Despite having a reputation for being conservative, the Fourth Circuit is becoming uncommonly debtor-friendly. The appeals court held that a chapter 13 debtor can strip off an underwater subordinate mortgage even if the lienholder did not file a proof of claim.
The opinion on March 29 by Circuit Judge Albert Diaz is important, given the effect that a contrary holding would have. By not filing a claim, the holder of a subordinate mortgage waives the right to distributions under a chapter 13 plan but would realize a bigger payday by having the lien pass through bankruptcy unaffected, if Judge Diaz had ruled the opposite.
If failing to file a proof of claim would immunize a subordinate mortgage-holder from having the lien stripped off, subordinate mortgagees would never file claims, precluding chapter 13 debtors from stripping off underwater subordinate mortgages, even though every circuit to address the issue has held that chapter 13 debtors have the statutory right to strip off underwater subordinate liens.
The Simple Facts
The chapter 13 debtors had three mortgages on their home, which was worth less than the debt on the first mortgage. The holder of the second lien did not file a proof of claim, but the holder of the third mortgage did.
The debtors sued to strip off the second and third mortgages. Both subordinate mortgagees defaulted. The bankruptcy judge stripped off the third mortgage but refused to strip off the second mortgage because the lienholder had not filed a proof of claim. The bankruptcy judge theorized that Section 506(d)(2) prohibits lien avoidance when no proof of claim has been filed. The district court affirmed on the same ground.
The Fourth Circuit Opinion
Section 506(d) provides that a lien is void to the extent it “secures a claim against the debtor that is not an allowed secured claim.” On appeal, the chapter 13 trustee argued that the claim on the second mortgage was not an allowed claim, because no proof of claim was filed. Therefore, according to the trustee, the debtor could not strip off the mortgage.
In short, Judge Diaz held that Section 506(d) plays no role in stripping off liens. He said the process is governed by Sections 506(a) and 1322(a). He also explained the statutory and caselaw basis for allowing or disallowing lien strip-off and lien strip-down.
In chapter 7, the Supreme Court decided in Dewsnup v. Timm, 502 U.S. 410 (1992), that a debtor cannot strip down a partially secured claim. In Bank of America v. Caulkett, 135 S. Ct. 1995 (2015), the high court extended Dewsnup to hold that a chapter 7 debtor cannot strip off a completely valueless subordinate lien.
In Nobelman v. American Savings Bank, 508 U.S. 324 (1993), the Supreme Court similarly prohibited strip-down in chapter 13 but has not granted certiorari to rule on strip-off in chapter 13. However, every court of appeals to consider the issue has held, like the Fourth Circuit, that strip-off is permissible in chapter 13. (Strip-off means eliminating a lien entirely. Strip-down means reducing the amount of a lien according to the value of the collateral securing the claim.)
Regarding the issue at bar, Judge Diaz said that a court “correctly” looks not to Section 506(d) but to Section 506(a) for valuation of the collateral to decide whether the debtor can modify the rights of the secured creditor under Section 1322(b)(2).
Judge Diaz said that the lower courts confused “the claim allowance and lien avoidance process.” In addition, the lower courts turned “a blind eye to economic reality.” He said that “the language and purpose of Section 1322(b) compels” reversal.
Judge Diaz noted that Section 1322(b) does not refer to modifying claims. Rather, the statute talks about modifying the “rights of holders of secured claims.” He therefore held that “an entirely valueless lien may be stripped under Section 1322(b) whether or not a proof of claim has been filed.”
Ruling otherwise, he said, “would require us to ignore the plain fact that . . . such a creditor has no incentive to file a proof of claim.” Furthermore, the debtor could remedy any defect by filing a claim as permitted by Section 501(c), he said.