Stripping in Bankruptcy

Now that I've got your attention, let me say that there is nothing uncommon about "stripping" in bankruptcy. We're not going to have a discussion about "disrobing" here - we're going to talk about systematically and unemotionally dismantling any secondary liens on your home, if the circumstances are "just right." 

By "dismantling" I mean that your second mortgage or home equity lien attached to your home, can be stripped off and removed from the public records of your county clerk, if the circumstances are "just right."

So what are the "just right" circumstances?  Well, right now, those circumstances would be that because of the steep decline in the fair market value of your home, it's actually worth less than the amount of your first mortgage.

The logic in bankruptcy is that if your home is worth less than the first mortgage, then there simply isn't any equity to go around to the secondary liens attached to your home.  In other words, if your home was sold or foreclosed, today, your first mortgage holder would be paid something (maybe even everything), but the secondary lien holders would go home with an empty paper bag. 

Chapter 13 would enable you to categorize those secondary liens as "unsecured" for all intents and (bankruptcy) purposes.  Your chapter 13 plan can shift those liabilities into a low-priority unsecured status, being paid pennies on the dollar in many cases.  The legal terminology here is often referred to "turning lemons into lemonade."  By the time you complete your chapter 13 case, the real estate market could rebound, and you could very well find your property value back in the black, so to speak - ahead of the game. 

Ah, stripping in a 13.  A good thing, if the circumstances are "just right."

"Mike, but what about stripping in a Chapter 7 case?"

Funny you should ask.  For years, the simple answer for most consumer bankruptcy practitioners has always been absolutely not.  Now - depending - on where you live - the answer is either still no or a resounding maybe.

Yet, the logic of the argument seems simple enough: You're in bankruptcy. You show the court there's no equity to go around to the secondary liens.  You argue that those secondary lenders  are - in essence - unsecured - since they would not be able to squeeze a drop of money out of your property. Why oh why then,  can't we strip those secondary liens like we can do in a chapter 13?   

 The short but divisive answer lies in a seminal decision of the United States Supreme Court, in a case entitled, Dewsnup v. Timm, 502 U.S. 410 (1992).  The Dewsnup case dealt with a primary (i.e., first and only ) mortgage that was partially secured.  Meaning, the fair market value of the property was less than the amount of the mortgage, but because the property still in fact had some value, the mortgage was partially secured.   The Dewsnup court declined to modify the terms of that first and only mortgage, even though it was only partially secured. 

Whether or not Dewsnup was intended to be applied broadly, to wholly unsecured secondary liens, has become a hotbed issue among the various federal courts.  The Fourth Circuit (Maryland, North Carolina, South Carolina, Virginia, and West Virginia) , Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee) and Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Nevada, Oregon, Washington, Guam, Northern Mariana Islands)  have all applied Dewsnup broadly, holding that you cannot strip a secondary lien in a chapter 7 case.  Period.  

However, there's a beautiful little case that hails from my hometown in the Eastern District of New York (part of the Second Circuit), by a rather astute bankruptcy judge, by the name of Dorothy T. Eisenberg.  The case is entitled, In re Mark T. Lavelle and Sandra S. Lavelle (Chapter 7) Case No. 09-72389-478. 

Judge Eisenberg gives a well thought out, analytical opinion as to why these wholly unsecured secondary liens can and should be stripped in a chapter 7, and in how doing so, does not violate the holding of Dewsnup.     That's pretty good news for some of the folks living in The Big Apple. Other New York judges in the bankruptcy courts may agree with Judge Eisenberg's logic.  

Now if you're living in Alabama, Georgia or Florida  (the 11th Circuit) then you are living in a "maybe" jurisdiction, with perhaps some promise of future stripping.  There's a case out of the Middle District of Georgia by United States Bankruptcy Judge James D. Walker, Jr., who signed off on a default judgment in favor of the debtor against his secondary lender, to strip off the secondary lien. The case is entitled, William Carrera et.al. v. Bank of America, N.A., Adv. Pro. 09-05127.   Some colleagues have criticized the decision as having been possibly entered in error - perhaps the product of judicial oversight - though for now the decision stands. 

A similar scenario may be brewing in the Middle District of Florida, Orlando Division.  I will keep you posted on further developments.  

July 28, 2010 UPDATE:  Alas,  not looking good for lien stripping in Florida Chapter 7 cases.  In a series of consolidated cases for the purpose of determining this very issue, Orlando-based U.S. Bankruptcy Judge Karen S. Jennemann sided with the majority of courts to find lien stripping in a chapter 7 impermissible.  Perhaps the issue will be revisited but for now, it appears that the only remedy to "strip" in Florida would be under Chapter 13.   

Stripping in a bankruptcy court.  Stripping in a Chapter 7?  Maybe in New York, but not in Florida. At least not yet.