The real estate collapse of 2008 hurt senior mortgage lenders, but it pummeled junior lenders, whose second liens went from above to below water, almost in a heartbeat. Some homeowners, however, saw an opportunity: if a home purportedly had no value above the amount of the senior lender's claim, why not use Chapter 7 of the United States Bankruptcy Code to value the junior lender's secured claim at zero - effectively stripping the junior lien off of the property and leaving the home closer to the water's surface, where the borrower might more easily start re-building equity?
Bankruptcy professionals might have thought they knew the answer to that question. Over 20 years ago, the United States Supreme Court, in Dewsnup v. Timm, barred Chapter 7 debtors from stripping a creditor's partially-secured claim down to the value of the collateral securing it.
However, a unanimous panel of the Eleventh Circuit Court of Appeals recently found Dewsnup to be irrelevant when applied to a junior lien on collateral of insufficient value to put the second lien holder in the money. The appellate panel instead relied on one of its own pre-Dewsnup decisions, a decision some bankruptcy courts thought had been abrogated by Dewsnup. Then, by refusing to publish its opinion, the Eleventh Circuit left debtors, lawyers, and judges in a quandary from which they have yet to emerge. (The case is In re McNeal, Appeal No. 11-11352, 2012 WL 1649853 (11th Cir. May 11, 2012).)
Under the Bankruptcy Code, an undersecured creditor with an "allowed" claim (that is, a claim that is entitled to be paid out of the bankruptcy estate) really has two claims: a secured claim in an amount equal to the value of the creditor's collateral and an unsecured claim for the remainder. For example, a lender holding a $1 million mortgage claim secured by real estate worth $400,000 would have a secured claim for $400,000 and an unsecured deficiency claim for $600,000. Moreover, the same section of the Bankruptcy Code that provides for bifurcating the lender's claim into secured and unsecured portions also provides that, to the extent a lien secures a claim that is not an allowed secured claim, that lien is void.
Before the Dewsnup decision, therefore, a homeowner in bankruptcy might ask the court to value his or her home at less than the full amount owed on the mortgage; if the court did so, the homeowner would then ask the court to void the lien to the extent that the lender's claim exceeded that court-determined value - a procedure informally referred to as "stripping down" the lien. The debtor might then pay that value and extinguish the lien. Of course, if the court had undervalued the property or the property later appreciated in value, the debtor, not the lender, benefited from the additional value.
In 1991, the Supreme Court, in Dewsnup, put a stop to lien-stripping in Chapter 7 cases, finding that, so long as an allowed claim is secured by a lien - even one worth less than the full amount of the claim - a debtor could not strip down the lien. Instead, the lien would survive the bankruptcy, and the lender could foreclose it even after the Chapter 7 debtor received a discharge of his or her debts. While the discharge prevented the lender from collecting a deficiency from the former debtor, the lender would, at least, benefit from any increase in the value of the real estate itself, whether by appreciation or as a result of the court's low-ball valuation. At least two considerations weighed heavily in the Court's ruling:
- honoring the bargain between the borrower and the lender that the lien would stay with the property until foreclosure, thereby insuring that increases in property value would benefit the lender; and
- observing the rule, established long before the enactment of the Bankruptcy Code, that liens survive bankruptcy.
The Dewsnup opinion may have given comfort to Lorraine McNeal's junior lender. McNeal owed $176,413 to her first mortgage lender and $44,444 to her second, each of which held liens encumbering a home that, the parties agreed, was worth just $141,416 - less than the amount of the first mortgage, leaving the junior lien completely valueless. McNeal argued that, because the lien of the second mortgage holder did not actually secure any allowed secured claim - the junior lender's claim was wholly unsecured - that lien was void and should be "stripped off" of her home completely.
Most courts, including bankruptcy courts within the Eleventh Circuit, had held that the Dewsnup rule against "stripping down" liens that had some value applied equally to "stripping off" liens that had no apparent value, and the bankruptcy and district courts both held against McNeal, forbidding her from stripping the second lien from her home.
However, the Eleventh Circuit found that Dewsnup did not control its decision, and it reversed, holding for the debtor. Without significant analysis, the panel decided that the case of a lien determined to have some value (Dewsnup) had no relevance to the case of a lien determined to have no value (McNeal), and, instead, applied a pre-Dewsnup Eleventh Circuit decision that had permitted a lien to be stripped off of collateral whose value was insufficient to support the second lien. The result is surprising, in part, because it splits from the opposite rulings of the Fourth and Sixth Circuits and departs from the understanding of Dewsnup found in opinions of some bankruptcy courts in the Eleventh Circuit. It also departs from the central policy arguments advanced by the Supreme Court in Dewsnup, which appear to apply equally to "strip down" and "strip off" cases: that courts should respect the lender's bargain with its borrower and that they should preserve the long-standing practice of leaving liens unaffected by bankruptcy.
Perhaps even more confounding is the fact that the Eleventh Circuit chose not to publish its McNeal opinion. Under the Circuit's rules, that means McNeal is not binding precedent, but may be cited as "persuasive authority." One might sympathize with bankruptcy courts in Alabama, Florida, and Georgia as they try to determine the degree to which they should be "persuaded" by a unanimous panel decision from their controlling circuit that nonetheless is not strictly precedential. Some practitioners in those jurisdictions report that, where Chapter 7 debtors have filed contested motions to strip second liens off of their homes, the bankruptcy courts are simply holding the motions in abeyance, indefinitely, pending further guidance from the Eleventh Circuit. Meanwhile, debtors in jurisdictions outside the Eleventh Circuit have also sought to strip second liens from their property.
Guidance does not appear to be within ready reach. In January, debtor's counsel asked the appellate panel to publish its opinion in McNeal and thereby put to rest the issue of McNeal's authority within the circuit. However, at the time of that request, both lender-appellees had commenced Chapter 11 bankruptcy cases, and, in February, the Eleventh Circuit therefore stayed all proceedings in the McNeal appeal, until it is notified that the bankruptcy court has granted relief from the automatic stay in the lenders' cases.
For now, then, debtors with homes worth less than their total mortgage debt have found a friend in the Eleventh Circuit, while home equity lenders may impose stricter loan-to-value requirements as they try to weigh the risks posed by McNeal.