Seventh Circuit Confirms That A Strip-off Of Underwater Second Mortgage Lien Is Not Allowed In A Chapter 7 Bankruptcy Proceeding

The debtors in Palomar v. First American Bank, 12-3492 (7th Cir. July 11, 2013) brought an adversary action in a chapter 7 bankruptcy against the holder of a second mortgage on their home asking the court to strip off the mortgage under 11 U.S.C. § 506(a) of the Bankruptcy Code because the first mortgage exceeded the value of the home which meant the second mortgage was worthless. The bankruptcy court dismissed the adversary case and the district and appellate courts affirmed. The Seventh Circuit observed that _Dewsnup v. Timm_, 502 U.S. 410 (1992) holds that section 506(d) does not allow the bankruptcy court to squeeze down a fully valid lien to the current value of the property to which it’s attached. The debtors try to distinguish _Dewsnup_ by wanting to reduce the value of the lien to zero. They point to section 506(a), which makes a claim of a creditor secured by a lien on property a secured claim only to the extent of the value of such creditor’s interest in [the] property. But the court observed that _Dewsnup_ treated the undersecured loan in that case as a secured claim within the meaning of section 506(d), and in so doing denied that the words ‘allowed secured claim’ must take the same meaning in § 506(d) as in § 506(a). [T]he point of section 506(a) is not to wipe out liens but to recognize that if a creditor is owed more than the current value of his lien, he can by filing a claim in bankruptcy (rather than bypassing bankruptcy and foreclosing his lien) obtain, if he’s lucky, some of the debt owed him that he could not obtain by foreclosure because his lien is worth less than the debt. The debtors pointed out that liens on residential property can be stripped off in bankruptcies in a Chapter 13 bankruptcy which the court conceded. But the strip-off right is a partial offset to the advantages that Chapter 13, relative to Chapter 7, grants creditors, such as access to a larger pool of assets because for several years the debtor must commit all disposable income to repaying his unsecured debts. The court also took no notice of the debtors’ argument that liens can sometimes be stripped off even in Chapter 7 bankruptcies because the provisions they cite relate to liens on property that are expressly exempt from creditors’ claims. The court concluded by making the following practical observation: Given the gross disparity between the current market value of the [debtors’] home and the claims secured by it, [the creditor] is unlikely, to say the least, to foreclose in the immediate or near future. For that would entail the bank’s incurring legal expenses to obtain the ownership of property worth less than the first mortgage on the property; the bank would be compounding its loss. So all that failing to extinguish [the creditor’s] lien does from a practical standpoint is deprive the debtors of the chance to make some money should the value of their home ever exceed the balance on [the] first mortgage. It is hard to see how the deprivation of so speculative a future opportunity could be thought to impair the debtors’ ability to make a fresh start.

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