Wachovia Mortgage v Smoot, 478 B.R. 555 (E.D.N.Y. 2012) –

In Smoot, the bankruptcy court held that a  totally underwater junior lien on a residential property could be “stripped off” in a Chapter 7 case – choosing to follow a Second Circuit case that addressed the issue in a Chapter 13 case.  On appeal, the district court reversed, concluding that the mortgage lien could not be stripped off.

Section 506(a) of the Bankruptcy Code provides that an allowed undersecured claim is treated as a secured claim to the extent of the value of the interest in the collateral and an unsecured claim to the extent of the deficiency.  Section 506(d) in turn provides that generally a lien that secures a claim that is not an allowed secured claim is void.  Based on these two sections, some courts have held that a lien can be “stripped down” to the value of the collateral.  The question raised by Smoot is whether a claim that is totally underwater can be “stripped off” using the same reasoning.

The district court went back to basics and focused on two Supreme Court decisions addressing the ability to “strip down” an undersecured mortgage:  Dewsnup v Timm, 502 U.S. 410, 112 S.Ct. 773, 116 L.Ed.2d 903 (1992) dealt with the issue in the context of a Chapter 7 case, and In re Nobelman, 508 U.S. 324, 113 S.Ct. 106, 124 L.Ed.2d 228 (1993) dealt with the issue in the context of a Chapter 13 case.  (As background, a Chapter 7 case provides for liquidation of the estate assets by a trustee, while a Chapter 13 case involves an individual’s reorganization plan where post-petition income is used to repay pre-petition claims – similar to a Chapter 11 reorganization for businesses.)

In Dewsnup, the collateral was valued near the time of the bankruptcy filing as substantially below the amount of the debt.  The collateral was later sold for a higher amount.  The trustee argued that the “allowed secured claim” for purposes of Section 506(d) was a secured claim in the amount of the value of the collateral that had been determined.  Thus, the original secured claim was bifurcated into an “allowed secured claim” equal to the value of the collateral and an allowed unsecured claim equal to the deficiency (i.e. stripping off the lien to the extent of the deficiency).  In response, the lienholder contended that Section 506(d) should be construed without reference to Section 506(a) so that an “allowed secured claim” simply meant that the claim was allowed and there was a lien on collateral.

The Supreme Court came out on the side of the lienholder, finding that a “secured claim” did not have the same meaning in Section 506(d) as it did in Section 506(a).  Allowing a creditor’s secured interest to be frozen at a judicially determined value would result in a windfall to the debtor if there was an increase in value since the parties had bargained that the lien would stay with the property until foreclosure.  In addition, the court concluded that Congress probably did not intend to change the pre-Bankruptcy Code rule that liens on real property pass through bankruptcy unaffected.  Thus, a lien could not be “stripped down” in the context of a Chapter 7 case.

In Nobelman, the Supreme Court came to the same result in the context of a Chapter 13 case.  Language in Section 1332(b)(2) of the Bankruptcy Code allows modification of the rights of creditors under a debtor’s repayment plan.  However, that section does not permit modification of claims secured only by the debtor’s principal residence.  The Supreme Court decided that even though the mortgagee was undersecured, its “rights” were set forth in the loan documents and included the right to retain its lien until the debt was repaid.  Thus, permitting bifurcation of an undersecured mortgage claim under Section 506(a) would be an impermissible modification of the mortgagee’s rights under Section 1332(b)(2).

Although there have been cases since Dewsnup and Nobelman that have permitted undersecured mortgages to be stripped down or stripped off in the context of a Chapter 13 case, the majority of courts have concluded that this is not permissible in a Chapter 7 case.  The Smoot district court sided with the majority.

While acknowledging that the bankruptcy court decision was “in many ways the more logical position, and one that is supported by a large volume of legal commentary,” the district court reversed, concluding that it was bound by Dewsnup and the mortgagee’s lien could not be stripped off:  “While the [Dewsnup] opinion may be the subject of scholarly criticism, it remains the law of the land.”

As reflected by the district court’s ambivalence, this is an area that remains somewhat unsettled.

Vicki R. Harding, Esq.