With the advent of the housing crisis, many homeowners find themselves owing a great deal more on their property than it is worth. Under the right facts, a “lien strip” can provide relief to such homeowners.
Lien strips are not allowed in Chapter 7 bankruptcy.[1] However, despite language in 11 U.S.C. §1322(b)(2) which precludes the modification of a claim secured only by a security interest in real property that is the debtor’s principal residence, the Ninth Circuit has ruled that lien strips are allowed with respect to a debtor’s principal residence in Chapter 13 cases.[2] This difference has emerged as one of the primary reasons that a debtor might choose Chapter 13 over Chapter 7.
Although lien strips are also allowed in Chapter 11 cases, Chapter 11 cases are generally not available to the average debtor – not only because of the cost involved, but also due to additional requirements including, but not limited to, the fact that creditors have a right to vote on the plan. Therefore, debtors have attempted to use the so-called “Chapter 20” cases to strip liens in situations where they are not eligible to file Chapter 13 initially due to unsecured debt exceeding the statutory limitation, which is currently $360,475.
In reality, there is no such thing as a Chapter 20; rather it is jargon referring to the situation in which a debtor files a Chapter 7 bankruptcy followed by a Chapter 13 bankruptcy. [3] By filing a Chapter 7 bankruptcy first and obtaining a discharge of general unsecured debt, the debtor can reduce unsecured debt to less than $360,475, and then be eligible to file Chapter 13. [See further discussion below]
This article will describe the basics of what a lien strip is and how you proceed. It will also examine the evolving law concerning the availability of lien strips in so-called “Chapter 20” cases.
What is a lien strip?
The term “lien strip” is colloquially used by bankruptcy practitioners to refer to several different situations.[4] In this article, we are talking about removal of junior deeds of trust that are “underwater”, i.e, the amount of any senior liens exceed the fair market value of the real property. The procedure by which this is accomplished is formally known as a “Motion to Value Security” and is based upon 11 U.S.C. §506.
In order to strip a junior lien on a primary residence, the junior lien must be completely out of money. If there is any value to secure any portion of the junior lien, then lien stripping is not available. For example, let’s say that the value of the Debtor’s residence as reflected in the bankruptcy papers filed by Debtor is $450,000. The lender holding the first position deed of trust is owed $500,000. The lender holding the second position deed of trust has a claim in the amount of $100,000. In this scenario, upon a proper showing, the Debtor will be able to obtain a lien strip order regarding the second deed of trust.
However, if we change the foregoing hypothetical by placing the value of the residence at $525,000, the result would be different. The second deed of trust is now secured by $25,000 of value. Although this amount is less than the full amount of the claim, it is enough to defeat a motion to strip the junior lien.
How to Proceed
In order to strip a lien, the debtor must affirmatively do something. Although the plan must provide for the lien strip (if a lien strip is desired), a lien is not stripped just because one’s bankruptcy plan provides for it. The debtor must also seek an order from the court providing the desired relief. How is this done?
First of all, make sure the Court has the jurisdiction to grant you the relief you need. As stated above, the procedure is based upon 11 U.S.C. §506 which refers to the determination of secured status and provides, in part, “An allowed claim of a creditor secured by a lien on property in which the estate has an interest,…. is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, …” The Oakland bankruptcy judges have all taken the position that the property at issue must be property of the bankruptcy estate at the time the motion and/or the adversary proceeding seeking to value the security is filed.
Another jurisdictional issue to consider in planning whether and how to file a Chapter 13 case to strip a lien is whether the Bankruptcy Court has jurisdiction over the property to do so. For example, if title to the real property is held in joint tenancy, both joint tenants must file the bankruptcy in order for the Court to have jurisdiction over the entire property. If only one of the joint tenants files bankruptcy, the junior lien can only be stripped from the one-half of the real property that became property of the bankruptcy estate. The half of the property belonging to the non-filing joint tenant is still encumbered by the junior lien and therefore, the property cannot be sold without paying off the junior lien. It is unclear whether the lien could be stripped at all, and what the ramifications would be if the non-filing joint owner fails to make the ongoing payments.
If you decide the Court has the necessary jurisdiction and you are ready to proceed, you will need to consult local practice. There is a great deal of local variation in bankruptcy practice. Therefore, a great place to start with any bankruptcy issue is the bankruptcy court website for the relevant district for the local rules and any published guidelines on your topic. For example, the guidelines published by the Bankruptcy Court in the Northern District of California are particularly good and there is an immensely helpful set of guidelines for practitioners on how to proceed with lien strips. See Northern District of California Bankruptcy Court,Guidelines for Valuing and Avoiding Liens in Individual Chapter 11 Cases and Chapter 13 Cases (Sept. 9, 2010) at http://www.canb.uscourts.gov/procedures/dist/guidelines/. The Guidelines there provide information on required papers, setting hearings, proposed orders, and more.
Nationally, there is some debate about the proper procedure for stripping a lien. May one file a motion or must one file an adversary proceeding complaint (a separate lawsuit within the bankruptcy proceeding)? In the Northern District of California, at least, the Court has issued guidelines allowing debtors to pursue “lien strips”via motion. The lien strip is often a critical component in making a Chapter 13 plan feasible, and, therefore, the motion should be brought and the order obtained early in the case, before confirmation. Local guidelines generally require entry of an order valuing the security prior to confirmation of a Chapter 13 plan. [See Court guidelines, referenced above]
Giving proper notice is a critical requirement in obtaining an order on a Motion to Value Security.[5] The Debtor’s attorney must be certain to provide proper notice of the motion to the affected lienholder in compliance with Federal Rule of Bankruptcy Procedure (FRBP) Rule 7004. In particular, where the lender is an FDIC insured institution, service must be made in compliance with FRBP Rule 7004(h). (Go to www.fdic.gov to find the proper address for service of federally insured lenders; if the lender is not insured, go to the California Secretary of State website to find an agent for service of process.)
When it comes to providing notice of a Motion to Value Security, it is better to err on the side of caution. Serve the motion not only on the address that you have identified with the FDIC or Secretary of State, but also on every address that the creditor may have provided to you in the bankruptcy case, such as in connection with filing a Proof of Claim. Print and retain in the file hard copies of anything that will show why you served the motion at the addresses that you did on the date you served your motion. Addresses for service can change between the date of service and the date you request your order from the Court. Without evidence of proper service, upon a challenge by the lender, you may run into difficulty actually removing the lien after the plan has been completed, even if the Court grants your motion at the outset.
The End Game
Although an order is obtained near the beginning of the Chapter 13 case, the lien is not really removed until the debtor successfully completes the Chapter 13 plan, usually about five years later. The plan must provide that in the event the debtor’s case is dismissed or converted without completion of the plan, the secured creditor retains its lien to the extent recognized by non-bankruptcy law. 11 U.S.C. § 1325(a)(5)(B)(i)(II).
So how does the lien actually come off of the property? Although there is a split of authority among jurisdictions regarding the proper procedure to follow (among the possibilities are an adversary proceeding, a contempt action or possibly a superior court action to quiet title), the Northern District has made it relatively simple. Its standard-form Order Valuing Lien, found in its Guidelines, provides that “upon application by Debtor, the court will enter an appropriate form of judgment voiding the Lien.” The Guidelines also provide a standard-form Judgment Voiding Lien. Also, it is best to try to contact the creditor (some are easier to communicate with than others) to request a reconveyance of the deed of trust based upon the Judgment Voiding Lien having been entered. Some creditors will cooperate with this request.
Chapter 20 Bankruptcy and Lien Strips
As stated above, “Chapter 20” is jargon that refers to filing a Chapter 13 shortly after receiving a discharge in a Chapter 7 bankruptcy case. The debtor is generally ineligible to receive a discharge in the Chapter 13 case since it is usually filed within four years of receipt of the Chapter 7 discharge.[6] If there is no discharge, why would you want to file a Chapter 20 bankruptcy?
As noted above, one reason is because the debtor was not eligible to file Chapter 13 initially. Another reason may be that most Chapter 7 cases are short, lasting a matter of months. Although many debts are discharged in Chapter 7, some debts and some creditors’ rights survive. After the Chapter 7 closes, the debtor loses the protection of the bankruptcy court and, to the extent creditors’ rights survived the Chapter 7, creditors can resume collection activity.
By contrast, Chapter 13 cases are long, anywhere from three to five years. By filing a “Chapter 20” case and getting a plan confirmed, a debtor can extend the protection available in bankruptcy court for another three to five years to deal with surviving obligations (say, income tax arrearages) in an orderly manner by making monthly payments.
Because lien strips are not available in a Chapter 7 bankruptcy and no discharge is available in the Chapter 13 portion of a Chapter 20, the question arises whether you can strip a junior lien in connection with the Chapter 13 case which is part of a Chapter 20 bankruptcy? Jurisdictions across the country, and even in California, have been divided on this point. However, the answer in the Northern California district (at least for now) is yes. Moreover, the trend of authority may be moving in favor of allowing lien strips in Chapter 20 cases. Two new decisions have broken ground here in California in just the last few months.
The Northern District
The leading decision in Northern California is In re Tran (Bankr ND Cal. 2010) 431 B.R. 230, written by the Honorable Edward D. Jellen before he left the bench. In Re Tran holds that the ability to strip a lien in a “Chapter 20” case does not depend upon eligibility for a discharge, but rather upon the successful completion of the bankruptcy plan. However, an important limitation in the Tran case is that the case be filed in good faith. The Court found in In Re Tran that the debtor Tran was unfairly manipulating the bankruptcy system because she did not have an independent reason for filing the Chapter 13 case.[7] Rather, the debtor Tran had filed it solely to seek a lien strip that was otherwise unavailable under Chapter 7.
Although not controlling on courts in other districts or even on other bankruptcy judges in the Northern District,In Re Tran has been cited approvingly several times as “persuasive” authority on this issue. [8] The Honorable Stephen L. Johnson of the San Jose Division of the Northern District has followed In Re Tran in a memorandum decision signed on March 10, 2011 in the matter of In Re Garcia, Case Number 10-55411 SLJ.
The Southern District
A battle seems to be brewing in the Southern District. In April 2010, in the case of In Re Casey (Bankr. S.D. Cal. 2010) 428 B.R. 519, the Honorable Peter W. Bowie held that lien strips were not available in the Chapter 20 context. Later in 2010, in the case of In Re Hill (Bankr. S.D. Cal. 2010) 440 B.R. 176, the Honorable Margaret M. Mann ruled in favor of allowing lien strips, specifically stating that she was “persuaded by In Re Tran.” (However, she also seemed to indicate that the creditor may be entitled to receive payment on a pro rata basis with all other general unsecured creditors notwithstanding debtors’ receipt of their Chapter 7 discharge.) In July 2011, Judge Bowie responded in In Re Victorio, (Bankr. S.D. Cal. 2011) 454 B.R. 759, holding that “debtors in a Chapter 20 case cannot ‘permanently’ avoid a wholly unsecured junior lien”, which is to say, that lien strips are not available.
Although the Victorio case had fairly simple facts, Judge Bowie authored an exhaustive opinion of over twenty pages, seemingly mindful that this issue may be taken up by a higher court in the near future. In the meantime, practitioners in the Southern District face the quandary that the availability of lien strips in these cases depends upon which judge you draw, you do not know which judge you will draw until you file, and whether you want to file or not may depend upon whether a lien strip will be available.
The Central District
Until recently, the Central District might have been put down into the column of jurisdictions that do not allow lien strips in Chapter 20. The case of In re Winitzky (CD Cal., May 7, 2009) 2009 Bankr Lexis 2430, although an unpublished decision, had nonetheless managed to be cited numerous times for the proposition that lien strips are not allowed in Chapter 20 cases. However, in an as yet unpublished Central District decision just a few weeks ago, the contrary result was reached. (In Re Darzian (Bankr. C.D. Cal., March 27, 2012). The really interesting thing about this development is that In Re Winitzky and In Re Darzian were both authored by the same judge, the Honorable Maureen Tighe, whose analysis in the Darzian case was influenced by the intervening decision of In Re Tran.
The Eastern District
On March 8, 2012, in the case of Frazier v. Real Time Resolutions Inc., (No. 2:11 CV-00290-MCE), the Eastern District Court decided this issue in favor of allowing Chapter 20 lien strips. This decision, too, relied upon In Re Tran, calling it “persuasive.” Moreover, unlike the other decisions noted herein, this decision emanates from the district court level rather than from a bankruptcy judge. However, like Judge Mann in In re Hill, the Court stated the creditor would be entitled to receive a pro rata share of the distribution to general unsecured creditors notwithstanding debtors’ receipt of their Chapter 7 discharge. See also the unpublished opinion of In Re Eaton, 2006 Bankr. LEXIS 4862 (9th Cir.BAP 2006).
Conclusion
Any of the foregoing could be swept away if a higher court addresses this issue, which would seem to be just a matter of time. The arguments of the opposing sides have been framed by In re Tran and In re Victorio. Although none of the three new judges in the Oakland Division have as yet been called upon to write an opinion on this issue, at least one judge in the San Jose Division has supported the analysis in In Re Tran.Thus, for now, lien strips appear to remain available to debtors in Chapter 20 in the Northern District. This will be good news for homeowners who continue to struggle through the Great Recession.
Steven T. Knuppel practices civil litigation, including business, real estate and debtor/creditor litigation from his office in Danville. He is a member of the board of the Bankruptcy and Commercial Law Section of the Contra Costa County Bar Association.
[1] Lien strips are limited to reorganization cases (Chapter 11, 12 and
13). Lien strips are not available in Chapter 7 cases, which provide for
a liquidation approach to bankruptcy. Dewsnup v. Timm, 502 U.S. 410, 417-20
(1992). Because Chapter 11 is not practical for the average debtor and
Chapter 12 is available only for family farmers and fishermen, this article
focuses on Chapter 13 lien strips.
[2] Zimmer v PSB Lending Corp (In Re Zimmer) (9th Cir. 2002) 313 F.3d
1220, 1222-1225.
[3] Frazier v. Real Time Resolutions Inc. (E.D. Cal. 2012) March 8, 2012
(No. 2:11 CV-00290-MCE), p. 13.
[4] The term “lien strip” can refer to removal of judgment
liens on real estate that impair a debtor’s exemptions. Also, a
“lien strip” may occur on non-real estate assets, although
the economics often do not justify seeking such relief. The term “lien
strip” can refer to what is also known as “cramming down”
a secured claim. That is, when a debt is only partially secured, for example,
due to a drop in collateral value (say the debt is $100,000, but the collateral
is worth $75,000), the claim can be broken into secured ($75,000) and
unsecured portions ($25.000). There are a couple of catches: (1) you cannot
cram on a principal residence; and (2) the secured portion of the debt
has to be paid off entirely during the bankruptcy plan.
[5] “[A] plan can effectively determine value and/or avoid a lien
only if the creditor receives clear notice that the plan will do so.”
Shook v CBIC (In re Shook) (BAP 9th Cir 2002) 278 BR 815, 824.
[6] 11 U.S.C. §1328(f)(1)
[7] In Re Tran was actually a single opinion addressing a common issue
of law that arose in two unrelated Chapter 13 cases. The other debtor,
Bennett, was not found to be manipulating the bankruptcy system and the
judge overruled the objection to Bennett’s proposed lien strip.
[8] As mentioned in this article, the In Re Tran has been cited favorably
by Frazier v. Real Time Resolutions Inc; In Re Hill; and In Re Darzian..
In addition, the In Re Tran decision was cited favorably at the Court
of Appeals level by the Eighth Circuit in the opinion of In re Fisette,
455 B.R. 177 (B.A.P. 8th Cir., 2011).