Introduction This article explores the possibility of utilizing a Chapter 13 case to modify the rights of junior mortgage holders. Under the Bankruptcy Code, debt weary consumers typically file either under Chapter 7 or Chapter 13. Chapter 7 is a straight liquidating bankruptcy case and usually results in a fresh start after a discharge of debt. A Chapter 13 is a debt repayment plan that among other things can be used to save a home from foreclosure, a car from repossession or simply repay creditors over time under court supervision and protection.
In the 2nd quarter of 2008, the Standard and Poors Housing Index showed a record 15.4% fall in home prices. Also, in 2008 The Office of Federal Housing Enterprise Oversight showed the largest drop in the history of the organization. Despite the prayers of would-be George Baileys across the country, property values are sliding like the Jesse White Tumblers performing on the north slope of K-2. But in that cloud may also be a silver lining in the form of a Chapter 13 bankruptcy case.
Section1322(b)(2) of the Bankruptcy Code allows a debtor in a Chapter 13 case to modify the rights of secured claims. However, it specifically excludes a claim secured by an interest in real property that is the debtor’s principal residence. On face value this would appear to leave the homeowner out of luck. However, the focus of the question is whether the junior mortgage falls under the definition of a "secured" claim.
Supreme Court Precedent: The attention of the United State Supreme Court is usually reserved for constitutional crises, hanging chads and Larry Flint. However, they occasionally grant decisions on bankruptcy matters, perhaps as part of hazing the new justices.
The Court in Dewsnup v. Timm, 502 U.S. 410 (1992) looked at "stripping down" a mortgage in a Chapter 7 bankruptcy. The Dewsnups had a primary loan for $120,000 secured by a lien on Utah farmland. The land was determined to be worth only $39,000. The Dewsnups wanted the lien to be "stripped down" to the value of the land. The court said that it cannot be stripped down to the determined value of the collateral because respondent’s claim is still secured by a lien. They said that the creditor’s lien is still secured and stays with the real property until foreclosure. "Any increase in the judicially determined valuation during bankruptcy rightfully accrues to the benefit of the creditor, not to the benefit of the debtor and not to the benefit of other unsecured creditors whose claims have been allowed and who had nothing to do with the mortgagor-mortgagee bargain".
In Nobleman v. American Savings Bank, 508 U.S. 324 (1993) the court again looked at stripping a primary mortgage, but this time in a Chapter 13 case. The mortgage was for $71,335 and the value of the home was only $23,500. The Debtors tried to "cram down"2 to the value of the home and to bifurcate the claim into secured and unsecured portions. The court affirmed that 11 U.S.C. §506(a) empowers the bankruptcy court to make a judicial determination of the value of the property to determine if the claim is secured or unsecured. The court ruled that if the claim is even partially secured, then the lien is protected from modification under §1322(b)(2). This creates an important bright line that if even one Rupee (PKR) of value secures the lien then the lien cannot be lifted. However, the decision left open the possibility of lifting wholly unsecured junior mortgages.
Circuit Court Cases: Of the Circuit Courts, the 1st (In Re Mann, 249 B.R. 831 (B.A.P. 1st Cir. 2000)), 3rd (In Re McDonald, 205 F.3d 606 (3d Cir. Pa. 2000)), 5th (In Re Bartee, 212 F.3d 277 (5th Cir. 2000)) and 9th (In Re Tam Lam, 211 B.R. 36 (B.A.P. 9th Cir. 1997)) have addressed the issue. District Courts appear to be split. However, all the appellate decisions have stripped the junior mortgage lien if there is no equity in the home after the balance of the first mortgage.
The 1st Circuit in In Re Mann treated the junior mortgage as unsecured and voided the lien. This case sets up the analytical framework for examining these types of cases. In Mann, the Court summarized as follows:
1. Section 506 defines what is secured. It provides that a claim "is deemed to be secured only to the extent of the value of the creditor’s interest in the subject collateral." In this case it was established that the value of the home was less than the balance on the first mortgage. Therefore, the court ruled that the junior mortgage was not secured under the definition of Section 506.
2. Section 1322(b)(2) allows Chapter 13 plans to modify the rights of secured claimholders, other than those secured by debtor’s primary residences. If the mortgage had been partially secured, it would have been protected and could not have been modified.
3. Since the junior mortgage was not secured under Section 506 then it fell into the class of General Unsecured Creditors (GUC’s). It is a principle in Chapter 13 that unless there is a special class of unsecured creditors, then the GUC’s should all receive equal treatment under the plan. Therefore, the court ruled that it was not appropriate for a junior mortgage to be treated differently than any other GUC.
4. Precedent in the 7th Circuit? The seventh circuit has not ruled on this issue as of yet. However, several bankruptcy judges have allowed lifting of junior mortgages. The bankruptcy court in In re Havel, 2002 Bankr. LEXIS 1004 (Bankr. S.D. Ill. 2002) held that a creditor holding a second mortgage on the Chapter 13 debtors’ residence was wholly unsecured under 11 U.S.C.S. § 506(a), and thus was not protected by the antimodification exception of 11 U.S.C.S. § 1322(b)(2).
In the case of In Re Waters, 276 B.R. 879 (Bankr. N.D. Ill. 2002), the court found that the junior creditor’s lien was wholly unsecured and should be stripped off debtor’s residence and avoided if debtor performed under the confirmed plan and made all required payments. Similarly, the court in In re Issaac, 2005 Bankr. LEXIS 2838, 7-8 (Bankr. N.D. Ill. Aug. 25, 2005), while not ruling on the issue, noted that second and or third mortgages could potentially be subject to a strip-down or a strip-off if the debtor so chose.
Before filing a motion to lift a junior mortgage it is important to have a good appraisal to show that the mortgage is wholly unsecured. Two appraisals would be better. The debtor should get an updated payoff on the primary mortgage and real estate taxes. The debtors are often behind on their payments. The late fees and charges that accrue will be a benefit as they increase the payoff on the primary mortgage.
Congress has given some tantalizing hints that they would pass legislation allowing a cram down on under-secured mortgages. However, the law remains unpromulgated and consistently tantalizing. In the meanwhile, as homeowners get lemons the Bankruptcy Court can help to make a little lemonade.
1 The author would also like to credit and thank Mary Ann Leuthner and Paul M. Bach for their contributions to the article. Mr. Bach is principal of the Bach Law Firm in Northbrook. Ms. Leuthner is an associate with the Law Offices of Richard Sexner.
2 "cram-down" refers to using the Bankruptcy Code to modify the loan. In a "cram-down" a creditor gets a secured claim to the extent of the fair market value of the collateral and an unsecured claim for rest of the loan balance.
Richard E. Sexner is the current Chair of the DCBA Bankruptcy Law Committee and principal of the Law Offices of Richard E. Sexner in Elmhurst, Illinois. Richard opened his law office in 1994. He is a 1994 graduate of the University of Illinois Law School and a 1991 graduate of Northwester University. He concentrates his practice in consumer bankruptcy cases; Chapter 7 and Chapter 13.