Ninth Circuit BAP Squarely Upholds ‘Chapter 20’: No Lien and No Claim Survive

At least when the debtor is eligible for a discharge in chapter 13, the Ninth Circuit Bankruptcy Appellate Panel squarely holds that a debtor may employ so-called chapter 20 to strip off an underwater subordinate mortgage while simultaneously avoiding personal liability for the debt.

The typical chapter 20 case works like this: The consumer first files under chapter 7 to extinguish personal liability on an underwater home mortgage. Later, sometimes the day after receiving a chapter 7 discharge, the consumer files a separate chapter 13 case to strip off the mortgage lien that survived chapter 7 as an in rem liability solely against the real property. 

Although the debtor may not be eligible for a discharge in chapter 13, the debtor can strip off the subordinate lien by full payment under the plan of whatever unsecured debts she or he has.

Two Supreme Court decisions potentially bear on the issue. The Supreme Court held in 1992 in Dewsnup that a mortgage cannot be stripped off in chapter 7. Dewsnup v. Timm, 502 U.S. 410 (1992). In Bank of America N.A. v. Caulkett, 135 S. Ct. 1995 (2015), the high court held that a debtor may not strip down a mortgage in chapter 7.

So far, the Supreme Court has erected no explicit roadblock to prevent chapter 20 from stripping off an underwater mortgage.

The Facts in the BAP

The facts in the BAP were actually better for the debtor than in the typical chapter 20 case. The debtor was eligible for a chapter 13 discharge because she filed the new petition more than four years after the order for relief in her prior chapter 7 case. See Section 1328(f)(1).

The debtor owned a home worth $410,000. It was subject to a $580,000 first mortgage. The home was also subject to a second mortgage of some $300,000, but the debtor’s personal liability on the second mortgage had been eliminated by the prior chapter 7 discharge.

On motion by the debtor but without opposition from the holder of the second mortgage, the bankruptcy court valued the lien of the second mortgage at zero.

Later, the holder of the second mortgage filed an unsecured claim for $300,000.

The bankruptcy court overruled the debtor’s objection to the unsecured claim, ruling that the valuation of the lien at zero required the debtor to provide for the claim in full in her chapter 13 plan.

The debtor appealed and won in a July 30 opinion for the BAP written by Bankruptcy Judge William Lafferty.

The Circuit and BAP Authorities

Two precedents provided guidance for the BAP. 

In HSBC Bank USA N.A. v. Blendheim (In re Blendheim), 803 F.3d 477 (9th Cir. 2015), the Ninth Circuit held that a debtor could strip off a subordinate mortgage in chapter 20. Technically speaking, the appeals court did not rule on whether the holder of the subordinate mortgage enjoyed an unsecured claim that somehow arose from the dead in the subsequent chapter 13 case.

The second, analogous authority came from the BAP itself. Free v. Malaier (In re Free), 542 B.R. 492 (9th Cir. BAP 2015). There, the BAP held that personal liability on an underwater mortgage that had been extinguished in a prior chapter 7 discharge is not counted toward eligibility in subsequent chapter 13 filing.

Reversing the bankruptcy court, Judge Lafferty interpreted the authorities to mean that the unsecured claim of the subordinate lienholder “should have been disallowed.” He found “simply no statutory basis for resurrecting the debtor’s personal liability or for treating the claim as a claim against the estate.” 

Furthermore, Judge Lafferty said that the lien claim “was conditionally avoided through the valuation motion.” If the debtor were to complete payments under a chapter 13 plan, the lien would be stripped off, and she would continue having no personal liability on the subordinated mortgage debt.

To read ABI’s report on the bankruptcy court’s decision that was reversed, click here.