7th Circuit Splashes Cold Water on Chapter 7 “Lien Stripping” Hopes

14 Jul 7th Circuit Splashes Cold Water on Chapter 7 “Lien Stripping” Hopes

puzzleOver the past dozen or so years, the bankruptcy process known as chapter 13 lien stripping has become universally accepted by the courts. Recently, advocates of lien stripping have expanded their efforts in the next logical direction: gaining judicial recognition of lien stripping in chapter 7 bankruptcy cases.

Indeed, a three-judge panel of the Eleventh Circuit Court of Appeals, in an unpublished decision issued in 2012, approved of a chapter 7 debtor’s ability to lien strip. However, because this decision was not approved for publication, and because the case is on appeal to the full panel of Eleventh Circuit appeals court judges, this decision has limited precedential value.

Lien stripping is when the bankruptcy court “strips”(in other words, avoidsand nullifies)a junior home mortgageencumbering a home whose fair market value is less than the amount of thesenior mortgage or mortgages.

However, the Seventh Circuit Court of Appeals recently ruled that lien stripping is not available to homeowners in chapter 7 bankruptcy cases. This rulingis a serious setback to those hoping to expand lien stripping to chapter 7.

Palomar v. First American Bank, No. 12-3492 (7th Cir. July 11, 2013), involved an Illinois couple who filed chapter 7 in 2011. The first mortgage on their home had a balance of $243,000; the second mortgage had a balance of something less than $50,000.

Because the home had been appraised at only $165,000, the second mortgage was not actually secured by any real value of the home. To put it another way, the second mortgage would have received exactly $0 in a hypothetical foreclosure sale conducted by either of the two mortgage holders.

The homeowners arguedthat bankruptcy code section 506(d) rendered the second mortgage wholly unsecured. Therefore, they claimed,the court should order that it be stripped from the property, just as it wouldhave beenif the case had been filed as a chapter 13 bankruptcy.

The Seventh Circuit made short work of this argument, holding that lien stripping could not be accomplished in chapter 7 bankruptcy cases. Dewsnup v. Timm, a 1992 U.S. Supreme Court case, had previously held that partially secured home mortgages were immune from being modified by section 506(d). The Seventh Circuit found that the reasoning of Dewsnup should apply to a completely unsecured junior mortgage as well.

Predictably, the Seventh Circuit’s decision did not mention the contrary unpublished 2012 decision of the Eleventh Circuit Court of Appeals allowing the stripping of an entirely unsecured home mortgage in chapter 7.

Image credit: David Goehring, CarbonNYC’s Photostream, Flickr.

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Craig W. Andresen is a consumer bankruptcy lawyer in Bloomington, Minnesota, with 22 years’ experience in consumer and small business bankruptcy cases. He is the Minnesota chair of the National Association of Consumer Bankruptcy Attorneys, and is a member of the Minnesota State Bar Association’s Bankruptcy Section. Mr. Andresen lectures often on the topic of consumer bankruptcy at local and national legal seminars.
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