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4th Cir. Allows Chapter 13 Lien Stripping When No Proof of Claim Filed

The U.S. Court of Appeals for the Fourth Circuit recently held that a completely unsecured lien may be stripped off in a Chapter 13 bankruptcy proceeding under 11 U.S.C. § 1322(b) even though a proof of claim has not been filed.

A copy of the opinion in Edwin Burkhart v. Nancy Spencer Grigsby is available at:  Link to Opinion.

Debtors filed a Chapter 13 bankruptcy petition in 2012.  At the time, the debtors’ principal residence was valued at $435,000 and encumbered by four liens.

Creditor 1 held the mortgage lien with the highest priority in the amount due of $609,500.  Creditor 2’s two junior mortgage liens had the second highest priority valued at $127,700.91. Creditor 3’s mortgage lien had the lowest priority valued at $105,995.75. Thus, the three junior liens were completely unsecured and the senior lien was only partially secured.

Only Creditor 1 and Creditor 3 filed a proof of claim.

The debtors filed an adversary proceeding seeking to avoid the liens held by Creditor 2 and Creditor 3.  The bankruptcy court entered a default judgment against Creditor 2 and Creditor 3 finding the liens completely underwater. Creditor 3’s lien was stripped.

However, the bankruptcy court refused to strip the two liens held by Creditor 2, finding that 11 U.S.C. § 506(d)(2) (“Section 506(d)(2)”) prohibits lien avoidance where no proof of claims are filed.

The debtors appealed to the district court which also refused to strip Creditor 2’s liens.  The district court held that a strip off could not occur without the application of 11 U.S.C. § 506, but Section 506(d)(2) barred a lien from being voided when a proof of claim is not filed, and therefore, not an “allowed secured claim.” The district court found that it would reach the same result under 11 U.S.C. § 1322(b)(2) (“Section 1322(b)(2)”) because that section could not be considered unless a proof of claim had been filed and allowed and valued under 11 U.S.C. § 506(a) (“Section 506(a)”).  The debtors appealed the ruling of the district court.

On appeal, the Fourth Circuit considered whether a Chapter 13 debtor could strip off a completely unsecured junior lien under Section 1322(b)(2) when no proof of claim has been filed.

The Court first examined the role 11 U.S.C. § 506(d) (“Section 506(d)”) plays in a Chapter 13 lien strip.  The Court noted that its past rulings made clear that the power to strip a lien in Chapter 13 proceedings stems from Section 506(a) and Section 1322(b). The Court explained that Section 506(a), which classifies valueless liens as unsecured claims, operates with Section 1322(b)(2) to permit a court in a Chapter 13 case to strip off a lien against a primary residence with no value.

On the other hand, the Court explained that Section 506(d) voids liens on the basis of whether the underlying claim is allowed or disallowed under 11 U.S.C. § 502.  The Fourth Circuit noted that the Supreme Court of the United States explained that the applicability of Section 506(d) depends on whether a claim is an allowed secured claim, which “gives the provision the simple and sensible function of voiding a lien whenever a claim secured by the lien itself has not been allowed.”  Dewsnup v. Timm, 502 U.S. 410, 417 (1992).

The Fourth Circuit noted that § 1322(b) permits a plan “to modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence.” The Court explained that the critical focus under Section 1322(b)(2) concerns “rights.”  By contrast, Section 506(d) speaks only of allowed “claims.”

The Court noted that a Chapter 13 plan’s power to modify rights has never been restricted to the universe of allowed claims, and therefore, Section 1322(b) should apply equally when it comes to avoiding an entirely unsecured lien.  In the Fourth Circuit’s view, the valuation process of Section 506(a) does not determine a creditor’s rights under Section 1322(b); rather, these rights turn on whether there is any value in the collateral.

Here, the debtors were not challenging the validity of the underlying debt.  Rather, the debtors argued that Creditor 2’s otherwise valid debt was now unsecured due to the value of Creditor 1’s senior security interest.  Thus, the Court found that it may look to Section 506(a) to determine the status of Creditor 2’s secured claim and then modify the rights Creditor 2 enjoys as a mortgagee under Section 1322(b).

The Fourth Circuit explained that Creditor 2 had no incentive to file a proof of claim because its liens were entirely without value. In addition, the Court noted, bankruptcy proceedings routinely modify a non-participating creditor’s rights.

Thus, the Court found that the filing of a formal proof of claim is not a prerequisite to valuing a claim under Section 506(a) for the purposes of modifying a creditor’s rights under Section 1322(b)(2).  Otherwise, as it stood, Creditor 3 who filed a proof of claim had its lien stripped, while Creditor 2’s liens survived even though a proof of claim was not filed. The Court held that this could not be the law.

In sum, the Court found that the ability of a Chapter 13 debtor to strip off an underwater lien stems from Section 1322(b), not Section 506(d).  Thus, the Fourth Circuit held, the valuation of claims under Section 506(a) is not limited to claims that have been filed and allowed.

Section 1322(b) permits plans to modify the rights of the holders of unsecured claims and whether a creditor has an unsecured claim turns on the value of the underlying collateral, not merely the existence of a security interest.  However, the Court held, where a senior lienholder is only partially secured, any junior lienholder is by definition the holder of an unsecured claim for the purposes of Section 1322(b), and therefore, the liens may be stripped without the filing of a proof of claim.

Accordingly, the Fourth Circuit reversed the district court’s ruling and remanded for further proceedings.

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