these types of claims were one of the fertile sources for post-Stern confusion. 28 U.S.C. §157(b)(2)(H) identifies all fraudulent transfer claim determinations as “core”. However, there are federal fraudulent transfer claims – asserted under 11 U.S.C. §548 – and state fraudulent transfer claims – asserted under §544(a). Moreover, there are jury trial rights associated with fraudulent transfer claims, if the transferee had not filed a proof of claim.   Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989); Langenkamp v. Culp, 498 U.S. 42 (1990).

     In this particular case, the transferee had not filed a proof of claim. At the bankruptcy court level, the court entered summary judgment for the trustee bringing the claims. The U.S. District Court (W.D. Wash.) treated the bankruptcy court’s findings and rulings as proposed, reviewed those findings and rulings de novo, and the matter proceeded up to the 9th Circuit Court of Appeals.  After the appellant’s opening brief, the SCOTUS decided Stern v. Marshall. Despite the appellant’s argument, based on Stern, that the bankruptcy court lacked any authority under Article III to rule on the summary judgment motion, the 9th Circuit affirmed the U.S. District Court.  The 9th Circuit held that either the appellant had, in effect, consented to bankruptcy court jurisdiction below, or the bankruptcy court in this instance issued only proposed findings and rulings that the U.S. District Court then confirmed.  

Executive Benefits Agency  v. Arkinson SCOTUS Decision: Justice Thomas authored the decision for a unanimous court. The justices ignored the “consent” issue, and went directly to the issue of whether the U.S. District Court could have treated the bankruptcy court summary judgment determinations as “proposed” despite the lack of an indication from the bankruptcy court regarding whether it issued a “final” or “proposed” summary judgment order. Justice Thomas, focusing on the statutory scheme in 28 U.S.C. §157, stated that Stern v. Marshall effectively invalidated §157(b)(2) as to any “core” matter that Article III prohibited the bankruptcy court from deciding as a “core” and final matter. The Court noted, however, that in enacting 28 U.S.C. §157, Congress also enacted a “savings” provision, as follows:

“If any provision of this Act or the application thereof to any person or circumstance is held invalid, the remainder of this Act, or the application of that provision to persons or circumstances other than those as to which it is held invalid, is not affected thereby.” 98 Stat. 344, note following 28 U. S. C. §151.

     Using that savings provision, Justice Thomas held that the invalidation of a matter as “core” on constitutional grounds threw that matter into the “non-core” bin. As a result, the bankruptcy court could still issue proposed findings and rulings on the matters under 28 U.S.C. §157(c)(1). The U.S. District Court’s review of the bankruptcy court’s summary judgment order on a de novo basis treated that order as “proposed”, and the SCOTUS affirmed the 9th Circuit decision on those narrow grounds. The slip opinion is located here: http://www.supremecourt.gov/opinions/13pdf/12-1200_2035.pdf

What Comes Now?  Three thoughts after reviewing the Executive Benefits Agency  v. Arkinson decision:

·         The SCOTUS has blessed the creation of three categories of bankruptcy court matters: “core” matters, “non-core” matters, and “core” matters treated as non-core per Stern. It also has told us that Stern issues may safely be handled as if they were "non-core" matters instead of "core" matters defined in §157(b)(2).

·         Although the SCOTUS ignored the consent issue raised in the 9th Circuit (see Slip Op. at p. 4 fn. 4), its decision opens the back door to allowing a bankruptcy court’s final determination of a Stern matter “by consent” under 28 U.S.C. §157(c)(2). If the savings provision allows treatment of an invalidated “core” matter as a matter under §157(c)(1), it also allows it to be treated as a matter for consent under §157(c)(2), which provides: “Notwithstanding the provisions of [§157(c)(1)], the district court, with the consent of all the parties to the proceeding, may refer a proceeding related to a case under title 11 to a bankruptcy court to hear and determine and to enter appropriate orders and judgments, subject to review [as final orders and judgments under 28 U.S.C. §158(a)].” Check your local rules and orders of reference from your local U.S. District Court, as well as any post-Stern orders and rules adopted. Arguably, in Massachusetts, LR 206 modifies the general reference in LR 201 and requires proposed findings and ruling on Stern matters; however, who knows what happens if the bankruptcy court determines that LR 206 does not apply because it finds that all parties consented to its final determination?

·         The Executive Benefits Agency  v. Arkinson decision, following Stern v. Marshall, places the onus on both bankruptcy courts and litigants to confront – early in a case -- whether a “core” matter is really a Stern matter, and act accordingly. The hard issues will continue to be in the area of avoidance recoveries – especially preferences and fraudulent transfers. Note that the SCOTUS left open – and did not decide – whether a §544 avoidance action is really a Stern matter (Slip Op. at p. 11). The justices seemed more concerned with straightening out the procedural morass rather than wrestling with the limits of bankruptcy court jurisdiction over §544 avoidance actions. Thus trustees, debtors, creditors with proofs of claim, and transferees without proofs of claim remain free to argue most of the questions set forth above to probe the extent of bankruptcy court jurisdiction over certain matters.

©Kevin C. McGee 2014