Developments in Complex Individual Bankruptcies:  Recent Fourth Circuit Opinions on Underwater Mortgages — Part One:  Lien Stripping in Chapter 20

12.04.2013

In 2013, the Fourth Circuit issued two opinions on the issue of underwater mortgages:

• Branigan v. Davis (In re Davis), 716 F.3d 331 (4th Cir. 2013) – permitting lien stripping in Chapter 20
• Alvarez v. HSBC Bank USA, Nat’l Ass’n (In re Alvarez), 733 F.3d 136 (4th Cir. 2013) – qualifying lien stripping of property held as tenants by the entirety in Chapter 13

This first installment of a two-part alert will analyze Davis and its possible consequences for Chapter 20 debtors.

Background:  “Chapter 20” is a term of art that refers to the situation where a debtor, within four years of receiving the Chapter 7 discharge, files a second bankruptcy case under Chapter 13.  The Chapter 20 debtor is ineligible for a Chapter 13 discharge.  11 U.S.C. § 1328(f)(1).  A Chapter 7 discharge removes personal liability on an unsecured lien, but, because lien stripping is generally not permitted in Chapter 7 cases, in rem liability on liens survives the discharge.  To discharge the in rem liability, the debtor must file a case under Chapter 13.  Because the debtor is not entitled to a Chapter 13 discharge, courts have struggled with whether a lien may actually be stripped off in a Chapter 20 in the absence of a Chapter 13 discharge.

Holding:  A debtor may strip off a wholly unsecured lien in a Chapter 20 case. 

Reasoning:  A holder of a secured claim in a Chapter 13 case retains his or her lien until either the debt is paid or the debtor receives a Chapter 13 discharge.  11 U.S.C. § 1325(a)(5)(B)(i)(I).  The value of the collateral determines whether a claim is secured or unsecured.  Id. § 506(a).  A claim must first be valued pursuant to section 506(a) before the requirements of section 1325(a) may apply.  In re Davis, 716 F.3d at 338.  Because there is no equity in the collateral to support a valueless lien, the lien is an unsecured claim and, therefore, not entitled to the protections afforded by section 1325(a).  Id.  The availability of the discharge had no effect on whether the debtor is able to strip a lien.  Id.  The Chapter 13 discharge removes personal liability only; in rem liability may be removed with a lien-stripping order and completion of the Chapter 13 plan.  Id.  Judge Keenan dissented on the grounds that a 506(a) valuation does not affect whether a claim is an “allowed secured claim” for purposes of section 1325(a)(5)(B).

Implications:  The Fourth Circuit’s holding in Davis has opened the door for Chapter 20 lien strips.  Before debtors get overzealous, the Fourth Circuit did provide that a Chapter 20 filed for the sole purpose of lien stripping may be bad faith.  Id. at 338; See also In re Mulhern, No. 12-20857PM, 2013 WL 3992458 (Bankr. D. Md. Aug. 2, 2013) (dismissing case as bad faith filing because its sole purpose was to strip off a second mortgage).  Accordingly, Chapter 20 lien strips may only be available where there are sufficient alternative grounds for filing the subsequent Chapter 13 case, such as significant arrears on secured debts, a large amount of priority debt, or the incurrence of substantial amounts of unsecured debt since receiving the Chapter 7 discharge.

Stay tuned for part two, which will analyze Alvarez and its implications for individuals considering Chapter 13.