Disallowed Claims and Lien Stripping: Plain English May Not Be Sufficient to Win the Day

Kohout v. Nationstar Mortgage, LLC, 576 B.R. 290 (N.D.N.Y. 2017) –

Chapter 13 debtors sought to avoid a mortgage lien after the claim was disallowed on procedural grounds. The bankruptcy court found in favor of the mortgagee and the debtors appealed to the district court. The matter turned on interpretation of section 506(d) of the Bankruptcy Code regarding liens securing claims that are not allowed secured claims.

After the debtors filed bankruptcy, the servicer filed a proof of claim on behalf of a mortgagee for a mortgage debt of ~$127,000 with an arrearage of ~$20,000. The debtors objected because (1) the proof of claim did not include documentation showing that the mortgagee had a security interest in the mortgaged property, and (2) they questioned the arrearage portion of the claim. The court entered an order disallowing the claim on the grounds that no opposition was filed by the mortgagee.

The mortgagee subsequently filed a motion for relief from the automatic stay, but withdrew it, and the claim was transferred a couple of times.

The debtors then brought an adversary proceeding seeking a determination that the mortgage lien was void pursuant to section 506(d) of the Bankruptcy Code. (They also sought a finding that the lien was dischargeable.) The latest mortgagee moved for summary judgment seeking an order dismissing the adversary proceeding and “allowing its secured first priority mortgage lien to pass through bankruptcy.”

Section 506(d) provides (emphasis added):

(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 is disallowed only under section 502(b)(5) [unmatured debt not subject to discharge] or 502(e) [reimbursement or contribution claims] 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.

The debtors first argued that the disallowance should be treated the same way as disallowance under section 502(b)(1) of claims that are not enforceable against the debtor. And if the claim was not an allowed secured claim, the related lien should be void. They argued that the bankruptcy court erred when it concluded that their objection was procedural, not substantive, so that section 506(d) did not apply.

Alternatively, even if the lack of documentation was not a basis for disallowing a claim under section 502, the debtors contended that there was a final ruling disallowing the claim that was not appealed, so should be treated as final and binding. As before, if the claim is not an allowed secured claim, the lien should be void.

Finally, the debtors argued that equitable considerations weighed in favor of holding the mortgagee to the clear legal consequences of disallowance of its claim. The mortgagee’s predecessor should not have ignored a properly noticed objection to the claim.

In response, the mortgagee argued that a narrow literal reading of section 506(d) ran contrary to (1) nationwide precedent that section 506(d) cannot be used to avoid a lien unless the claim was disallowed for substantive reasons, and (2) the long-standing bankruptcy principle that a secured creditor can ignore the claims allowance process and later rely on its in rem rights (e.g. foreclose its lien).

In affirming the bankruptcy court decision, the district court commented that the case was a close call. The plain language of section 506(d) appeared to support the debtors’ position. However, it quoted with approval from decisions suggesting that this section “only empowers the bankruptcy court to avoid liens supporting disallowed claims if it judges those liens to be invalid in substance.”

On the other hand, the district court noted decisions by other courts in its circuit that claims can be disallowed for failure to provide supporting evidence if the proof of claim is not sufficient to compel the objector to concede validity of the claim. But in this case the bankruptcy court made no determination as to validity, and the debtors conceded that the mortgagee had a valid perfected mortgage lien.

So, while the court chided the mortgagee for filing a proof of claim, thus subjecting itself to the jurisdiction of the bankruptcy court, and then deciding without warning that it could ignore the claims allowance process without losing its rights, the court affirmed the bankruptcy court decision with the result that the mortgage lien survived.

In Dewsnup v. Timm, 502 U.S. 410, 112 Sup. Ct. 773, 116 L.Ed.2d 903 (1992) the Supreme Court decided in the context of a chapter 7 case that a bankruptcy discharge extinguished a secured creditor’s enforcement of a claim against the debtor in personam while leaving its in rem enforcement rights intact. Courts have continued to struggle with the tension between the plain meaning of section 506(d) and the pre-Bankruptcy Code concept articulated in Dewsnup that a lien against the debtor’s property can pass through bankruptcy even if the claim against the debtor does not.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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