Stripping Off a Wholly Unsecured Mortgage Lien in Chapter 7: Revisiting Dewsnup and Nobelman

A majority of individuals filing for bankruptcy relief do so in the wake of mounting mortgage debt and collapsing home values. In such circumstances, the ability to “strip off” a wholly unsecured mortgage lien could bring tremendous relief to debtors who are homeowners. Stripping off an unsecured mortgage lien requires it to be treated as an unsecured claim in the bankruptcy case. Such a claim would be discharged in a chapter 7 case or be paid as a pro rata distribution under a chapter 13 plan in conjunction with unsecured creditors.

While a majority of courts have allowed the strip-off of an unsecured mortgage lien secured solely by a debtor’s principal residence in chapter 13, only a handful of courts have been willing to extend this remedy to chapter 7 debtors, despite the fact that the legal analysis involved in a “strip-off” remains largely the same between the two.

Relevant Code Provisions
Section 506 of the Bankruptcy Code provides, in relevant part:

(a)(1) An allowed [1] claim of a creditor secured by a lien on property in which the estate has an interest 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. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.
(d) To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless (1) such claim was disallowed only under section 502(b)(5) or 502(e) of this title; or (2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title.

Under 11 U.S.C. § 506(a)(1), “a claim is secured only to the extent of the value of the property on which the lien is fixed; the remainder of that claim is considered unsecured.” [2] Therefore, under § 506(d), the unsecured portion of a creditor’s lien should be voided. [3] Thus, a $100,000 claim, secured by a lien on property worth $60,000, is considered to be a secured claim to the extent of $60,000, and to be an unsecured claim to the extent of $40,000. [4]

Nobelman and Stripping Off Unsecured Mortgages in Chapter 13
The Nobelman case held that a chapter 13 debtor could not bifurcate or strip down an undersecured mortgage lien secured solely by a debtor’s principal residence, into secured and unsecured components, due to the anti-modification restriction placed on it by § 1322(b)(2), which prohibits the modification of claims secured by the debtor’s principal residence. [5] Nobelman also held that chapter 13 debtors should look to § 506(a) to determine whether a claim was secured for purposes of 11 U.S.C. § 1322(b)(2). [6]

It followed that as long as there was some equity to which the creditor’s lien attaches, the claim was secured under § 506(a), and therefore, the partially secured lien could not be stripped down under the anti-modification clause of § 1322(b)(2). [7] Nobelman did not specifically address the issue of whether wholly unsecured mortgage liens secured by primary residences could be stripped off in chapter 13. [8]

However, since Nobelman asserted that chapter 13 debtors could look to § 506(a) for the definition of a secured claim, several courts have reasoned that a junior mortgage lien unsupported by any equity in the residence is an unsecured claim under § 506(a). Therefore, under Nobelman, the anti-modification restriction of § 1322(b)‌(2) would not apply to such an unsecured claim, and the rights of the holder of such claim may be modified even though the lien may encumber a debtor’s primary residence. The In re Geyer [9] court stated:

The Nobelman court’s concern does not apply here when the creditor’s claim is totally unsecured. Where the estate’s interest in property is zero, the claim under section 506(a) is completely unsecured and is not entitled to the protection of section 1322(b)(2).

Dewsnup and Stripping Off Unsecured Mortgages in Chapter 7
Dewsnup preceded Nobelman in a chapter 7 context, wherein the petitioner argued that the $120,000 lien should be reduced to the fair-market value of the land [10] under § 506(a) and that the unsecured portion of the lien should be voided under § 506(d). [11]

The Dewsnup court stated that the application of § 506(d) is not “rigidly tied” to § 506(a). The term “allowed secured claim” in § 506(d) should “not be read as an indivisible term of art defined by reference to § 506(a), but should be read term-by-term to refer to any claim that is first allowed, and, second, secured generally.” [12] In determining whether a claim could be voided, the Dewsnup court reasoned that under § 506(d), the questions are twofold: (1) Is the lien allowed under § 502?, and if so, (2) is the lien secured with recourse to the underlying collateral? If the answers to both of these questions is affirmative, then the lien is an allowed secured claim for purposes of § 506(d) and cannot be voided.

Therefore, we hold that § 506(d) does not allow petitioner to “strip down” respondents’ lien, because respondents’ claim is secured by a lien and has been fully allowed pursuant to § 502. [13]

However, the Dewsnup court prefaced its ruling by stating:

Were we writing on a clean slate, we might be inclined to agree with petitioner that the words “allowed secured claim” must take the meaning in §506(d) as it does in §506(a). But, given the ambiguity in the text, [14] we are not convinced that Congress intended to depart from the pre-Code rule that liens pass through bankruptcy unaffected. [15]

The ability to strip off an unsecured junior mortgage in a chapter 13 case with relative ease has evaded debtors in a chapter 7 case, primarily due to the Dewsnup decision. The question then becomes: What is the requirement for a claim to be “secured” under §506(d)? There are two possibilities: Is there a lien that is at least partially secured by value in the collateral?, or is it sufficient that there exists a properly perfected mortgage lien on the collateral irrespective of whether there is equity to cover even a portion of the lien?

Even though the facts of Dewsnup involved a lien that was partially supported by value in the property, the majority of courts interpret Dewsnup’s definition of a “secured claim” under § 506(d) as the latter of the two possibilities described above. [16] The In re Cook [17] court stated:

Under Dewsnup, an allowed claim is secured for purposes of § 506(d) simply because the claim is subject to a lien with recourse to collateral. Valuation is not a factor in the determination.

As long as a claim is secured by a mortgage on a residence, irrespective of whether it is wholly unsecured or partially secured, courts take the position that the claim is secured for purposes of § 506(d). Therefore, according to these courts, Dewsnup’s prohibition against stripping down an undersecured lien also applies as a prohibition to a strip-off of an unsecured mortgage lien. [18]

While the determination of a mortgage lien as unsecured in both a chapter 7 and chapter 13 case is made pursuant to § 506(a), the ensuing strip-off is allowed in chapter 13 pursuant to § 1322(b)(2). However, with no corresponding Code provision in chapter 7, a lien strip-off has generally been disallowed owing to the narrow reading of Dewsnup, which defined “secured” differently in § 506(a) compared to § 506(d). Under Dewsnup, § 506(a) defined a secured claim as one that is secured only to the extent of the value of the property on which the lien is fixed, whereas § 506(d) defined a secured claim as one that is secured by a mortgage or security interest in collateral irrespective of whether there is value in the property to support the lien claim.

If courts limited the application of the Dewsnup ruling to partially secured liens, similar to the Nobelman ruling, they may be more willing to consider a strip-off of a fully unsecured mortgage lien in a chapter 7 case. In November 2009, Hon. Dorothy T. Eisenberg of the U.S. Bankruptcy Court for the Eastern District of New York allowed the strip-off of a wholly unsecured mortgage lien in a chapter 7 case. [19] She considered the Dewsnup case and narrowly construed the decision to limit the ruling to partially secured liens. Therefore, to the extent that the lien was worthless and not supported by any value in the collateral, the lien was unsecured under § 506(a) and thus not an allowed secured claim under § 506(d), which permitted the court to void the lien. Judge Eisenberg stated that

[the] holdings in a Chapter 13 context clearly demonstrate that under the Code it is appropriate under § 506(a) and § 506(d) to distinguish partially secured liens from wholly unsecured liens. Once it is established that Dewsnup is distinguished, there is no reason why in a Chapter 7 context the same language in § 506(a) and (d) should not void the lien of a wholly unsecured claim. [20]

The policy reasons underlying Dewsnup were the following: (1) liens pass through bankruptcy unaffected; (2) the mortgagee and mortgagor bargained for a consensual lien that would remain against real property until foreclosure; (3) any increase in value of the real property collateral should accrue to the benefit of the mortgagee creditor, not the debtor or other unsecured creditors; and (4) the fresh-start principles of bankruptcy relate to a discharge of the debtor from personal deficiency and not to an in rem deficiency. [21]

While these concerns are valid, they similarly exist in a chapter 13 case. However, wholly unsecured junior liens are routinely avoided in chapter 13 cases. There is no legitimate reason to isolate these so-called policy concerns solely to chapter 7 debtors when the strip-off relief is available to chapter 13 debtors. As Judge Eisenberg stated in the Lavelle case, the possibility that debtors will receive windfalls from avoided liens is not persuasive since “markets are uncertain, and it is not certain that such a scenario will ever occur.” [22] If a creditor with a wholly unsecured mortgage were to foreclose on the property, it will receive no monetary gain since there is no value in the property. [23]

Conclusion
Under such circumstances, it makes sense to provide the debtor with the requisite fresh start, whether in chapter 7 or chapter 13, especially in the current economic climate, where it is beneficial for debtors to retain ownership of their homes rather than abandon their properties and cause further diminution of home prices. Allowing bankruptcy judges to determine the validity and existence of liens in a streamlined and consistent manner may be more cost-efficient than having borrowers and lenders wade through a loan-modification process that is neither streamlined nor monitored in any meaningful way. In light of the foregoing, it may be worthwhile to revisit the Dewsnup decision and its legal inconsistencies, as further highlighted by the current economic conditions.