BAP Narrowly Reads Section 506(d) on Voiding Liens Following Claim Disallowance

A debtor may employ Section 506(d) to avoid a lien only if disallowance of the associated secured claim was based on the merits of the underlying debt, according to the Bankruptcy Appellate Panel for the Ninth Circuit.

The case featured a clever debtor’s lawyer who almost won a free house for his client, who never disputed owing about $675,000 to the mortgage lender.

The Strategy that Almost Worked

The chapter 13 debtor scheduled his home as worth $420,000. He listed a bank as being owed $625,000 on the first mortgage. The lender filed a secured proof of claim for about $675,000.

The debtor filed a “check the box” claim objection, asserting that the lender lacked standing. Although the lender evidently did have standing, the lender for some reason did not file an opposition. Consequently, the bankruptcy judge entered an order on default disallowing the claim.

The lender may not have filed an objection through negligence or inadvertence. Or, perhaps the lender relied on the principle that a lien rides through bankruptcy. However, the disallowance of a claim has consequences in chapter 13 because a trustee makes distributions under a plan only to holders of allowed claims.

The debtor’s chapter 13 plan in substance provided no distributions on the mortgage until there was a creditor with standing. The lender objected to the plan but withdrew the objection because the final order disallowing the claim meant that the lender could not receive distributions under the plan.

As Bankruptcy Judge Julia W. Brand said in her September 19 BAP opinion, the lender “then proceeded to disappear for five years,” not receiving payments on the mortgage and not moving to modify the automatic stay to permit foreclosure.

The debtor received a discharge after completing plan payments. 

Six months after discharge, the lender woke up, reopened the chapter 13 case, and moved to set aside the claim disallowance order. The bankruptcy court denied the motion, but the lender did not appeal.

Meanwhile, the debtor initiated an adversary proceeding under Section 506(d) to void the mortgage lien. The bankruptcy judge voided the mortgage on summary judgment. The lender appealed to the BAP.

There Is More to Section 506(d) than Appears on the Surface

Section 506(d) provides: “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless” either of two exceptions apply. The parties agreed that neither of the exceptions was applicable.

The lender latched onto a line of cases holding that claim disallowance does not invoke Section 506(d) if the disallowance was procedural rather than substantive. It appeared as though the debtor had a “free” house when Judge Brand followed authorities holding that an objection to standing is substantive, not merely procedural.

However, that wasn’t the end of the story.

Judge Brand dealt with HSBC Bank USA v. Blendheim (In re Blendheim), 803 F.3d 477 (9th Cir. Oct. 1, 2015), and the notion that liens pass through bankruptcy. To read ABI’s discussion of Blendheim, click here.

Blendheim was an important case. It validated the use of so-called chapter 20 cases in the Ninth Circuit. The opinion also upheld avoidance of a lien under Section 506(d) when the associated secured claim had been disallowed on the ground of forgery.

Judge Brand said that Blendheim was inapplicable because the bankruptcy judge in the case on appeal “never adjudicated the validity of the first-position lien and the underlying note.” She went on to say that Blendheim included an “implicit” conclusion that “Section 506(d) should apply only when a claim disallowance addresses the merits of the underlying debt.”

Unlike the debtor in Blendheim, Judge Brand said that the debtor in the appeal before her “never attacked the validity of the underlying loan documents.” She said the “bankruptcy court never judged the first-position lien to be invalid in substance, only that [the lender] lacked standing to enforce it.”

Judge Brand said that the “‘true’ lienholder never subjected itself to the bankruptcy court’s jurisdiction by filing a proof of claim; nor was this never-filed claim deemed disallowed.” She said the bankruptcy court “violated an unknown party’s due process rights by expunging its deed of trust without notice and an opportunity to be heard.”

In other words, the mortgage lien “remains against the property, notwithstanding the final determination that [the lender] could not enforce it.”