Since the decline in real estate values, lien stripping of junior mortgages has become quite common in Chapter 13 cases.  Lien stripping can be defined as the process Chapter 13 debtors use to cancel second or junior mortgages when their residences are worth less than the amount of their first mortgage.  This article will explain the procedure as well as the legal basis for lien stripping in Georgia.  Creditor strategies for responding to lien stripping actions are also suggested. 

Legal Basis

The 1993 US Supreme Court decision, Nobelman v. American Sav. Bank, 508 U.S. 324 held that in Chapter 13 cases, under § 1322, a lender’s lien could not be stripped and the creditor was entitled to the full value of its lien if the lender’s only collateral was the debtor’s primary residence.  However, the 11^th Circuit in Tanner v. First Financial, Inc., 217 F. 3d 1357 (11^th Cir. 2000), held that the Nobleman protection did NOT extend to homestead lenders where their lien was wholly unsecured.  A mortgage is wholly unsecured when the amount of the senior mortgage is greater than the value of the debtor’s residence. 

Example

Scenario One

A Chapter 13 debtor’s residence is worth $200,000.  There is a first mortgage on the residence for $175,000 and a second mortgage for $50,000.  In this case, there is $25,000 equity over and above the first mortgage so the lien on the second mortgage cannot be stripped off.  This is the case even though the equity is less than the full amount of the second mortgage.

Scenario Two

The Chapter 13 debtor’s residence is worth $200,000.  However, in this case, the first mortgage on the residence is for $205,000 and the second mortgage is for $20,000.  Since there is no equity over and above the amount owed on the first mortgage, the second mortgage is wholly unsecured and subject to being stripped off.

Procedure

A Chapter 13 debtor initiates a lien stripping action in the bankruptcy court by filing a motion or by an adversary proceeding to determine the extent and validity of a lien under Section 506 (a) of the Bankruptcy Code.  In the Northern District of Georgia, the action may be brought by motion or by adversary proceeding.  In the Middle District, the action is brought by an adversary proceeding and in the Southern District, the action may be brought before the court by motion or simply as a provision in the Chapter 13 plan.  Other courts across the country require the action to be brought by adversary proceeding, reasoning that due process entitles the lender to the heightened notice through service of a summons and complaint required in adversary proceedings.

The Bankruptcy Code allows Chapter 13 debtors to modify the rights of secured creditors, including mortgagees, in their Chapter 13 plan.  For example, a plan can provide for the payment of a mortgage arrearage over an extended period of time rather than requiring the debtors to immediately bring the loan current.  The plan also provides a mechanism for stripping off a wholly unsecured mortgage as described above.  Where the debtors seek to modify a secured creditor’s rights, a motion or adversary proceeding is appropriate as long as the Chapter 13 plan also provides for the modification.

There are several reasons motions are denied.  The most common reason is improper or insufficient service of process on the lender.  Motions can also be denied if the wrong party is named as respondent.  Additionally, if the plan is silent, unclear or treats the claim differently than the motion, the motion may be denied.  If the property is jointly owned and only one owner files bankruptcy, the individual debtor cannot file a motion to strip the lien.  Finally, the motion may be denied if it fails to state a claim for relief or if the creditor can prove that the property has value, over and above the first mortgage, to support its lien. 

Response

Once a lender receives such a motion, the lender must decide whether it is cost effective to oppose the motion.  The motion may be opposed on procedural grounds as described above or if the Chapter 13 debtor is statutorily ineligible for a discharge.  For example, a debtor would be ineligible if they have received: (i) a discharge in a Chapter 7 or Chapter 11 during the four year period preceding the date of the order of relief in the Chapter 13; or (ii) a discharge in a Chapter 13 within the two year period preceding the date of the order for relief in the current Chapter 13 case.  Additionally, if the lender determines that there is equity in the property, even a minimal amount, there is a basis to oppose the motion. 

If the motion is not opposed or if the court finds that the junior lien is wholly unsecured, an order granting the motion will be entered and the mortgage claim is treated in the plan as a general unsecured claim.  If the case is later dismissed or converted to a Chapter 7, the mortgage lien is not affected by the order and remains valid. 

Conclusion

Bankruptcy courts across the country are dealing with debtors’ actions to strip liens but how the actions are brought to the court depends on the jurisdiction.  A mortgagee can oppose lien stripping motions or adversary proceedings where the debtor has failed to follow the proper procedure or is ineligible for a Chapter 13 discharge.  The mortgagee can also oppose the lien strip on substantive grounds if the residence has equity over and above the first mortgage.  Even if an order is entered voiding the junior lien, the order will become void if the Chapter 13 is dismissed or converted to a Chapter 7.  Lien stripping will continue to be a part of the bankruptcy landscape as long as real estate values remain depressed.  If you have additional questions regarding this topic, please contact us at 678-384-7000.