Eastern District Clarifies No ‘Strip Off’ of Wholly Unsecured Junior Mortgage Liens

In the recent Eastern District of New York decision Wachovia Mortgage v. Smoot,6 Judge Spatt resolved the split among the Eastern District bankruptcy judges by holding that a Chapter 7 debtor may not “strip off” an underwater junior mortgage pursuant to section 506(d) of the Bankruptcy Code. Section 506(a) of the Bankruptcy Code provides that an allowed under-secured claim is treated as a secured claim to the extent of the value of the interest in the collateral, and as an unsecured claim to the extent of any deficiency.7 Section 506(d) states that a lien that secures a claim against a debtor is void unless it is an “allowed secured claim.”8

Observing that whether a Chapter 7 debtor may void an unsecured junior mortgage is currently an open issue in the Second Circuit,9 Judge Spatt concluded that pertinent U.S. Supreme Court precedent, specifically Dewsnup v. Timm,10 governed, and that the majority of cases interpreting Dewsnup to prohibit lien stripping were correct.11

In beginning his analysis, Judge Spatt first examined the significant distinctions between Chapter 13 and Chapter 7.12 The Court distinguished that Chapter 7 is a “liquidation chapter,” while Chapter 13, the “repayment chapter,” focuses on a reorganization plan that provides the debtor with a blueprint to repay pre-petition debts within 3 to 5 years. A creditor’s liens on real property generally pass through a debtor’s Chapter 7 bankruptcy unaffected, while the same is not always true in a Chapter 13 case.

In addition, Judge Spatt thoroughly examined two seminal Supreme Court precedents – Dewsnup v. Timm and Nobelman v. American Savings Bank13 – and several other cases in the Second Circuit and beyond. In Dewsnup, a Chapter 7 debtor sought to strip down a mortgage lien to the fair market value of the property under sections 506(a) and 506(d) of the Bankruptcy Code. The Supreme Court held that section 506(d) does not permit a Chapter 7 debtor to reduce the lien, because the claim was secured by the lien and was fully allowed. Approximately one year after deciding Dewsnup, the Supreme Court issued its opinion in Nobelman v. American Savings Bank, which analyzed whether a Chapter 13 debtor could invoke section 1322(b)(2) of the Bankruptcy Code,14 the anti-modification clause, to strip down a mortgage.15 In Nobelman, the Supreme Court ultimately disallowed the bifurcation of an under-secured claim secured by a lien on a debtor’s principal residence in a Chapter 13 case.

A majority of courts that have considered whether a Chapter 7 debtor may void an underwater mortgage lien have concluded that Dewsnup’s holding regarding stripping down also prohibits stripping off of unsecured mortgage liens.16 As affirmed by Judge Trust, such an interpretation of the Dewsnup decision is a “proper and consistent application of Section 506, and not inconsistent with the Second Circuit’s decision in In re Pond.”17 Furthermore, from a public policy standpoint, enabling a Chapter 7 debtor to nullify a mortgage lien would entirely eradicate the creditor’s in rem rights against the property, which would furnish a debtor with a head start rather than a fresh start, which is contrary to the primary purpose of Chapter 7.18

However, a minority of courts have held the contrary, permitting a Chapter 7 debtor to strip off a junior mortgage lien. For example, in a recent unpublished decision, In re McNeal, the Eleventh Circuit held that a Chapter 7 debtor could use sections 506(a) and 506(d) to strip off a wholly unsecured junior mortgage lien.19 Notably, many of the cases adopting this minority view have been overruled or questioned.20

Judge Spatt concurred with the preponderance of courts that have addressed the issue and held that Dewsnup prohibited the debtor from avoiding the mortgage lien in question.21 The Court further expounded that the Supreme Court in Dewsnup resolved that the term “secured” has a “specific definition in the Chapter 7 context, so that valuation of the underlying collateral is irrelevant.”22 Thus, whether a lien is voided under section 506(d) is not ascertained through reference to section 506(a), and is not a result of the value of the underlying security interest.23

Notwithstanding Judge Spatt’s recent Smoot decision, the state of the law regarding lien stripping remains, to some degree, uncertain. While a majority of courts have held that a Chapter 7 debtor may not avoid liability on an underwater mortgage, as is now the case in the Eastern District of New York, there is some divergent case law. In fact, Judge Spatt remarked in dicta that the minority opinions allowing a Chapter 7 debtor to strip off unsecured liens “are premised on sound principles of statutory interpretation, and would be controlling here if we were writing on a clean slate.”24 As a result, practitioners must remain abreast of the status of the evolving case law in each district (and sometimes how a particular judge may have ruled within a district) in order to evaluate the most effective case strategy, whether representing a Chapter 7 debtor or a secured lender.

Although the Smoot decision made clear that wholly unsecured mortgage liens will generally pass through a Chapter 7 bankruptcy case unaffected in the Eastern District of New York, Judge Spatt warned that ultimately, the inconsistent treatment of underwater mortgages on debtors’ principal residences may need to be settled by the circuits and possibly the Supreme Court.25 Indeed, it is likely this issue will reach the Supreme Court within the next five years.