These are dark times in the galaxy….
Unemployment is stubbornly high. The recovery has nearly stalled. People’s savings are low. The housing market’s so-called rebound has been uneven. Since June 2011 almost a million and a half people have sought bankruptcy protection. The number of filers keeps growing (so much for the salutary effect of BAPCPA). Is there hope?
A New Hope
One effective feature of Bankruptcy is the lien strip. Traditionally Chapter 7 debtors could not take advantage of a lien strip, which permits a debtor to treat unsecured mortgages and lines of credit the same way as other unsecured debts such as credit cards. If they could, those debts – previously treated as a “secured loan” or “mortgage” would really be discharged at the end of the case like a credit card debt.
Instead, Courts have permitted lien strips to be employed only in connection with Chapter 13 reorganizations. Ironically this meant that the Chapter 7 debtors least able to keep their 2nd mortgage or HELOC could not get relief. And Courts have adhered to the Chapter 7 v. Chapter 13 distinction right up to the present – even as real estate values have plummeted.
But in a recent decision the 11th Circuit Appellate Court held that a Chapter 7 debtor could avoid a junior lien, in essence giving millions of Americans a new hope.
The Empire Strikes Back
So what makes Chapter 13 and 7 so different when it comes to the treatment of unsecured mortgages and home equity loans? Why let the Chapter 13 debtor to pursue a lien strip but deny it to the Chapter 7 debtor?
Chapter 7 of course is reserved for those who make less than the median income in their State or can demonstrate that letting them liquidate despite having an above the median income isn’t an abuse of the Code. Chapter 7 cases move quickly- assets are liquidated or abandoned by the case Trustee within a short time-frame.
Chapter 13 by contrast is the adjustment of debts by those with regular income who can meet their living expenses, but have fallen behind. The theory is they just need to catch up. Chapter 13 debtors are even their own trustees or Debtor in Possession and their repayment plans take up to 5 years to administer.
But are those really fair characterizations of Chapter 7 and 13 debtors? These days a sudden job loss, illness, drop in property value, or plain old economic malaise can transform a wage earner into a deadbeat. So why not offer the same benefit to both types of debtors? Why not permit Chapter 7 lien strips?
Return of the Jedi
Speaking of lien strips, what is a lien exactly? Answer: it’s a security interest in real property given or taken in return for value. Typically, a bank lends the money to buy your house and in return you grant a lien in the property. But not all liens are created equal, since only some are perfected. Holders of perfected liens get paid before the holders of unperfected liens.
That’s where McNeal v. GMAC Mortgage comes into play. In McNeal the 11th Circuit Court of Appeals concluded that Chapter 7 debtors had as much right as Chapter 13 debtors to strip unsecured junior liens. The Court’s reasoning rested largely on a linguistic choice – “stripping down” versus “stripping off.” In fact, policy considerations drove the decision and reversed a long line of precedent.
The facts were these: McNeal, a Chapter 7 debtor, had two mortgages. The amount due as to the first mortgage was $176,413, the amount due as to the second loan was $44,444 and the debtor’s house was wroth only $141,416. This would have qualified the debtor to perform a lien strip in Chapter 13. But this was a Chapter 7.
The Bankruptcy Court cited a long line of precedent, including a Supreme Court case, all of which pointed in a single direction: Chapter 7 debtors could not ‘strip down’ junior liens. But the 11th Circuit went a different way. It applied the U.S. Supreme Court case of Dewsnup v. Timm which concluded that a Chapter 7 debtor could “strip down” a partially unsecured lien even though the debtor could not ‘strip it off’ altogether. The result was essentially the same – the debtor got out of paying the entire value of the lien.
Boom goes the dynamite!
Epilogue: Yes, There is Hope
Okay, was the 11th Circuit really persuaded by the distinction between a “stripping down” and “stripping off?” Probably not. But for years consumer groups had called for a vehicle by which debtors could strip liens in Chapter 7 and escape crushing debt without losing their house and home. Many of the Circuits criticized Dewsnup too because it seemed to declare once and for all that only Chapter 13 debtors could employ lien strips then stopped just short of overturning the practice altogether.
So is this an unconditional victory for Chapter 7 debtors? Not exactly. The rest of the Federal Circuits, including the 7th Circuit, have recently reaffirmed their allegiance to Dewsnup and the narrow reading of the practice of lien stripping. But the circuit split means the Supreme Court may yet have to address the issue in its next term. But until then, all bets are once again off.