Courts have long grappled with the question of whether “stripping” an unsecured junior lien is permitted by § 506 of the Bankruptcy Reform Act of 1978 (the Bankruptcy Code).[1] In 1992, in the case of Dewsnup v. Timm, the Supreme Court granted certiorari on the topic, holding that “stripping down” partially unsecured junior liens was not permissible under the plain meaning of the Code.[2] Recently, however, the practical implications of the intersection of § 506(a) and (d) of the Code have been in flux as courts across the country weigh in on the distinction between “stripping down” and “stripping off.”
In May 2012, the Eleventh Circuit Court of Appeals in McNeal v. GMAC Mortgage broke with circuit consensus, finding that the Supreme Court’s 1992 decision failed to address the permissibility of “stripping” wholly unsecured junior liens.[3] In a landmark (but unpublished) decision, the Eleventh Circuit permitted a debtor to avoid a wholly unsecured junior lien under § 506(d) of the Code. Although the circuits remain split on strict adherence to Dewsnup, the Supreme Court has been reluctant to clarify its decision, and its recent denial of certiorari on the issue has left the holding of McNeal undisturbed.[4]
Lien-Stripping, Generally
The notion of stripping junior liens in bankruptcy was born out of the reading of § 506(a) and (d) of the Code in tandem with one another. Section 506(a)(1) of the Code permits bifurcation of a debtor’s secured claim, providing that “[a]n allowed claim of a creditor secured by a lien on property … 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….”[5] In other words, a secured creditor has a secured claim to the extent of the value of its collateral, and if the collateral is worth less than the claim, an unsecured claim remains for the remainder of the claim. For example, a creditor with a $100,000 claim secured against a property worth only $30,000 would end up with two claims: a secured claim in the amount of $30,000, and an unsecured claim for the remaining $70,000. Moreover, § 506(d) of the Code provides for the voiding of a lien “to the extent that a lien secures a claim against the debtor that is not an allowed secured claim.”[6]
Reading these two provisions together advances the interpretation that the reference in § 506(d) to an “allowed secured claim” is defined by the language in § 506(a). That is to say that the portion of a lien that is unsecured under § 506(a) would not be considered an allowed secured claim, and thus is voidable under § 506(d). Prior to the holding in Dewsnup, the practical implication of this interpretation was that “a homeowner in bankruptcy might ask the court to value his or her home at less than the full amount owed on the mortgage … [and] the homeowner would then ask the court to void the lien to the extent that the lender's claim exceeded that court-determined value.”[7] This process has come to be known as “lien-stripping.”
History of Lien-Stripping and the Dewsnup Decision
Prior to the Supreme Court’s decision in Dewsnup, lien-stripping was common practice in the majority of circuits.[8] Leading the pack was the Third Circuit Court of Appeals, which, in Gaglia v. First Federal Savings & Loan Association, adopted interpretation that the reference in § 506(d) to an “allowed secured claim” is defined by the language in § 506(a).[9] In Gaglia, the debtors asserted that § 506(a) of the Code permits bifurcation of a secured creditor’s claim and that the unsecured portion of the claim can be voided under the plain language of § 506(d).[10] The Third Circuit agreed, holding that “[a]lthough no court of appeals has directly ruled on the question, the two cases that have discussed the application of Section 506 in this context indicate that a debtor may use Section 506(d) to avoid liens[11] … [and] we agree with the Gaglias that, on its face, Section 506 allows them to avoid the [debtors unsecured] lien.”[12]
The decision in Gaglia gained prominence on the issue of lien-stripping, but its prominence was short-lived. A mere three years after the Third Circuit decided Gaglia, the Supreme Court granted certiorari in the case of Dewsnup v. Timm and held that it is impermissible for a chapter 7 debtor to strip down a partially secured lien under § 506(d) to the value of the underlying collateral.[13] Dewsnup involved a debtor faced with liens in bankruptcy that far exceeded the value of the collateral at issue. The debtor petitioned the bankruptcy court to reduce a creditor’s secured claim in the amount of $120,000 to $39,000, the judicially determined value of the collateral securing the claim.[14] The Supreme Court found that § 506(a) was not meant to define “allowed secured claim” with respect to § 506(d) and thus “does not allow Dewsnup to ‘strip down’ respondents' lien to the judicially determined value of the collateral, because respondents' claim is secured by a lien, and has been fully allowed pursuant to 502.”[15]
The Supreme Court in Dewsnup honored “the bargain between the borrower and the lender ... [and] the rule, established long before the enactment of the Bankruptcy Code, that liens survive bankruptcy.”[16] In its opinion, the Supreme Court explicitly stated that if “writing on a clean slate, we might be inclined to agree with petitioner that the words ‘allowed secured claim’ must take the same meaning in § 506(d) as in § 506(a). But, given the ambiguity in the text, we are not convinced that Congress intended to depart from the pre-Code rule that liens pass through bankruptcy unaffected.”[17] Justice Scalia, however, in a scathing dissent, condemned the majority’s disregard for the principle of statutory construction, which has not gone unnoticed.[18]
Revisiting Dewsnup in the Wake of the Mortgage Crisis
The decision by the Supreme Court in Dewsnup has come under some criticism in the wake of the 2007 mortgage crisis. This can be attributed perhaps in part to the fact that the Supreme Court’s ruling in 1992 was rooted in Congress’s traditional treatment of liens in bankruptcy, and the loan-to-value ratios of home mortgages advanced during the early 2000s were not contemplated by the country’s early Congress or the 1992 Supreme Court. As one author aptly put it, “[w]hile the [Dewsnup] case w[as] certainly significant at the time, the Court could not have foreseen the resulting effects nearly 20 years later following the subprime mortgage crisis of 2007.”[19] Consequently, the Dewsnup decision and the subprime mortgage crisis of 2007 that resulted in the depreciation of housing values across the country has left bankruptcy courts unprepared to deal with the question of how to treat junior liens in chapter 7 filings in a new legal era.
A unique aspect of the housing boom of the early 2000s was the rapid growth of home equity loans, often referred to as junior liens or second mortgages. Conservative estimates have stated that “the total balance of home equity loans increased … [at] an average growth rate of 16.8% between 2000 and 2008.”[20] In a perfect world, each borrower would simply pay back their loans over time and would be left with a clean slate and a house no worse for the wear. However, when financially unstable borrowers began to default, the entire system collapsed. Foreclosures increased exponentially, and housing prices plummeted. “The sudden disastrous drop in home values left many people ‘underwater,’ owing much more debt than value in their homes.… This steep drop in home values left many homeowners stuck with homes that have depreciated in value so much that their value does not even cover the debt they owe on principal mortgages, much less junior mortgages.”[21]
The combination of sudden home value depreciation and the popularity of junior liens exposed the limitations of Dewsnup. Although Dewnsup clearly forbade debtors from using the “valuation process under § 506(a) to ‘strip down’ … undersecured mortgages to the fair market value of the property and void the unsecured portion of the lien,” it said nothing of the legality of stripping off a lien that was wholly rather than partially unsecured.[22]
Stripping Down vs. Stripping Off
Take, for example, the case of Sally. Sally lives in a nice neighborhood and owns a two-bedroom home worth $300,000. When Sally bought her home, she took out a mortgage from Bank A. A few years down the line, in 2006, Sally’s daughter applies to college. At this point, Sally owes Bank A $200,000 and decides to borrow against the remaining $100,000 of equity in her home to pay for her daughter’s tuition. Sally now owes Bank A $200,000 and Bank B $100,000. Suddenly, all of Sally’s neighbors begin losing their jobs, defaulting on their mortgages and are facing foreclosure. The value of Sally’s home is halved, and she now owes $300,000 on a home that’s only worth $150,000. Sally subsequently loses her job and files for bankruptcy. The question facing the bankruptcy court in Sally’s jurisdiction is how to treat Bank B’s lien on Sally’s home.
This case study highlights a crucial difference, often unrecognized by courts, between stripping down and stripping off a junior lien. The Dewnsup decision did not explicitly address Sally’s circumstance. The Supreme Court in Dewsnup was asked only to weigh in on “‘strip downs’ (reducing an under-secured lien to the fair market value of the collateral), and did not address ‘strip offs’ (eliminating a wholly unsecured junior lien),” and thus is not clearly on point.[23] The Eleventh Circuit decision in McNeal recognized this fundamental difference between stripping down and stripping off and used the distinction to significantly alter the discussion surrounding § 506(a) and (d) of the Code.
Eleventh Circuit Decision in McNeal v. GMAC Mortgage
Decided in 2012, McNeal concerned a debtor with two mortgages, the first in the amount of $176,413 and the second at $44,444, on a home worth less than $142,000.[24] Thus, the home’s value did not even cover the entirety of the first mortgage, leaving the junior lien completely valueless.[25] Prior to the McNeal decision, “[m]ost courts … had held that the Dewsnup rule against ‘stripping down’ liens that had some value applied equally to ‘stripping off’ liens that had no apparent value.”[26] Both the bankruptcy court and district court ruled against McNeal. McNeal countered their position by arguing that “because the lien of the second mortgage holder did not actually secure any allowed secured claim — the junior lender's claim was wholly unsecured — that lien was void and should be ‘stripped off’ of her home completely.”[27] The Eleventh Circuit reversed the lower courts, holding that the Code permits lien-stripping in chapter 7 cases where there is a wholly unsecured lien or second mortgage.[28]
In its decision, the Eleventh Circuit, recognizing that the Supreme Court in Dewsnup had expressly limited its decision to the precise issue raised, stated that “[o]bedience to a Supreme Court decision is one thing, extrapolating from its implications a holding on an issue that was not before that Court in order to upend settled circuit law is another thing.”[29] The Eleventh Circuit also recognized, however, that other circuits had reached the opposite conclusion and thereby extended the holding of Dewsnup to stripping off a wholly unsecured junior lien. Ultimately, the Eleventh Circuit opted to follow pre-Dewsnup circuit precedent on the issue.[30]
Practical Implications of the McNeal Decision
The Eleventh Circuit remains a maverick among the U.S. circuits for its decision in McNeal, with the Fourth, Sixth and Ninth Circuits all prohibiting lien strip-offs in chapter 7 cases.[31] However, the continuing fallout from the mortgage crisis has consumer activists pushing to advance the rule in McNeal. While the McNeal decision would seem to extend hope to many affected by the bursting of the housing bubble, there is no predicting how long the relief will last or whether it will be adhered to consistently. In March of this year, the Supreme Court denied certiorari in Bank of America v. Sinkfield, a chapter 7 strip-off case from the Eleventh Circuit, thus leaving the McNeal decision fully intact.[32] Many attribute the denial of certiorari to the Supreme Court’s express limitation of the holding of Dewsnup and its clear distaste for its own decision in that case, but with the circuit split ever widening, it may not be long before the Supreme Court opts to clarify its holding in Dewsnup.
[1] 11 U.S.C. §§ 101, et seq. (2006).
[2] Dewsnup v. Timm, 502 U.S. 410, 417 (1992).
[3] McNeal v. GMAC Mortgage LLC (In re McNeal), 735 F.3d 1263, 1265 (11th Cir. 2012).
[4] Bank of America v. Sinkfield, No. 13-12141 (11th Cir. July 30, 2013), cert denied, 83 U.S.L.W. 3566 (U.S. Mar. 31, 2014) (No. 13-700).
[5] 11 U.S.C. § 506(a)(1).
[6] 11 U.S.C. § 506(d).
[7] Christopher Combest, “Lien ‘Strip Down’ vs. Lien ‘Strip Off’: Dewsnup v. Timm Is Still the Law – Isn’t It?,” ABA Business Law Today, May 2013.
[8] See William R. Baldiga & Theodore Orson, “The Effect of Dewsnup v. Timm on Chapter 11 Cases,” 110 Banking L.J. 130, 131 (March-April 1993).
[9] Gaglia v. First Fed. Sav. & Loan Ass’n, 889 F.2d 1304, 1308 (3d Cir. 1989); see also Baldiga & Orson, supra note 9.
[10] Gaglia, 889 F.2d at 1306.
[11] Id. at 1306 (discussing In re Folendore, 862 F.2d 1537 (11th Cir. 1989) and In re Lindsey, 823 F.2d 189 (7th Cir. 1987)).
[12] Id. at 1308.
[13] Dewsnup, 502 U.S. at 417.
[14] Id. at 413.
[15] Id. at 417; see also 11 U.S.C. § 502 (addressing allowed claims generally).
[16] Combest, supra note 8.
[17] Dewsnup, 502 U.S. at 417.
[18] Id. at 420 (Scalia, J., dissenting); see In re Cunningham, 246 B.R. 241, 246 (Bankr. D. Md. 2000) (compiling law review articles criticizing Dewsnup).
[19] Michael Meyers, Dewsnup Strikes Again: Lien-Stripping of Junior Mortgages in Chapter 7 and Chapter 13, 53 Ariz. L. Rev. 1333, 1335 (2011).
[20] Michael LaCour-Little, et al., “The Role of Home Equity Lending in the Recent Mortgage Crisis,” Real Estate Economics, Forthcoming, August 7, 2012, at 3.
[21] Meyers, supra note 20, at 1335.
[22] Id.
[23] Scott St. Amand and J. Ellsworth Summers, Jr., “‘Down’ is Out, ‘Off’ is In: Stripping Liens after McNeal, XXXI ABI Journal 6, 43, July 2012.
[24] McNeal, 735 F.3d at 1264.
[25] Combest, supra note 8.
[26] Id.
[27] Id.
[28] McNeal, 735 F.3d. at 1265-66.
[29] Id.
[30] Id (discussing pre-Dewsnup precedent on the question of strip-off in chapter 7); see also In re Folendore, 862 F.2d 1537 (11th Cir. 1989).
[31] Cynthia A. Riddell, “Stripping Off Allowed in Chapter 7,” 10 ABI Consumer Bankruptcy Committee Newsletter 4, August 2012.
[32] Jean Braucher, “Supreme Court denied certiorari in Sinkfield (chapter 7 lien strip-off case),” March 31, 2104, www.creditslips.org/creditslips/2014/03/supreme-court-denies-certiorari….