Now in Play: §506(d) "Strip-Offs" in Chapter 7

     On March 31, 2014, the Supreme Court of the United States denied certiorari in Bank of America, N.A. v. Sinkfield, Petition No. 13-700. To put it in terms appropriate to Major League Baseball’s opening day, this was the equivalent of Casey’s mighty whiff at strike three in the ninth inning, with the bases loaded, a full count, and the chance for a walk-off win.

     The elements were all in place; a “rogue” circuit makes a holding that three other circuits would not dare to make, on an issue that many debtor lawyers fantasize about revisiting and that many banks dread like a recurring nightmare. The 11^th Circuit (albeit summarily, in an order) held that a fully unsecured second mortgage lien could be “stripped off” a Chapter 7 debtor’s residence in Georgia, when the value of that residence is only enough to (partially) secure the first mortgage lien. The 11^th Circuit based the order on its previous (unpublished) decision in In re McNeal, No. 11-11352 (11th Cir. 5/11/12), in which the circuit limited the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992) to prohibiting the strip-down of partially secured first mortgages in Chapter 7.  The McNeal court held that fully unsecured second mortgages are fair game to be stripped off under 11 U.S.C. §506(d), and relied on its own, pre-Dewsnup 1989 decision, Folendore v. United States Small Bus. Admin., 862 F.2d 1537 (11th Cir. 1989), as precedent for doing so. The 4^th Circuit, 6^th Circuit, and 7^th Circuit (as well as many lower courts) all reached opposite results in holding that Dewsnup v. Timm did apply and prohibited any lien stripping in Chapter 7. Throughout most of the country, the old adage that liens float unaffected through a (Chapter 7) bankruptcy is alive and well.

Bankruptcy 101 on Lien-Stripping (in Chapter 7):

     11 U.S.C. §506(d) seems clear on its face. It states that:

  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 is disallowed only under section 502(b)(5)[as an unmatured debt for a domestic support obligation] or 502(e) [as a contingent claim for reimbursement or contribution] 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 claim under section 501 of this title.

      Add to this §506(a)(1), which states 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 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.”  

      Thus, under recent Supreme Court precedent, it seems like a “no-brainer” to hold that the statutes say what they say:  you determine secured claims according the value of the debtor’s property (and we can fight about what that “value” is); there is no secured claim or lien beyond the value of the property;  the only exceptions to the lien-voiding rule in §506(d) are certain unmatured  and contingent secured claims; and a creditor does not have to file a proof of claim to have its lien determined as an “allowed secured claim”.  After all, look at the unanimous decision last month in Law v. Seigel, in which the justices solemnly proclaimed that “’whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of ‘the Bankruptcy Code” and “We have recognized  … that in crafting the provisions of§522, ‘Congress balanced the difficult choices that exemption limits impose on debtors with the economic harm that exemptions visit on creditors.’  … The same can be said of the limits imposed on recovery of administrative expenses by trustees. For the reasons we have explained, it is not for courts to alter the balance struck by the statute.” [1]

But - Dewsnup v. Timm

      As many law school professors will gleefully tell you after you cite this straight-forward analysis – we have the 1992 precedent of Dewsnup v. Timm, in which the Supreme Court held that a partially unsecured first mortgage could not be “stripped down” in Chapter 7 using these two statutes. The pillars of that decision are as follows:

 (a)  Congress could not have meant to change long-standing bankruptcy law that “that liens pass through bankruptcy unaffected”, and courts do not look at a clean slate (with no history) when interpreting Bankruptcy Code provisions;

(b)  even though §506(a) and §506(d) both use the term “allowed secured claim”, it is an ambiguous, undefined term, and does not necessarily mean the same thing in each statute or elsewhere in the Bankruptcy Code;

(c)  the function of §506(a) is to determine the relative interests of secured creditors and debtors in property that is part of the debtor’s estate, while the function of §506(d) is to void “only liens corresponding to claims that have not been allowed and secured”; and

(d)  if the Court were to hold otherwise, it would ignore pre-Code bankruptcy practice and “freeze the creditor's secured interest at the judicially determined valuation.  By this approach, the creditor would lose the benefit of any increase in the value of the property by the time of the foreclosure sale. The increase would accrue to the benefit of the debtor, a result some of the parties describe as a ‘windfall.’”

      Dewsnup contains a dissent authored by Judge Scalia, who – unsurprisingly – disagrees with the majority’s decision because the plain language of both §506(a) and §506(d) compels the voiding of the unsecured portion of the lien, notwithstanding pre-Bankruptcy Code practice. Judge Scalia is still on the Supreme Court;  one of the justices joining the majority, Judge Kennedy, is also still on the Supreme Court. The rest of the participants in the majority opinion – Judge Blackmun (the author of the majority opinion), Judge O’Connor, Judge White, and Judge Stevens – have been replaced. So has Judge Souter, who joined in Judge Scalia’s dissent. But Judge Thomas, who did not participate in the decision and often joins with Judge Scalia, is still on the court.

     So, all the conditions seemed right for a revisiting of §§506(a) & 506(d): a split in the circuits; a (mostly) new cast of characters on the Supreme Court; and a different perspective in recent decisions of the Supreme Court on whether the plain language of the Bankruptcy Code or the historical precedent of bankruptcy practice is more important.  Yet, the petition for certiorari is denied, and mortgagees across the country breathe a sigh of relief -- except, of course, in Georgia, Alabama, and Florida, where motions and adversary proceedings for lien-strip offs in Chapter 7 continue unabated[2].  Casey was expecting a fast ball on a 3 and 2 count, and got a curve ball instead, leaving the home crowd unsatisfied.

     The practical effect is that a debtor’s attorney in the First, Second, Fifth, Eighth, Ninth, or Tenth Circuit will have to take the right case up for an appeal, and obtain a reasoned circuit decision on this issue. The 11^th Circuit has the outlier opinion already in In re McNeal – it’s just a matter of finding an appeal with the right ingredients.

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[1]  Note also that the justices threw an earlier Supreme Court case, Marrama v. Citizens Bank of Mass., 549 U. S. 365 (2007) under the bus, ignoring that the Marrama court had blessed an equitable exception to express statutory language, and then finessing the issue by saying that another statute disqualified the debtor from converting his case to Chapter 13.

[2]  The NACBA’s amicus brief opposing the certiorari petition likely gives the real reason for the order denying certiorari: Bank of America “fast-tracked” the petition by agreeing that the 11 Circuit’s order was final, and deprived the Supreme Court of a “deliberative” decision by a circuit court setting up a true conflict in the circuits on the issue.

©Kevin C. McGee