New Jersey Bankruptcy Court Rejects Debtor’s Attempt to Avoid Lien in a Chapter 7 Case

By: Karina Velter, Esq.

August 23, 2010

Following the trend of a majority of the Circuit Courts, the United States Bankruptcy Court for the District of New Jersey concludes that a Chapter 7 debtor may not void a lien under §506(d) where the claim is wholly unsecured.  This is an important decision for creditors as it solidifies the principle that a wholly unsecured lien on real property will survive a Chapter 7 bankruptcy unaffected.  For example, a Chapter 7 debtor owns real property with a fair market value of $125,000, which is encumbered by two liens.  The first mortgage is in the amount of $150,000 and the second is in the amount of $35,000.  Based on the ruling of a majority of jurisdictions, the second mortgage (which is wholly unsecured) would survive the bankruptcy unscathed.

In this New Jersey case, a Chapter 7 debtor filed a motion to reclassify a wholly unsecured second mortgage on his primary residence from a secured claim to unsecured, relying on §506(a) and (d).  Section 506(a) bifurcates and reclassifies claims into secured and unsecured status.  The claim is secured to the extent of the value of the creditor’s interest in the property, and unsecured to the extent that the amount of the claim exceeds the value of the creditor’s interest in the property.  Section 506(d) provides for a mechanism to avoid a lien that secures a claim that is not an allowed secured claim.

The court observed that although the debtor’s motion was styled as a motion to “reclassify,” the debtor was actually attempting to void the lien under §506(d).  Citing to the Supreme Court’s decision in Nobelman v. American Savings Bank and the Third Circuit’s ruling in In re McDonald, the Chapter 7 debtor attempts to draw a distinction between “stripping off” and “stripping down” a wholly unsecured lien.  However, the court rejects the debtor’s argument, concluding that the Supreme Court’s decision in Dewsnup v. Timm, precludes the voiding of a lien under §506(d) in a Chapter 7 case where the claim is wholly unsecured.

To reach this conclusion, the court analyzes several Supreme Court and Circuit Court decisions.  In Dewsnup, a Chapter 7 debtor sought to avoid the unsecured portion of a mortgagee’s lien.  Reading §506(a) and §506(d) together, the debtor argued that because under §506(a), a claim is secured only to the extent of the judicially determined value of the real property on which the lien is fixed, a debtor can void the lien pursuant to §506(d) to the extent the claim is no longer secured and thus is not an “allowed secured claim.”  The Supreme Court disagreed and held that §506(d) does not allow debtor’s proposed “strip down,” because the mortgagee’s claim is secured by the lien and has been fully allowed pursuant to §502, and therefore, cannot be classified as “not an allowed secured claim” for the purposes of §506(d).  The Court rejected the debtor’s position that the words “allowed secured claim” must take the same meaning in 506(d) as in 506(a), that is to be read as allowed “secured claim.”  The Court reasoned that Congress must have had a full understanding of the pre-Code rule that liens pass through the bankruptcy unaffected, and, “given the ambiguity in the text, the Court was not convinced that Congress intended to depart from that rule. 502 U.S. 410, 112 S. Ct. 773, 116 L.Ed. 2d 903, (1992).  “The words in 506(d) need not be read as indivisible terms of art defined by reference to 506(a) but should be read term-by-term to refer to any claim that was, first, allowed—as in the case at hand has been pursuant to 11 U.S.C 502—and second, secured, thereby voiding liens only when the claims they secure have not been allowed.”  Id. at 417.

In Nobelman v. American Savings Bank, a Chapter 13 debtor, relying on §506, sought to bifurcate an understated claim, make regular payments toward the “secured” portion of the claim, while paying zero to unsecured creditors, which included the bifurcated “unsecured” portion of the claim.  Nobelman v. American Savings Bank, 508 U.S. 324, 113 S. Ct. 2106, 124 L.Ed.2d 228 (1993).  The Supreme Court held that the debtor’s proposed plan is prohibited under §1322(b)(2), which provides that a Chapter 13 plan may “modify the rights of holders of secured claims, other than a claim secured by a security interest in real property that is the debtor’s principal residence.”  In other words, this section prohibits the modification of an undersecured claim against a debtor’s principal residence.  Id. at 328.  The court again looked at the wording of the statute and concluded that the use of the phrase “claim secured …by” instead of “secured claim,” in §1322(b)(2), indicates an intent to “encompass both portions of the undersecured claim.”  Id. at 331.

Thus, under Nobelman, if there is some value in the debtor’s principal residence to which the creditor’s lien may attach, the antimodification provision in  §1322(b)(2) will protect the creditor’s rights as they relate to both the secured and unsecured portions of the claim.

The question presented by this New Jersey debtor is whether a “strip off” rather than a “strip down” of a wholly unsecured lien is permissible in a Chapter 7 case.  A majority of courts addressing this issue concluded that there is essentially no distinction between “stripping off” and “stripping down” wholly unsecured liens, and that both actions are prohibited by the Supreme Court’s decision in Dewsnup.

The vast majority of courts do not allow the avoidance of wholly unsecured or undersecured liens in Chapter 7 proceedings.  However, a minority of courts still reason that Dewsnup is limited by its facts to the application of cases of partially secured claims, and, therefore, allow the avoidance of wholly secured claims.

In Ryan v. Homecomings Fin. Network, 253 F.3d 778 (2001), the Fourth Circuit Court of Appeals held that although junior lien holders have limited opportunity to recover their unsecured claims, the parties bargained for their positions with knowledge that a superior lien existed.  Nonetheless, “under a Chapter 7 proceeding, they are entitled to their lien position until foreclosure or other permissible final disposition is had.”  Id.

In In re Talbert, 344 F.3d 555, the Sixth Circuit set forth three bases for the Supreme Court’s holding in Dewsnup: “(1) any increase in the value of the property from the date of the judicially determined valuation to the time of the foreclosure sale should accrue to the creditor” (otherwise it would create a “windfall for debtors); “(2) the mortgagor and mortgagee bargained that a consensual lien would remain with the property until foreclosure; and (3) liens on real property survive bankruptcy unaffected.”

Applying these principles, the court held that to allow a “strip off” would be in contradiction to the pre-Code rule that real property liens pass through the bankruptcy unaffected.  Additionally, a “strip off would rob the mortgagee of the bargain it struck with the mortgagor”, i.e., that the consensual lien would remain with the property until foreclosure.

In In re Laskin, the Ninth Circuit Bankruptcy Panel drew a distinction between the application of §506(d) in a Chapter 7 and that in a Chapter 13.  The court noted that unlike in a Chapter 13, where the claim must be allowed or disallowed to determine what is paid through the plan, and where the determination of a creditor’s secured status is relevant, “the allowance of a secured claim, or determination of secured status is meaningless in a Chapter 7 where the trustee is not disposing of putative collateral.”  In re Laskin, 222 B.R. 872 (B.A.P. 9th Cir. 1998).

Rejecting the debtor’s argument that Nobelman and McDonald compel the voiding of a lien in a Chapter 7 where the lien does not attach to some existing value in the property, the New Jersey Bankruptcy court reasoned that the question of voiding a lien on a wholly unsecured claim depends on whether the debtor’s case is filed under Chapter 7 or Chapter 13.  In Chapter 13, there must first be a determination whether a junior lien holder has a secured claim for purposes of §1322(b)(2).  In a Chapter 7 context, determination of the value in the collateral is irrelevant for purposes of §506(d), as long as the claim is allowed under §502.  Thus, the court concluded that in the instant matter, the claim sought to be avoided is both allowed and secured by the debtor’s property.

A major policy consideration in rejecting the debtor’s position is the implication “strip down or strip off” would have on the creditor’s right in the property.  The courts conclude that even the “fresh start” policy cannot justify an impairment of the creditors’ property rights because the fresh start does not extend to a claim against the property, but rather, is limited to a discharge of personal liability of the debtor.  Another consideration for disallowing the relief sought by the debtor is the potential windfall a “strip off” would create.  Because the unsecured creditor would lose any increase in the value of the property by the time of the foreclosure sale, the increase in value would accrue to the benefit of the debtor.

This is an important decision because it precludes debtors from divesting the creditors’ of their rights in the property.  This decision supports the principle that wholly unsecured liens pass through the Chapter 7 bankruptcy unaffected.

As more and more courts consider this issue, Weltman, Weinberg & Reis Co., LPA will continue to monitor the status of the lien avoidance cases and keep you apprised of the trends and new developments in the law.

If you have any questions on this matter, please contact Ms. Karina Velter, Esq. Karina is an associate in the Bankruptcy Group of the Weltman, Weinberg & Reis Co., LPA Philadelphia office. Karina can be reached at (215) 599-1500 or via email at kvelter@weltman.com.

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