Supreme Court Gets Active in Bankruptcy Law

While overall bankruptcy filings continue a decline that started in 2010, the U.S. Supreme Court is unusually active in bankruptcy issues this term, having accepted six cases with bankruptcy issues (by comparison, it accepted only three such cases in 2013, and only one in 2012). In this article, we discuss one of the issues the Supreme Court is considering: whether a debtor can strip a lien off of real estate in a Chapter 7 case.

The Supreme Court takes up Chapter 7 Lien Strip Offs

By way of brief review, a lien strip off is a complete removal of a lien, such as a mortgage lien, from real estate based upon the absence of equity in the real estate to secure the underlying debt. A common strip-off scenario involves a second mortgage that is completely "underwater" because the payoff on the first mortgage exceeds the value of the real estate.

In our August article we noted that strip off is not possible in Chapter 7 bankruptcy in Virginia. The Supreme Court, however, has now decided to take up the issue - in November 2014 it accepted two cases from the Eleventh Circuit Court of Appeals in which the Chapter 7 debtor was allowed to strip off a second mortgage.

What seems to be a clear prohibition against strip offs in Chapter 7 bankruptcy originates with the Supreme Court's decision in 1992, in Dewsnup v. Timm, that a Chapter 7 debtor could not "strip down" the first lien on his real estate. The debtor in Dewsnup, whose real estate was worth far less than the payoff on the single deed-of-trust lien that encumbered it, argued that he should be allowed to reduce the amount of the lien (i.e., strip it down) to the value of the real estate. He argued that the plain language of the Bankruptcy Code states that a lien is void to the extent it is underwater.^[1] The Supreme Court rejected the argument, primarily on the grounds that (a) the traditional rule is that "liens pass through bankruptcy unaffected," and (b) the debtor's argument could result in him receiving a windfall if the real estate appreciated in value after the bankruptcy filing.

So, if adherence to traditional bankruptcy law and aversion to debtors receiving windfalls as a result of upswings in the real-estate market preclude lien strip downs in Chapter 7, why would they not also preclude strip offs in Chapter 7? Indeed, the Fourth Circuit Court of Appeals, which covers Virginia, and the Sixth Circuit have ruled that the strip off is not allowed in Chapter 7.^[2]

Nevertheless, the Eleventh Circuit has allowed Chapter 7 strip offs based on one of its own pre-Dewsnup cases. In that earlier case, the Eleventh Circuit was persuaded by the "plain-language-of-the-Bankruptcy-Code" argument that was rejected in Dewsnup, and it also commented that "[t]he whole point of bankruptcy is to provide a debtor with a fresh start" and that the Bankruptcy Code "does not give a debtor its property back as some sort of windfall."

So, it seems that the Eleventh Circuit's view of strip off is simply contrary to the Supreme Court's, and we therefore expect that in these new cases the Supreme Court will reaffirm Dewsnup and rule that strip off is not allowed in Chapter 7. However, we can't completely discount the possibility that, in these troubled economic times, the Supreme Court will find a way around Dewsnup and give Chapter 7 debtors a powerful new tool to fix their mortgage problems.

[1] The Bankruptcy Code states, in effect, that (1) an allowed claim secured by a lien on property is a secured claim to the extent of the value of the creditor's interest in the property (Bankruptcy Code section 506(a)), and (2) to the extent that a lien secures a claim that is not an allowed secured claim, it is void (Bankruptcy Code section 506(d)).

[2] Ryan v. Homecomings Fin. Network, 253 F.3d 778, 782 (4th Cir. 2001); Talbert v. City Mortg. Servs. (In re Talbert), 344 F.3d 555 (6th Cir. 2003).