The Housing Bubble and Consumer Bankruptcy (Parts I and II)
David Gray Carlson*
Once again, Americans are enjoying the glorious summer of a housing bubble. The clouds of the 2008 recession that loured over the consumer homestead are now in the deep bosom of the ocean buried. Recently bankrupt consumers have found themselves eyeing a stupendous profit if they sell their home.[1] What are the prospects that the debtors can keep this profit away from their prepetition creditors? The answer depends on whether the debtor filed a chapter 7 or chapter 13 bankruptcy.
Part I covers the scene in chapter 7 cases, where the debtor cannot exclude underwater mortgage lenders from appreciation value. Arguably the Bankruptcy Code, as originally promulgated, invited debtors to “strip” underwater mortgages. In the notorious case of Dewsnup v. Timm[2] the Supreme Court ended that practice.
A chapter 7 debtor may still strip a judgment lien in whole or part, thereby diverting appreciation value from the judgment creditor to the debtor. Under either federal or state law, a debtor is usually entitled to a monetary exemption on a home. Any appreciation value funds the monetary exemption at the expense of the judgment creditor.[3]
Everything changes in a chapter 13 case. Part II explains that the underwater senior mortgage lender is guaranteed the first right to drink from the waterfall of appreciation value. Nobelman v. American Savings Bank[4] expressly protects the senior mortgage lender from lien stripping. A junior mortgage lender, however, can be stripped, if the second mortgage is “out of the money” – the first mortgage lender is under water and there is no valuable remaining equity available for the junior mortgage lender. Once a chapter 13 plan is confirmed, the debtor gets appreciation value above and beyond the claim of the first mortgage lender. But if during the plan, the debtor realizes a capital gain from the sale of the house, the gain can be captured by the creditors because the gain is “disposable income” which the debtor is ultimately supposed to pay into the plan.
Part III[5] addresses the recent developments giving a chapter 13 debtor a real hope in keeping appreciated value away from the unsecured creditors by converting to a chapter 7 case. In such circumstances the law turns especially obscure.
In addressing ownership of appreciation value, I embrace the dry and desiccated spirit of positivism. I take no position on who deserves the windfall of appreciation value. Consumer bankruptcy is founded on the contradiction that creditors deserve to be paid and debtors deserve a discharge and a fresh start in life. I have no moral intuition as to which of these intuitions should predominate. These issues I leave to divine law. Rather, I examine whether allocations of value can be grounded in the text of the Bankruptcy Code as it currently exists.
The result, I fear, will strike the reader as unsatisfactory. Obtuseness and shadow dominate over clarity and light. Dark night strangles the travelling lamp of bankruptcy jurisprudence. A great many issues covered here were obviously not anticipated by the drafters of the Bankruptcy Code, and their scrivenings will seem arbitrary in application. In addition, Supreme Court interventions, no doubt well intentioned, have greatly complicated the scene. One gets the strong impression that the results demanded by a positivist approach are unintended and accidental. It is definitely not possible to say in general that either the creditors are entitled to the appreciation value, or that debtors may retain it as part of their fresh start. The reader should prepare for a bumpy ride.
Overview
Prior to examining the fate of the housing bubble in consumer bankruptcies, we need to rehearse the mechanics of liquidating exempt property in bankruptcy. The Bankruptcy Code is surprisingly opaque on these matters.
We learn in § 541(a) that “commencement of a case … creates an estate.”[6] The bankruptcy estate includes “all legal and equitable interests in property as of the commencement of the case.”[7] Bankruptcy therefore constitutes a transfer by a debtor (D )[8] of property to the bankruptcy trustee (T ) on behalf of creditors.
In all bankruptcy cases, whether chapter 7 or 13, exempt property initially goes into the bankruptcy estate and must be fetched out[9] by D. This was not so under the 1898 Bankruptcy Act. There, “property of the bankruptcy estate” was defined as property as to which a judicial lien might attach. Exempt property never was part of the bankruptcy estate in the first place.[10] In the modern era, then, whether the home is exempt or not, into the bankruptcy estate it goes.
When D owns a house and files for bankruptcy, the house becomes an asset of the bankruptcy estate. Title to the property does not transfer to T and D continues to hold the fee simple interest to the house.[11] For this reason, D may live in the house after bankruptcy and is no trespasser in it.[12] T, however, may use, sell or lease the house court permission.[13] Thus, D could be in danger of losing the house under certain circumstances. When the house is D ’s principal residence it is usually, at least in part, exempt property under state law or as federalized by the Bankruptcy Code.
The homestead is usually exempt from execution by unsecured creditors. In seven jurisdictions,[14] D gets an “exemption in kind” meaning the entire house is exempt. In the other states, and under federal law,[15] D ’s homestead exemption is monetarily limited. In bankruptcy, T is a hypothetical judicial lien creditor.[16] This means that, where D has only a monetary exemption, T has a judicial lien on the debtor’s equity in the home for the value above and beyond the exemption amount.[17]
Very frequently, when the nation is in a recession, the mortgage is under water. The exemption, of course, is no good against the mortgage.[18] Suppose the value of the house exceeds the amount of mortgage liens (ML) on the property plus the monetary exemption (ME). (The sum of these amounts I will refer to as ML+ME). Equity above ML+ME is not common at the commencement of a consumer bankruptcy. If D has a sizable equity in the home after the mortgage, D can often dull the edge of husbandry by borrowing against equity, thus staving off the evil day of bankruptcy.
Nevertheless, it is not unknown for the value of the home to exceed ML+ME.[19] In such a case, T can sell the home free and clear of the mortgages and the exemption. That T may sell free and clear of the mortgages is established by § 363(f)(3).[20] The Bankruptcy Code never says that T can sell free and clear of the monetary exemption, but under state law judicial lien creditors can do so.[21] Therefore it is logical and universally assumed that T can also do so,[22] since T is a hypothetical judicial lien creditor under § 544(a)(1).
By way of example, here is the situation involving a judicial lien under New York state law. A judgment creditor (JC ) may not, apparently, sell free and clear of a senior mortgage. According to New York’s CPLR § 5236(a), “the interest of the judgment debtor in real property … which was subject to the lien of judgment … shall be sold by the sheriff …”[23] Where D has conveyed a mortgage to ML and where JC subsequently obtains a judgment lien, the sheriff can only sell D’s interest as encumbered by ML.
In New York, if JC wishes to execute on the surplus above the monetary exemption of $150,000,[24] she must start a special proceeding.[25] The court must order that the sale occur, either through a sheriff or a receiver. Presumably, the court must pay D first for the exemption amount[26] (keeping in mind that ML survives the sale). As is true in many states,[27] the money remitted to D is entailed:
Money, not exceeding [the exemption amount], paid to a judgment debtor, as representing his interest in the proceeds, is exempt for one year, after the payment, unless, before the expiration of the year, he acquires an exempt homestead, in which case, the exemption ceases with respect to so much of the money as was not expended for the purchase of that property[.][28]
As for the surplus above the exemption amount, the court (presumably) pays the sheriff’s or receiver’s fee[29] and remits the balance to JC.[30]
PART I. Chapter 7
A. Exempt Property
When the house is D’s principal residence it is usually, at least in part, exempt property under state law or as federalized by the Bankruptcy Code. If there is no equity beyond ML+ME T cannot, or should not sell, the home in a chapter 7 case.[31] But if equity exists, T can do what JC could not do under state law —sell free and clear of ML.[32] In analogy to JC, T can sell the whole of the house, in spite of the monetary exemption.[33]
T’s power to sell free and clear of ML generally does not exist in state law and is rather unique to federal law.[34]
Presumably, T must, off the top, pay proceeds to ML. Where in the Bankruptcy Code is this provided for? It is hard to say. According to § 552(b)(1):
[I]f the debtor and an entity [ML] entered into a security agreement[35] before the commencement of the case[36] and if the security interest[37] created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds … then such security interest extends to such proceeds … acquired by the estate after the commencement of the case to the extent provided by such security agreement … [38]
This provision is designed (clumsily at that) to cover security interests in personal property under Article 9. It does not so clearly cover ML, whose mortgage agreement will probably not mention proceeds in free-and-clear sales. Nevertheless it is assumed (sensibly) that when T sells free and clear of ML, ML has “cash collateral.”[39] T is obliged to surrender this cash collateral to ML by § 725:
After the commencement of a case [in chapter 7], but before final distribution of property of the estate under section 726 … , [T] … shall dispose of any property in which an entity other than the estate has an interest, such as a lien, and that has not been disposed of under another section of this title.[40]
So far, we have established, largely through assumption and not via legislative clarity, that, after the free-and-clear sale, T must first pay ML her share of the proceeds.
The second thing T must do is to pay D the monetary exemption amount (which for purposes of this example is $150,000). Nothing in the Bankruptcy Code commands it. Arguably the conclusion is founded in the same above-quoted § 725. If D’s federal exemption right is “property in which an entity other than the estate has an interest,”[41] T should pay $150,000 to D before distributing the surplus to the unsecured creditors.[42]
Perhaps T will not be able to sell D’s house at all. Where there is modest equity above the mortgage, an exemption often applies to deny the chapter 7 trustee access to the house. Suppose, for example, that the home is valued at $500,000 and ML claims $400,000. Suppose D is entitled to an exemption of $150,000. T ought not to sell this home, as the unsecured creditors will not benefit. T ought to abandon the home to D.[43] If she does so, the home is expelled from the bankruptcy estate. The automatic stay lapses as to the home,[44] and ML may now foreclose.
Suppose T does not abandon. The Bankruptcy Code invites D to claim the house as exempt[45] on Schedule C.[46] If no creditor objects to the exemption, the equity is expelled from the bankruptcy estate.[47]
Now you might be tempted think that, once the house is exempt, the house cannot be reached by T. The house belongs to ML and D, and T has no interest in it. Therefore, appreciation value belongs solely to ML and D (where ML was under water at the time of the bankruptcy).
This may not be so. In Schwab v. Reilly,[48] the Supreme Court implied that appreciation value belongs to T. In Schwab, D claimed restaurant equipment as exempt, under a combined “tool of the trade” and “wildcard” exemption provided by § 522(d). On Schedule C, D valued the equipment at $10,718, less than a combined tool-wildcard exemption of $12,075.
T did not challenge the exemption within the time limit required by Federal Rule of Bankruptcy Procedure 4003(b)(1).[49] Reading the Supreme Court’s prior opinion in Taylor v. Freeland & Kronz,[50] D figured that she owned the equipment outright. The equipment had been expelled entirely and finally from the bankruptcy estate, she justifiably thought. She was wrong. Only the proceeds up to the value of the available exemption were expelled. The value above and beyond $12,075 remained within the estate. T could therefore sell the equipment under § 363(b)(1).
Important for this article is what the Supreme Court had to say about the function of § 522(a)(2), which defines value to mean:
fair market value as of the date of the filing of the petition or, with respect to property that becomes property of the estate after such day, the date such property becomes property of the estate.[51]
You would think that this provision means that, when T requests permission to sell a house under § 363(f), T must pretend the value is the bankruptcy-day value, not the present value. Since the bankruptcy-day value was below ML+ME, T cannot sell. Not so. In Schwab, T had the right to sell the equipment for market value, even though D had estimated value at below ML+ME. Therefore, the Supreme Court has effectively read § 522(a)(1) out of the Bankruptcy Code, insofar as T-D relations are concerned. The implicit holding in Schwab is that, where an exemption enters the bankruptcy estate with value below ML+ME and where, before the case closes, value is above ML+ME, appreciation value above ML+ME belongs to T.[52]
This is straightforwardly illustrated by Gebhart v. Gaughan (In re Gebhart),[53] where D valued a house at $210,000. ML and ME were $121,000 + $100,000 = $221,000. So, on bankruptcy day, T could not sell. T should have abandoned the property. T did not do so. Two years later, T thought she could find a buyer for an amount exceeding ML+ME=$221,000. She moved for permission to sell. D counter-moved to compel abandonment because “the value of the homestead for the purposes of the bankruptcy case had been locked in at the time of the bankruptcy filing …”[54]
The Ninth Circuit, applying Schwab, held that T was not bound to pretend that bankruptcy-day value is still the present value. Rather, T could sell in the hopes of achieving a realization in excess of ML+ME. The Gebhart court warned:
The Supreme Court’s decision in [Schwab] was based on a somewhat different situation than is present here. In [Schwab], the debtor underestimated the value of the exempt property at the time of filing. In both of the current cases, by contrast, the debtors accurately valued the equity interests in their homestead properties at the time of bankruptcy filing, but the fair market values of the properties increased subsequent to filing. This distinction, however does not alter the analysis. Under [Schwab], an exemption claimed under a dollar-value exemption is limited to the value claimed at filing. At least when the total fair market value of the property is in fact greater than the exemption limit at the time of filing … any additional value in the property remains the property of the estate, regardless of whether the extra value was present at the time of filing or whether the property increased in value after filing.
The debtors argue that this conclusion is inconsistent with [§ 522(a)(1)]. The debtors argue that this provision effectively freezes the value of property claimed as exempt as of the date of bankruptcy filing. [but] what is frozen as of the date of the filing the petition is the value of the debtor’s exemption, not the fair market value of the property claimed as exempt.[55]
This very last observation is confusing. What is frozen on bankruptcy day? Entitlement to the exemption (which comes from a statute and has nothing to do with value of the exempted thing). Thus, qualitatively, whether D is entitled to the exemption is decided on bankruptcy day. This is the so-called “snapshot” rule, induced from the ancient case of White v. Stump.[56] In White, D’s homestead right required D to file notice of the homestead claim in the real estate records. D filed for bankruptcy and thereafter filed the homestead recordation. The Supreme Court said that the homestead recordation was too late.
[T]he point of time which is to separate the old situation from the new in the bankrupt’s affairs is the date when the petition is filed … When the law speaks of property which is exempt and of rights to exemptions it of course refers to some point of time. In our opinion this point of time is the one as of which the general estate passes out of the bankrupt’s control, and with respect to which the status and rights of the bankrupt, the creditors and the trustee in other particulars are fixed. The provisions before cited show—some expressly and others impliedly—that one common point of time is intended and that is the date of the filing of the petition. The bankrupt’s right to control and dispose of the estate terminates as of that time, save only as to “property which is exempt.” § 70a. The exception, as its words and the context show, is not of property which would or might be exempt if some condition not performed were performed, but of property to which there is under the state law a present right of exemption—one which withdraws the property from levy and sale under judicial process.[57]
The “snapshot” is strictly qualitative. What is exempt? This is decided by the law as it existed on bankruptcy day. Quantitative criteria, however, are not frozen. Thus, the meaning of Schwab is that § 522(a)(2) is a dead letter in adjudicating exemptions by D from the bankruptcy estate. This will be an important principle for what follows.
What happens if the value of the house exceeds ML+ME? In such a case, the monetary exemption is expelled from the bankruptcy estate, but the house, as such, is not. T may liquidate the house. Because the value of the house is above the amount of the mortgage lien, T may sell free and clear of the mortgage[58] The Bankruptcy Code nowhere prevents T from selling where value is above the mortgage amount but below the sum of the mortgage amount and the exemption amount.[59] But since a sale below ML+ME yields nothing for the unsecured creditors and affirmatively harms D, a court will presumably deny permission when T moves to sell under § 363(b)(3).[60]
B. Abandonment
Eventually, T must close the chapter 7 case. According to § 350(a): “After an estate is fully administered and the court has discharged the trustee, the court shall close the case.” But “[a] case may be reopened in the court in which such case was closed to administer assets ….”[61] Thus, if D’s house was fully administered, T cannot reopen the case and recapture D’s appreciation value. But if the house was not fully administered, T may reopen the case and retrieve the appreciation value.
Section 554(a) invites T, “[a]fter notice and a hearing,” to abandon property “that is burdensome to the estate or of inconsequential value.”[62] If T troubles to abandon the exempted house, T cannot get the house back. Section 554(c) adds that property scheduled by the debtor as required by § 521(a)(1)(B)(i) is deemed abandoned when the case is closed.[63] If an asset is not disclosed on the schedules § 554(d) says that “unless the court orders otherwise, property of the estate that is not abandoned under this section and that is not administered in the case remains property of the estate.”[64]
When is the house “administered”? “Neither the Bankruptcy Code nor the Bankruptcy Rules define when an estate is ‘fully administered.’” [65] A sensible interpretation is that the house is administered when D schedules the house on Schedule A and C and T closes the case. Under § 554(c), the house is deemed abandoned—unless the court orders otherwise. But T may, with court permission, close a case and retain a judicial lien on exempt property. In In re Orton,[66] the case was closed, but T was permitted to reserve in perpetuity a judicial lien on a mineral royalty to which D had applied $1 of his federal “wildcard” exemption. Therefore, if the lessee struck oil years after the case was closed, D would get $1 from the gusher and the rest would go to the unsecured creditors of the bankruptcy case, once T re-opened it.[67]
After an underwater house is exempted, may T, citing Orton, reserve, after case closure, a lien on the homestead in case a surplus over ML+ME appears in a rising market?[68] After all, it costs T nothing to sit around and wait for prices to go up.
Price theory gives courts a reason to prevent T from encumbering the home for years even after the case is closed. Market value is a weighted average of possible future values. By definition, baked into market value is the probability that housing prices may go up and that housing prices may go down. If housing prices are certain to go up in the future, present value would already be higher today. By definition, T cannot second-guess the trend in the real estate market. Therefore, T has no economic reason to suppose that the bankruptcy estate will benefit if T lies in the weeds in the hope of appreciation value. In In re Barrera[69] (a significant opinion we shall examine later), Judge Elizabeth Brown wrote:
[I]f the chapter 7 estate is left open for some period of time, and the assets appreciate or the liens are reduced during this period, then the chapter 7 estate will reap the benefit of that increase in equity. Because of this, any debtor’s lawyer worth his salt will file a motion to abandon the asset under § 554 early in the chapter 7 case if it look like the estate will remain open for a significant period of time. Not doing so would be tantamount to malpractice. [70]
The assumption here is that of course a bankruptcy court would force T to abandon where T is simply stalling in the hope of appreciation value.[71]
We may conclude, then, that appreciation value in exempt homes (above ML+ME) belongs to T until the case is closed. After case closure, so long as the house appeared in the schedule of assets filed by D, appreciation value belongs to the mortgage lender (if the mortgage is under water) and then to the debtor. Abandonment signals the end of T’s right to a surplus over ML+ME.
C. Dewsnup v. Timm
Consumer chapter 7 cases usually wind up in a matter of months. Over the course of this short time, appreciation value is not likely to accrue. But in the present hot market, the phenomenon is not unknown. In any event, the case law provides examples of consumer chapter 7 cases that last for years.[72]
When D owns an underwater house and files for chapter 7, appreciation value belongs at first to ML and then to D to the extent of the monetary exemption.[73] Thereafter, T takes the surplus over ML+ME. Appreciation value is a waterfall, if I may mix hydric metaphors.
When the Bankruptcy Code was first promulgated, things were thought to be different. At first, T could divert the waterfall from ML to T (or, where the property was exempt from ML, to D and then to T). Such a belief was fueled by Bankruptcy Code § 506(d): “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void … “Promulgated in 1978 and amended in 1984, § 506(d) was thought to mean that an underwater lien was capped at the appraised value of the collateral. This seemed to be implied by § 506(a)(1):
An allowed claim of a creditor secured by a lien on property on 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 … and is an unsecured claim to the extent that the value of such creditor’s interest … is less than the amount of such allowed claim.[74]
Suppose ML claim a lien of $400,000 on property worth $350,000. Section 506(a) says that ML holds a bifurcated claim that is secured for $350,000 and is unsecured for $50,000. [75] The meaning of § 506(d) is then supposed to be this: To the extent ML claimed a lien for the $50,000 unsecured claim, such lien was void.[76] Not voidable, mind you, but void[77]—a state of unbeing. Thus, where appreciation value accrues, ML would be capped at $350,000 and T could have the appreciation value. This legal result came to be known as lien stripping.[78]
The Supreme Court ended lien stripping in Chapter 7 cases in Dewsnup v. Timm.[79] The Dewsnup majority ruled that “allowed secured claim” means one thing when used in § 506(a). There, it means a claim capped by the value of the collateral. In our example, ML is a secured creditor for $350,000 under § 506(a)(1). But “allowed secured claim” means something else in § 506(d). In subsection (d), “allowed secured claim” means the pre-bifurcation claim of the secured creditor, as secured by a lien.[80] In our example, ML is a secured creditor for $400,000 under § 506(d).[81] As the Supreme Court would later put it:
Dewsnup considered several possible definitions of the term “secured claim” in §506(d). The definition it settled on—that a claim is “secured” if it is “secured by a lien” and “has been fully allowed pursuant to §502” …
Under the second meaning of “allowed secured claim, appreciation value belongs to ML, not to T or to D.
Assuming house value is $350,000, what if there are two mortgages? ML1 claims $400,000 and is underwater. ML2 claims $75,000 and is completely out of the money. Dewsnup protects ML1 but what about ML2? Again, referring to § 506(a)(1), ML2 has an allowed claim if she files a proof of claim. The allowed claim is “secured by a lien on property on which the estate has an interest … “But this claim is a secured claim only “to the extent of the value of such creditor’s interest in the estate’s interest in such property … .” Since value is zero, ML2 arguably has no secured claim at all. But ML2 has a lien, and T needs an avoidance theory to dispatch ML2’s lien. In Bank of America, N.A. v. Caulkett,[82] the Supreme Court ruled that, for purposes of § 506(d), ML2 is indeed a secured creditor under the Dewsnup definition. In chapter 7 cases, lien stripping is out by either T or D, even as against ML2.
In support of the Supreme Court’s result is a deeper inquiry as to what value is. In our hypothetical, house value was stipulated to be $350,000. So conceived, ML2 would indeed seem to have a secured claim worth zero, or perhaps we should say no “secured claim” at all on the wording of § 506(a)(1).[83] But in fact the $350,000 is a weighted average of all future outcomes. If we conceive of $350,000 as a function f(x), ML2 has a claim of positive value. In Figure 1, the value of ML2’s junior position is a positive amount, as illustrated by the shaded area between [b,x] on the abscissa.
The mathematical theory of probability fully supports the idea that Dewsnup protects ML2 as well as ML1.[84] Accordingly, when ML1 is under water, ML1 is the first to enjoy appreciation value accruing in a chapter 7 case.[85] ML2 is second. Where the home is exempt property, D is third, to the extent of ME. T benefits from the waterfall in fourth place.
In Wilson v. Rigby,[86] the Ninth Circuit held otherwise. D was limited to whatever value existed for D above ML1-2’s claims on bankruptcy day. Any appreciation value went first to ML1-2. D was passed over and T got a bonus on behalf of the unsecured creditors at the expense of D’s exemption. Whereas neither T nor D could “lien strip” ML of appreciation value, T was able to “exemption strip” against D.
In Wilson D filed a Schedule C claiming that her Washington condominium was worth $250,000. Since it was subject to ML’s claim of $246,244, D’s equity was worth $3,560. D elected the federal exemptions and used the “wildcard”[87] to protect her equity in a condominium. Three years later, appreciation value paid a call. The condo was now worth $412,500. D filed an amendment to Schedule C, switching her election to the state exemptions and claiming “100% of fair market value, up to any applicable statutory limit.”[88] The Wilson court ruled D was frozen at $3,560. Appreciation value could not fill out D’s monetary exemption. With ML fully funded, all appreciation value went to T.[89]
The Wilson court derived this result from the “snapshot” rule in White v. Stump.[90] But the derivation was erroneous. White involved a qualitative distinction—one that asks on bankruptcy day whether D has any exemption right or not. The Wilson court also took the snapshot rule to be a quantitative one. “This rule determines not only what exemptions a debtor may claim, it also fixes the value that a debtor is entitled to claim in her exemption,”[91]
The court felt the result reached was compelled by § 522(a)(2), which, once again, defines value to mean
fair market value as of the date of the filing of the petition or, with respect to property that becomes property of the estate after such day, the date such property becomes property of the estate.[92]
We have already seen that the Supreme Court has eliminated this provision in D-T relations, though, as we shall see,[93] it still mediates relations between D and JC. For the moment, it can be observed that the Wilson court applied the rule of § 522(a) to cap D’s exemption right, but it ignored the rule when T were to sell for an amount above ML+ME. The court allowed T in Wilson to have her cake and eat it too.
As it turns out, this use of § 522(a) would not apply to the usual monetary exemption enacted into state law. The Wilson court tied the result to the exact wording of RWC § 6.13.030, which at the time of Wilson read:
A homestead may consist of lands, as described in RCW 6.13.010, regardless of area, but the homestead exemption amount shall not exceed the lesser of (1) the total net value of the lands … as described in RCW 6.13.010, or (2) the sum of [$125,000] in the case of lands …[94]
The idea of the Wilson majority was that, under the Washington statute, D was only entitled to the lesser of equity on bankruptcy day or $125,000.
Shocked by this interpretation, the Washington legislature hastily amended RCW § 6.13.030 to read:
(1) A homestead exemption amount is the greater of:
(a) $125,000;
(b) the county median sale price of a single-family home in the preceding calendar year …[95]
Since D no longer is limited to the lesser of $125,000 or “total net value of the lands,” Washington bankrupts, after May 12, 2021, are entitled to the full benefit of the waterfall, free and clear of the wrongly decided Wilson opinion.
D. Avoidance Under § 522(f)(1)
D may have suffered money judgments prior to bankruptcy. Those money judgments may exist as liens on D’s home,[96] subject to D’s exemption.[97] Ordinarily, if D gets a discharge in bankruptcy, the discharge voids any judgment held by JC against the home,[98] provided JC’s claim was discharged. Discharge affects the judgment that proclaimed D’s in personam liability, but not the underlying judicial lien that may have attached prepetition.[99] Where prepetition judgment liens encumber the house, these survive D’s discharge. When appreciation value rears its head, these surviving judgment creditors would take the appreciation value once ML+ME is covered.
But D has the opportunity to capture any appreciation value back from these prepetition judgment creditors. According to § 522(f)(1)
the debtor may avoid the fixing of a lien on an interest of the debtor in property to the extent that such lien impairs an exemption to which the debtor would have been entitled under [§522(b)], if such lien is—
(A) a judicial lien, other than a judicial lien that secures a debt of a kind that is specified in section 523(a)(5) … [100]
Section 523(a)(5) in turn references domestic support obligations. What we are about to describe is not possible when JC is an aggrieved family member.[101]
We have seen that Dewsnup prevents lien stripping with regard to ML.[102] Oddly, what is not permitted to T or D under § 506(d) is fully invited by § 522(f)(1) with regard to judicial liens on the homestead. Section 522(f)(1) provides that D may avoid judicial liens on the home to the extent the judicial lien impairs the exemption. But § 522(f)(1) does more than allow D to avoid judicial liens on the home to the extent the judicial lien impairs the exemption. It allocates to D appreciation value above and beyond ML+ME that accrues after the bankruptcy petition.[103]
Now this was probably an accident. The legislative history to the 1978 Bankruptcy Reform Act is brief: § 522(f)
protects the debtor’s exemptions, his discharge, and thus his fresh start by permitting him to avoid certain liens on exempt property. The debtor may avoid a judicial lien on any property to the extent that the property could have been exempted in the absence of a lien …[104]
Section 522(f) was necessary to effectuate the new federal exemption option. A federally exempt item might arrive in the bankruptcy estate encumbered by a state judicial lien (where the item is not exempt under the relevant state law). So § 522(f)(1) removes the lien and allows for the federal exemption to take effect.[105] In some states homesteads are not exempt until D files a claim of homestead with the real estate recording office.[106] Where JC has a lien on the homestead prior to bankruptcy and D has recorded a homestead claim and then files for bankruptcy, § 522(f) permits D to snatch back the home from JC, as the Supreme Court showed in Owen v. Owen.[107]
On these occasions, § 522(f)(1) saves D from losing the exemption. But that is not all that § 522(f)(1) does. It is now a device by which D might deprive JC of postpetition appreciation value. Impairment is robotically defined in § 522(f)(2):
For the purposes of this subsection, a lien shall be considered to impair an exemption to the extent that the sum of—
(i) the lien;
(ii) all other liens on the property; and
(iii) the amount of the exemption that the debtor could claim if there were no liens on the property;
exceeds the value that the debtor’s interest in the property would have in the absence of any liens.[108]
For example, suppose D’s exemption is for $150,000. D owes $400,000 on a mortgage, and the court values the house at $500,000. Suppose further that JC claims $1 million. The impairment formula defines the quantity of avoidance by which D may cut down the size of the judicial lien. Thus
[the lien+other liens+exemption] -FMV of house impairment
[$1 million+$400,000 +$150,000]- [500,000] = $1.05 million
We must now set the $1.05 million impairment calculation to work on JC’s judicial lien securing the judgment for $1 million. Since the entire lien impairs the exemption the judicial lien is entirely avoided—with $50,000 of avoidance power left unused.[109] Later, when the case is closed, appreciation value belongs first to ML and then to D, but not to JC. D recovers the exemption amount ($150,000) — and more! JC has lost her place in the waterfall. Suppose value increases to $650,000. We would distribute this fund as follows:
| 1. | ML’s lien | $400,000 |
| 2. | D’s exemption | $150,000 |
| 3. | D’s surplus equity | $100,000 |
| $650,000 |
In this example, the amount of avoidance ($1.05 million) exceeds the amount of the lien, and so JC’s lien entirely disappears. We get a more efficient match-up of avoidance puissance and the judgment lien avoided where the judicial lien is smaller. Suppose JC claims $51,000. The three-term sum (ML+ME+JC) is now $501,000, which exceeds the appraised value of the house ($500,000). The excess gives D $1000 worth of avoidance. So, if value increases to $650,000, ML receives $400,000, D receives the exemption amount of $150,000, JC receives $50,000 and D receives surplus appreciation value that, under state law, JC would have received. We have the following priority:
| 1. | ML’s lien | $400,00 0 |
| 2. | D’s exemption | $150,000 |
| 3. | JC’s lien | $ 50,000 |
| 4. | D’s surplus equity | $ 50,000 |
| $650,000 |
JC appears in this list because only $1,000 of JC’s lien impaired D’s exemption. The rest ($50,000) impairs D’s equity but not D’s exemption.[110] Later, when the property is abandoned, JC sells for $250,000. D gets $200,000 (more than the exemption amount) and JC obtains $50,000 on her judgment of $51,000.
One obscure piece of knowledge concerns the fact that, when a lien is avoided, it does not just disappear. It is preserved.[111] According to § 551, “Any transfer avoided under section 522, 544, 545, 547, 548, 549, or 724(a) … , or any lien void under section 506(d) … is preserved for the benefit of the estate but only with respect to property of the estate.”[112] “[A]voidance is a misnomer … Preservation, not avoidance, should be the theme of fraudulent transfer’s tongue.”[113] Metaphysical philosophers will recognize here the Hegelian moment of Aufhebung[114] in § 551.[115]
The attentive reader will have noticed that § 551 applies to avoidance under § 522. Has the Bankruptcy Code pulled a mean trick on D? When D avoids JC’s lien under § 522(f)(1), does the lien go back to T for T to enforce or sell? By no means! By the time D is avoiding JC’s lien, the monetary exemption has been expelled from the bankruptcy estate. Preservation works “only with respect to property of the estate.”[116] When D pursues an action under § 522(f)(1), D seeks avoidance with respect to property that is not property of the estate.
But D still benefits from lien preservation pursuant to § 522(i):
Notwithstanding section 551 of this title, a transfer avoided under … subsection (f) … may be preserved for the benefit of the debtor to the extent that the debtor may exempt such property under subsection (g) or paragraph (1) of this subsection.[117]
The reference to subparagraph (g) is otiose here. Subparagraph (g) cancels lien preservation for the benefit of D where D has voluntarily conveyed away the exempt property. Subparagraph (g) does not apply because the attachment of JC’s judgment lien was D’s involuntary conveyance.[118]
What § 522(i)(2) says is that D subrogates to JC’s lien on D’s exempted home. Does this mean that preservation permits D to snatch appreciation value from senior ML? It does not. JC has no right to snatch that value from ML. D only gets rights that JC had, and JC could not prevent ML from taking appreciation value. Therefore, neither can D.
But the story is different if ML is junior to JC. In 1994, Congress saw fit to legislate into § 522 the dissenting opinion in In re Simonson.[119] In that case, the following priority arose (in rounded numbers):
| 1. | ML’s | $25,000 | |
| 2. | JC1 | $13,000 | Exemption = $7,500 |
| 3. | JC2 | $ 1,000 | Value of house = $58,000 |
| 4. | ML2 | $41,000 |
Simonson arose before the mechanical “impairment” test was enacted (1994). At that time, courts had to figure out, to their dismay, what impairment meant.[120]
According to the majority, JC1-2 did not impair the exemption because the combined mortgages of ML1-2 ($25,000+41,000=$66,000) exceeded the value of the house ($58,000). Therefore, the liens of JC1-2 continued to exist, and D obtained no benefit from the exemption ($7,500). This makes perfect sense. JC1 came into existence when D had $58,000$25,000=$23,000 in value. JC1 ($13,000) did not impair the exemption. JC1 impaired the surplus above the exemption. JC2 did impair the exemption. But D gave the exemption away to ML2 and so deserved nothing at the expense of JC2.[121]
Judge Edward R. Becker dissented, and Congress would endorse this dissent as the meaning of the 1994 amendments.[122] According to Judge Becker, D should be able to avoid part of JC1’s lien and the entirety of JC2’s lien. These liens are preserved, and D is subrogated to them. Therefore, after bankruptcy when the automatic stay has ended, ML1 can foreclose, and the proceeds are to be distributed according to this priority:
| 1. | ML1 | $25,000 |
| 2a. | JC1 | $ 6,500 |
| 2a. | D | $ 6,500 |
| 3. | D | $ 1,000 |
| 4. | ML2 | $41,000 |
Thus, D climbs into the shoes of JC2 and into the left shoe of JC1 to gain a priority over ML2.[123]
Suppose ML is under water and JC is completely out of the money. Many a D will despair of the utility of dispatching JC’s lien and so will not bring the avoidance proceeding, figuring that there is no profit in it.[124] The chapter 7 case is closed. The trustee abandons the property. Suppose, however, years go by and real estate prices skyrocket. JC now is poised to capture the appreciation value from D. Can D, years later, get rid of JC?
The surprising answer is yes. D can have the chapter 7 case re-opened for the purpose of bringing the § 522(f) avoidance. And when she does so, D will be able to use the degraded value of the home that existed on bankruptcy day.[125] Recall that D has an avoidance theory if the three-term sum (ML+ME+JC) exceeds “the value that the debtor’s interest in the property would have in the absence of any liens.” Value is a function of time. And § 522(a) provides “In this section … (2) ‘value’ means fair market value as of the date of the filing of the petition … “This means that D can reach back for a very low value, which will have the effect of obliterating JC’s current lien. Seemingly back into the money, JC can be expelled from the waterfall. Although we have seen that § 522(a)(2) is a dead letter in D-T relations, it is very much alive in D–JC relations. Strange but true!
In many cases, § 522(f)(1) captures appreciation value for D and deprives JC of it, contrary to the result that would occur under state law. But we must acknowledge the following absurdity bestowed upon us by the Supreme Court. Suppose JC has a judgment against D and D has no real property. Obviously, JC has no lien on anything because D has no property. But now suppose D buys a home in the county where JC’s judgment is docketed. In New York and many other states, JC’s judgment has a “dragnet” effect. The instant D takes title to the real property, JC’s lien attaches. D and JC are simultaneous takers.[126] When this occurs, § 522(f)(1) cannot be used against JC. Why not? According to § 522(f)(1), D “may avoid the fixing of a lien on an interest of the debtor in property” that the lien impairs. In the dumbfounding case of Farrey v. Sanderfoot,[127] JC’s lien never affixed itself to D’s home. Fixation, it seems, means that first D owns the land and then JC’s lien attaches. When D and JC are simultaneous takers, JC has a lien but not via “fixing.” And therefore § 522(f)(1) does not apply.[128] When JC claims D’s after-acquired property, JC owns appreciation value (to the extent of the judgment) and D does not.[129]
Who then owns appreciation value in chapter 7? First, ML owns it if ML is underwater. D is next for ME. If § 522(f)(1) whittles down (or does not affect) JC, JC is third. Beyond that D owns the surplus. Although § 522(f)(1) aims at preserving the monetary exemption, it actually does more for D. It enables D to take appreciation value away from JC. D gets an extra-fresh start.
Part II. Chapter 13
In chapter 13, everything changes. From the beginning, a chapter 13 debtor is entitled to possess the house as licensee of the bankruptcy estate. In the pre-confirmation period, § 1306(b) establishes D’s right of possession: “Except as provided in a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate.”[130] The chapter 13 trustee cannot sell. Sales out of the ordinary course are governed by § 363(b), but § 1303 informs us that “the debtor shall have exclusive of the trustee, the rights and powers of a trustee under sections 363(b), 363(d), 363(e), 363(f), and 363(l) …”[131] D may sell the house with court permission, but T may not. This describes D’s rights in the house prior to confirmation of a plan.
Chapter 13 ultimately invites D to buy back property of the chapter 13 estate, including the house. Upon confirmation of the plan the bankruptcy estate is usually transferred from T back to D.[132] D in effect buys the house back from T with postpetition wages, which, in a chapter 7 case, would not have been property of the estate.[133] This may be described as “the basic chapter 13 bargain.”[134]
A. Mortgages in Chapter 13
1. Underwater First Priority Mortgages
When dealing with nonresidential mortgages in chapter 13, such a mortgage, if underwater, can be stripped down and capped. Dewsnup v. Timm prohibits D’s use of § 506(d) to strip down a mortgage in chapter 7 cases. But chapter 13 operates on an entirely different set of principles that in no way relies on § 506(d).[135] Suppose the nonresidential property is valued at $350,000 and ML1’s total claim is for $400,000. According to § 506(a)(1), ML1 is a secured creditor for $350,000 and is an unsecured creditor for $50,000. Under chapter 13 D may write a plan that “crams down” ML1. D must pay ML1 enough dollars over the life of a plan such that present value of the payments (according to a market rate of interest)[136] equals $350,000.[137] D can treat the $50,000 deficit as an unsecured claim. Who owns any appreciation value that arises after confirmation of a chapter 13 plan? That is controversial, but it does not belong to ML1, so long as the chapter 13 case continues and is completed.
Argus-eyed from the first, the home mortgage industry saw the danger of cram-down. It therefore insisted upon and got special treatment. Section 1322(b) is a list of things a chapter 13 can accomplish. Subsection (b)(2) invites debtors to “modify the rights of holders of secured claims.” But the mortgage industry obtained a prohibition arising in the middle of this permission. A plan may not modify “a claim secured only by a security interest in real property that is the debtor’s principal residence … .”[138]
Section 1322(b)(2) governs the mortgage going forward. Looking backward, if D entered the bankruptcy in arrears, the cure price may be paid within “a reasonable time.”[139] Thus, by the time the plan has been completed, the cure has been accomplished and the mortgage continues forward after the plan is finished.[140] Cram down of the senior home mortgage is not possible in a chapter 13 case.
Debtors have chafed under this prohibition against cramming down the home mortgage and have launched sneak attacks on ML1. For example, if ML1’s mortgage covered wall-to-wall carpeting, then § 1322(b)(2) did not apply, since carpet is personal property and § 1322(b)(2) required ML1 to be secured “only by a security interest in real property.”[141] The Bankruptcy Abuse Prevention and Consumer Protection Act[142] probably put an end to this subterfuge in 2005.[143]
A most prominent subterfuge was the assertion by D that, under § 506(a)(1), ML1 is a secured creditor only for $350,000. Therefore, D could write a plan that honors the mortgage agreement with the proviso that mortgage principal is lowered to $350,000. The plan had to preserve monthly payments at the contractual interest rate, but when those payments retired $350,000 worth of principal, the mortgage lien was discharged.[144] This was odd. A chapter 13 debtor craves financial relief immediately. The subterfuge gave relief a decade or more down the road, by terminating the payment stream slightly early.
The Supreme Court in Nobelman v. American Savings Bank,[145] put an end to this subterfuge. ML1 may be a secured creditor for $350,000 under § 506(a)(1), but ML1 had the right to be paid $400,000, and § 1322(b(2) prohibits modifying this or any other right of ML1.
Since Nobelman, it has been clear that first-priority home mortgages may not be capped or bifurcated in chapter 13. Thus, where D’s house is valued at $350,000 and ML1 claims $400,000, the plan must leave unmolested ML1’s right to be paid the full amount owing pursuant to the mortgage agreement. This guarantees that ML1 is in the first position in the chapter 13 waterfall engendered by appreciation value.
2. Second Mortgages Out of the Money
In our example, the house is worth $350,000 and ML1 claims $400,000. ML1 is underwater. Suppose there is also ML2, claiming $75,000 and therefore is completely out of the money, since ML1 takes all the value ($350,000). We have seen that in chapter 7 cases, D cannot rid herself of ML2’s mortgage lien.[146] But in chapter 13, a theory sprang up whereby ML2 could be capped at zero, even though ML1 cannot be capped at all. As it now stands, ML2 can be expelled from the waterfall.
Section 1322(b)(2) invites a plan to “modify the rights of holders of secured claims,” but not a claim secured” by a residential mortgage. Recall that § 506(a)(1) provides: “An allowed claim of a creditor secured by a lien on property on 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 … .” According to the vast weight of authority, ML2 is not the holder of a secured claim (even though ML2 has a mortgage which could be foreclosed under state law). Under § 506(a)(1), ML2 has a secured claim to the extent of the value available to her, which is zero. A secured claim for zero is supposedly not a secured claim at all. Therefore, ML2 is not protected by § 1322(b)(2). ML2’s claim is an allowed unsecured claim (even though ML2 has a mortgage lien).[147] ML2 can be “stripped off.”[148] Six courts of appeal have blessed this theory.[149]
Is this theory still viable after the Supreme Court’s ruling in Bank of America, N.A. v. Caulkett?[150] As a caveat, Dewsnup dropped the following footnote: “Accordingly, we express no opinion as to whether the words ‘allowed secured claim’ have different meaning in other provisions of the Bankruptcy Code.”[151] Therefore, the Supreme Court has reserved the right to define “allowed secured claim” in § 1325(a)(5) to exclude ML2’s out-of-the-money” claim. If so, ML2 is not entitled to the § 1322(b)(2) protection and can be treated as an unsecured creditor.
I assume here that § 506(d) is irrelevant to the operation of chapter 13. Not everyone agrees.[152] Caulkett and Dewsnup are interpretations of § 506(d). But chapter 13 bifurcation works independently of § 506(d).[153] In a chapter 13 case, should a court ignore Dewsnup and rely solely on the definition of § 506(a)?
a. Hints from the Supreme Court
Nobelman v. American Savings Bank[154]has contradictory things to say about this question. In Nobelman, decided a year after Dewsnup, the Supreme Court implied at one point that § 506(a)(1) supplies the chapter 13 definition, at least when reading § 1322(b)(2) as it applies to ML1. In describing D’s argument that ML1 could be written down to $350,000, Justice Thomas remarked that D was
correct in looking to § 506(a) for a judicial valuation of the collateral to determine the status of the bank’s secured claim. It was permissible for petitioners to seek a valuation in proposing their Chapter 13 plan, since § 506(a) states that “such value shall be determined … in conjunction with any hearing … on a plan affecting such creditor’s interest.” But even if we accept petitioners’ valuation, the bank is still the “holder” of a “secured claim,” because petitioners’ home retains $23,500 of value as collateral. The portion of the bank’s claim that exceeds $23,500 is an “unsecured claim component” under § 506(a)[.][155]
This passage says that § 506(a) supplies the definition of “allowed secured claim.”[156] Under that definition, ML2 is not a secured creditor.
Yet at another point in his opinion, Justice Thomas implies that the Dewsnup meaning applies, so that ML2 is fully entitled to § 1322(b) protection. In this passage, Justice Thomas ponders the relation of “secured claim” to “claim secured,” as that phrase appears in § 1322(b)(2):
Petitioners urge us to apply the so-called “rule of the last antecedent” … According to this argument, the operative clause “other than a claim secured only by a security interest in … the debtor’s principal residence” must be read to refer to and modify its immediate antecedent, “secured claims.” Thus, § 1322(b)(2)’s protection would then apply only to that subset of allowed “secured claims,” determined by application of § 506(a), that are secured by a lien on the debtor’s home … We acknowledge that this reading of the clause is quite sensible as a matter of grammar. But it is not compelled. Congress chose to use the phrase “claim secured … by” in § 1322(b)(2)’s exception, rather than repeating the term of art “secured claim.” The unqualified word “claim” is broadly defined under the Code to encompass any “right to payment, whether … secure[d] or unsecured” … . It is also plausible, therefore, to read “a claim secured only by a [homestead lien]” as referring to the lienholder’s entire claim, including both the secured and the unsecured components of the claim. Indeed, § 506(a) itself uses the phrase “claim … secured by a lien” to encompass both portions of an undersecured claim.
This latter interpretation is the more reasonable one … .[157]
This part of the Nobleman opinion suggests that the Dewsnup definition applies in chapter 13. ML2 has a claim and it is secured, meaning that Dewsnup and Caulkett apply after all![158]
It is therefore impossible to tell from Supreme Court opinions whether § 506(a)(1) defines “secured claim” or not.[159] A great many courts cite the first part of Nobelman to justify stripping off ML2.[160] They mostly ignore the second part, which implies that ML2 is protected by § 1322(b)(2).[161]
In Zimmer v. PSB Lending Corp. (In re Zimmer),[162] the court noted the contradiction in Nobelman and reasoned that the first remark (§ 506(a) definitions apply) outranks the second remark (§ 1322(b)(2) refers to the lien for both ML1’s secured and unsecured claims). First, ML1 had to qualify for secured claim status under § 506(a).
Finally, and only after determining that the creditor was the holder of a secured claim is a secured claim and thus eligible for anti-modification protection, the Court proceeded to the question of exactly what was entitled to such protection. The Court found that the rights of such a creditor were protected and, therefore, in order to protect such rights interpreted the antimodification clause to encompass the entire claim of such a creditor so long as it was secured by a homestead lien.[163]
Any attempt to Dewsnup ML2’s out-of-the-money lien
attempts to jump forward to the last step in this analysis—determining what is entitled to protection from modification—without considering whether the creditor even qualifies for such protection in the first place. While it is clear that the term “claim secured only by” in the antimodification clause is not limited to “secured claims,” it is equally clear that “holders of secured claims” does refer to the term of art as defined by § 506(a). The Nobelman Court recognized this when it pointed out that Congress used a different phrase in the antimodification clause “rather than repeating the term of art ‘secured claim.’”[164]
On this reading, Nobelman blesses strip-off of ML2. The Dewsnup afterthought may be disregarded.
b. The Role of § 506(d) in Chapter 13
I have said that § 506(d) has no role to play in bifurcating undersecured claims in chapter 13. When bifurcation is appropriate, it is enough that the secured claim is entitled to cram down protection under § 1325(a)(5). Cram down requires that ML receive the value of the collateral. The unsecured portion of ML’s claim deserves no cram down rights and is entitled to equal treatment with other nonpriority claims.[165] This treatment requires distributions at least equal to what the unsecured claim would have received in a chapter 7 liquidation,[166] and (if someone objects to plan confirmation) a plan that compels D to pay projected disposable income over the applicable commitment period.[167]
This raises the question: why did the drafters of the Bankruptcy Code bother writing §506(d) in the first place? This is rather hard to say. Being a chapter 5 provision, § 506(d) applies in chapter 7 and in chapter 13.[168] But it isn’t needed in chapter 13 or in the other reorganization chapters. It was clearly intended to apply in chapter 7, which certainly suggests Dewsnup was wrongly decided (as is very widely believed).
One view of Dewsnup is that it stands for the proposition that § 506(d) means one thing in the reorganization chapter and another thing in chapter 7. The general meaning of § 506(d) is that ML’s lien on a nonresidential property does not secure the allowed unsecured claim. But, says the Dewsnup majority, this meaning is suspended in chapter 7 cases because its application there would disrupt prepetition practice. Therefore, § 506(d), as interpreted by the Dewsnup dissenters, is alive and well in chapter 13.[169]
In In re Victorio,[170] Judge Peter W. Bowie opines that Dewsnup implies that § 506(d) means one thing in chapter 7 and another thing in chapter 11 or 13 because Justice Blackmun thought Congress did not intend to upset existing practice. Strip-downs were never recognized in chapter VII cases under the Bankruptcy Act of 1898, but could be accomplished in the reorganization chapters. Judge Bowie drew this from two cases cited by Justice Blackman: Long v. Bullard,[171] for chapter 7 cases, and Louisville Joint Stock Land Bank v. Radford,[172] for reorganization cases. Bullard stands for the proposition that there could be no strip-down in liquidations.[173] Radford stands for the proposition that strip-down can be achieved in reorganizations.[174] Thus the “true” definition of § 506(d) favors strip-down. But this definition is to be suppressed in chapter 7 cases.[175]
In Woolsey v. Citibank, N.A. (In re Woolsey)[176] the court held that under § 506(d) D could not strip off ML2 in a chapter 13 case because the Dewsnup definition carried over to chapter 13 cases. D had claimed that:
Dewsnup controls the meaning of the term “secured” under § 506(d) only in Chapter 7 cases. The very same term in § 506(d), they contend, should be given an entirely different meaning when it comes to handling Chapter 13 cases—requiring proof of value to avoid lien removal, just as the plain language of § 506(a) suggest.[177]
The Woolseys invite us to hand Dewsnup a loss even on its home court, within § 506(d) itself … The Woolseys say, we should go now a step further and read the term “secured claim” to mean two different things even within § 506(d) itself. When a Chapter 7 case comes along, they say, the term should mean what Dewsnup says it means: any claim secured under state property law is protected from removal, even if backed by no value. But when a case is faced with a Chapter 13 case, they argue, the term should be read to require proof of value before a lien is protected from removal in accord with § 506(a). [178]
Distressed with the methodology of Dewsnup, Judge Gorsuch proclaimed himself tempted by D’s argument,[179] but in the end he concluded that it supposedly conflicted with the rule that a court must not give the same words a different meaning for each category of cases to which they apply.[180] This is an not effective argument. We are trying to figure out what chapter 13 means for ML2. This is not a case of a statute meaning one thing for one fact pattern and another thing for another fact pattern. We are not changing the meaning of chapter 13 when the case involves bungalows v. split-levels. We’re just trying to apply § 506(d) in chapter 13 generally.
Disturbingly, Woolsey pretty much endorsed the view that strip off does not require § 506(d), but D did not argue for this. In his brief, D stood on the § 506(d) argument. Although D deserved to win, he did not deserve to win on the meaning of § 506(d). Apparently, D was being graded on the quality of their lawyer’s brief, not on whether justice was done when the bankruptcy court refused to strip off ML2.
In the end there is no reason to think that bifurcation of ML2 down to zero is barred by Dewsnup, because § 506(d) is not necessary for cram down in chapter 13.
c. Theater of the Absurd
If ML2 is not protected by § 1322(b)(2), absurdity ensues. ML2 still has a lien.[181] ML2 can foreclose on this lien under state law, dispossessing D in favor of some buyer (perhaps ML2 who may bid in for a dollar). Under state law, ML2 is a creditor with a security interest. Yet in bankruptcy, ML2 is not a secured creditor. But as Woolsey reminds us, in the world of definition, the author is king. Section 506(a):
explains that for purposes of federal bankruptcy law a ‘secured claim’ requires something more than a security interest recognized by state law. A claim, even if secured by a valid state law lien on property, qualifies as “secured” for purposes of § 506(a) … only to the extent it is support by value in the collateral.”[182]
“Secured claim” is a term of art,[183] quite divorced from ordinary usage. Similarly, in marginal cases, ML2’s mortgage exists, or does not exist, according to the whim of the valuer. To borrow a point from Justice Thomas in Caulkett,[184] suppose the property is worth $400,001 and ML1 claims $400,000. ML2 has a secured claim to the extent of a dollar. The rights of ML2 cannot be modified. Suppose on the morning of the confirmation hearing, D throws a brick through her basement window, which costs $25 to repair. A buyer would reduce her bid by $25 cover the cost of repair and so would pay $399,976, ML2 has just lost her mortgage—an absurdity not absolutely compelled by the § 506(a) definition. Thus, if absurdity is a reason to guard ML2 from 506(d) avoidance in chapter 7 cases, it becomes a reason to think that ML2 is entitled to § 1322(b)(2) protection, which also stamps out the absurdity.[185] In any case, recall that if we conceive value as a probability distribution, ML2’s interest always has some positive value.[186] Mathematics teaches that ML2’s claim is an option. It always has positive value.
Absurd it may be. But so far all courts of appeal agree that ML2 gets no protection, and no court has concluded that Caulkett changes the chapter 13 rule.[187]
B. Chapter 20 Cases
A strange theory, ultimately incorrect, has emerged in chapter 20 cases that saves ML2. In a chapter 20 case, D has filed for chapter 7, has obtained a discharge and then promptly (often one day later)[188] files in chapter 13. According to this theory, ML2 is admittedly subject to strip-off where D is entitled to a chapter 13 discharge. But ML2 is immune to strip-off where D is not entitled to a chapter 13 discharge.[189] At first blush, this is surprising. Since 1886, it has been understood that bankruptcy discharge does not affect a mortgage lien.[190] The only thing a discharge implies is that ML is a nonrecourse creditor.[191] How can a discharge affect ML2’s lien (if it exists)?
Prior to BAPCPA, any D who completed a chapter 13 plan was entitled to discharge. In contrast, chapter 7 heavily restricts discharges. If D misbehaves by hiding assets or destroying financial records, D loses the discharge.[192] Not being an honest unfortunate debtor means a debtor does not deserve it in chapter 7. But apparently in chapter 13 the issue of a debtor’s dishonesty is not relevant to obtaining a discharge.[193]
Since BAPCA, this is not exactly true. According to § 1328(f) (added by BAPCPA):
the court shall not grant a discharge of all debts provided for in the plan or disallowed under section 502, if the debtor has received a discharge-
(1) in a case filed under chapter 7 … during the 4-year period preceding the date of the order for relief under this chapter, or
(2) in a case filed under chapter 13 of this title during the 2-year period preceding the date of such order.[194]
Suppose D filed for chapter 7 on July 1, 2018, and received a discharge on November 1, 2019. In any chapter 13 case commenced before July 1, 2022, D may not obtain a chapter 13 discharge.[195] Of course, in a chapter 20 case,[196] D arrives in chapter 13[197] already discharged in chapter 7 from any in personam rights ML2 might have. In chapter 7, D’s in personam obligation to ML2 is discharged but, under Caulkett[198], ML2’s mortgage lien still lives and reigns. Only when that lien is gone can D count his gains.
Continuing with the chapter 20 theory, ML2 may be stripped off in a chapter 13 plan because ML2 has no secured claim for the purpose of § 1322(b)(2). But, says our theory, ML2 is nevertheless entitled to cram down protection. Cram down protection applies to “each allowed secured claim provided for by the plan ….”[199] Here is the weak point of the theory. The theory concedes that “secured claim” is defined so as to deny ML2 the protection of § 1322(b)(2). For § 1322(b)(2) purposes, ML2 is not a secured creditor. But for § 1325(a)(5) purposes, ML2 is the holder of a secured claim. Carrying the day in the Tenth Circuit is the theory that maintains the meaning of “secured claim,” a fickle changeling and poor discontent, capriciously dissembles from section to section in chapter 13.[200]
But we haven’t yet articulated the full theory. Assuming we can hustle past the unsteady footing of this the weak point, ML2 is supposedly a secured creditor for cram down purposes. Traditionally, this always included the right to receive future payments whose present value equal to the value of the secured claim. For ML2, this is zero, and so far cram down protection is useless. Under BAPCPA, however, ML2 is entitled to something else. The plan must provide that:
the holder of such claim retain the lien securing such claim until the earlier of
(aa) the payment of the underlying debt determined under nonbankruptcy law; or
(bb) discharge under section 1328 … [.][201]
In our hypothetical, ML2’s prebankruptcy claim is $75,000, and it will be receiving not a penny, because this liability was discharged in chapter 7. But D is disentitled to a discharge from claims held by other unsecured creditors. Therefore, ML2’s lien continues to exist—now and forever. The chapter 7 discharge never affected the enforcement of this lien against the property, it only served to relieve the debtor’s personal liability for payment. Nor could a chapter 13 discharge (of unsecured creditors other than ML2). But the inability of D to get a chapter 13 discharge generally signifies that ML2 retains the lien until “payment of the underlying debt determined under nonbankruptcy law.” ML2 survives to recapture appreciation value after completion of the plan. In short, ML2 regains all the protections under § 1325(a)(5) that were not available under § 1322(b)(2). Weirdly, this works only in those chapter 20 cases where § 1328(f) applies. In ordinary chapter 13 cases and even in some chapter 20 cases, ML2 can be stripped off.
The theory just expressed should be rejected. Recall that chapter 13 bifurcations do not require an assist from § 506(d). Rather, a secured party’s (SP’s) prepetition security interest is displaced by the chapter 13 plan.[202] We know this from § 1327(a): “The provisions of a confirmed plan bind the debtor and each creditor … “The plan says that SP has a security interest for some bifurcated amount. Under the plan, SP must receive a present value of that amount. Once the plan is complete, SP has been paid and the security interest is extinguished.[203] A similar point can be made about § 1327(c), which states:
Except as otherwise provided in the plan or in the order confirming the plan, the property vesting in the debtor under subsection (b) of this section is free and clear of any claim or interest of any creditor provided for by the plan.”[204]
As retired judge Professor Bruce A. Markell emphasized in In re Okosisi,[205] “interest” (undefined) must mean ML2’s mortgage lien. Therefore, once the plan is confirmed, ML2’s lien is dead.[206] Thus, prior to BAPCPA, the retirement of SP’s lien had nothing to do with receiving a chapter 13 discharge.[207] The same conclusion follows after BAPCPA.
In a pre-BAPCPA case, the Ninth Circuit in In re Leavitt[208] pondered a dismissal of a chapter 13 case for cause. In the course of its ruminations, the Leavitt court stated in passing, “A Chapter 13 case concludes in one of three ways: discharge pursuant to § 1328, conversion to chapter 7 case pursuant to § 1307(c) or dismissal of a Chapter 13 case ‘for cause’ under § 1307(c).”[209] This statement was entirely accurate in 1999. If the plan was completed, a discharge had to follow. But BAPCPA rendered the Leavitt trilemma inaccurate. Today, a chapter 13 case can be commenced with no hope of discharge. Yet the plan might be completed and then the case might be closed (without a discharge).[210] Closure without discharge was a fourth option for killing off ML2’s out-of-the-money lien.[211]
In In re Victorio,[212] vigorously disagreed with this fourth option and insisted the Leavitt dictum still held, even after BAPCPA. The Ninth Circuit would soon side with Judge Markell: there is indeed a fourth option for ending a chapter 13 case—closure without discharge.[213] Accordingly, ML2 can be stripped off in chapter 20 cases.
Why, then, did BAPCPA add a duration term (the italicized language above) to the retention term? This requires an excursus into automobile lending. Whereas the home mortgage industry was alert to cram down at the dawn of the Bankruptcy Code, the car lenders were asleep at the wheel. Car loans could be crammed down, and the unsecured deficit was to be treated as an unsecured claim.
That was bad enough. But chapter 13 practice heaped more indignities upon the house of car lenders. One “abuse” D used to perpetrate prior to BAPCPA was to sponsor a plan in which D front-loaded payment to a secured party (SP), so that SP’s lien (for $10,000, say) disappeared through payment. The plan then required SP to release the lien on the car, so that D owned the car free and clear.[214] Once that was accomplished, D would convert the chapter 13 case to chapter 7, where SP was entirely unsecured. D would stop paying in wages for the benefit of unsecured creditors, and SP wound up in chapter 7 with no lien on the valuable car and, for the unsecured deficit, a pro rata claim to basically nothing.
Accordingly, BAPCPA cram-down requires that SP retain the lien even after the $10,000 was paid. BAPCPA added these extra words in § 1325(a)(5)(b)(i)(II):
if the case under this chapter is dismissed or converted without completion of the plan, such lien shall also be retained by such holder to the extent recognized by applicable nonbankruptcy law.
This language shows that SP’s $10,000 lien survives receipt of $10,000. But it does come to an end. The lien goes poof when the plan is completed. So, returning back to the mention of discharge in § 1325(a)(5)(b)(i)(I)(bb), this was just BAPCPA’s way of saying SP’s lien exists until the plan is completed. Prior to BAPCPA, completion of the plan always ended in discharge. There was no real desire to say that strip-off of ML2 becomes impossible in chapter 20 cases.
In Branigan v. Davis (In re Davis),[215] the Fourth Circuit, over a dissent, blew up the chapter 20 theory, not on the irrelevance of discharge, but at the weak point previously identified—second mortgages entirely out of the money are not secured claims within the meaning of § 1325(a)(5).[216] According to the Fourth Circuit, § 506(a) applies universally in chapter 13. This is what Nobelman supposedly holds. Therefore, ML2 is not entitled to § 1322(b)(2) protection nor to cram-down protection. Section 1325(a)(5) does not apply.[217] The plan need not require that ML2 retain her lien (even though she has one).
But the Branigan majority overlooks a series of cases that do indeed confirm that the Dewsnup definition applies to cram-down. According to the Tenth Circuit, § 1322(b)(2) follows § 506(a)(1).[218] The Dewsnup definition, however, applies to § 1325(a)(5) cram-down.[219]
To see why the Tenth Circuit resorted to Dewsnup for cram-down, we have to return to the grievances of car lenders. In the negotiations leading up to BAPCPA, car lenders complained that D was frequently buying a new car and then promptly driving it straight to chapter 13, where the car security interest was instantly underwater. There, D could write down the car debt to the value of the luxury car, which was typically far south of the purchase-price-minus-down-payment.
To combat this abuse, the car lenders wrote the notorious “hanging paragraph”—a free-floating paragraph that hangs like a spider at the bottom of § 1325(a). According to the last sentence in §1325(a):
For purposes of paragraph (5), section 506 does not apply to a claim described in that paragraph if the creditor has a purchase money security interest securing the debt that is the subject of the claim, the debt was incurred within the 910-day [sic] preceding the date of the filing of the petition, and the collateral for that debt consists of a motor vehicle (as defined in section 30102 of title 49)[220] acquired for the personal use of the debtor, or if collateral for that debt consists of any other thing of value, if the debt was incurred during the 1-year period preceding that filing.[221]
This dumbfounding sentence basically means that car loans cannot be bifurcated. Rather, we are to pretend that the car is worth whatever the car debt is. For example, suppose the new car (bought less than 910 days before the bankruptcy petition) is worth $10,000 and the car debt is $40,000—plausible numbers if the car has been banged up in a collision. If D wants to keep the car, D will have to pay future wages with a present value of $40,000.[222] If § 506(a)(1) had applied, the car lender would be entitled to $10,000 only. The $30,000 deficit becomes an unsecured claim perhaps getting pennies on the dollar.
Cram down has always given D a “surrender” option. According to § 1325(a)(5)(B), D can pay $40,000 for a 910-vehicle worth $10,000. Alternatively, under § 1325(a)(5)(B), D can surrender the car. Early on, D figured that, under the hanging paragraph, the car was deemed worth $40,000. So, surrendering the car was an “asset payment” extinguishing SP’s $40,000 claim in full. The car lender has lost the unsecured claim of $30,000 in exchange for a car worth $10,000. The car lender has been outfoxed.
Car lenders argued against this turnabout, fair play though it seems to have been. In DaimlerChrysler Financial Services Americas LLC v. Ballard (In re Ballard),[223] the Tenth Circuit ruled that, where D intends keep the car, bifurcation is not allowed, but where D intends to surrender the car, the car claim must be bifurcated. D can surrender the car as an asset payment on the $10,000 secured claim. But SP retains the unsecured claim of $30,000. In so ruling, the court found itself saying:
In addition, nothing in § 1325(a)(5) suggests that § 506(a) determines the meaning of the phrase “allowed secured claim in that section. In the absence of express language linking the meaning of “allowed secured claim” in § 1325(a)(5) to § 506(a), the most natural reading of the phrase is that it describes a claim that is both ‘allowed’ under the Bankruptcy Code and ‘secured’ by a lien … Thus, the phrase ‘allowed secured claim” in § 1325(a)(5) simply means a claim that is allowed under § 502 and is secured by a lien under state law.”[224]
Dewsnup thus supplies the definition of “secured claim” for § 1325(a)(5), according to the Ballard court.
We seem to have a circuit split. The chapter 20 theory requires the Dewsnup definition for cram-down.[225] In the Tenth Circuit the chapter 20 theory carries the day. Of course, we have rehearsed a theory under which ML2 can be crammed down to zero, regardless of whether “secured claim” takes on the Dewsnup meaning in § 1325(a)(5). Even if the Tenth Circuit is right that ML2 is a secured creditor for cram-down purposes, ML2’s lien waves farewell if the plan is completed, even where D in a chapter 20 case is entitled to no discharge. We do not presently need to know what “secured claim” means for cram-down purposes.
According to the court in In re Tran,[226] it is bad faith to strip off ML2 in a chapter 20 case, because to do so is simply a subterfuge of Dewsnup in chapter 7.[227] In Tran, D’s plan had minor goals, such as paying D’s chapter 13 attorney and curing defaults on ML1’s mortgage. The main goal was to strip off ML2.[228] Doing what the Bankruptcy Code expressly invites was found to be bad faith. Accordingly, some courts think that D must show other parts of the plan have significant utility, in which case the strip-off, otherwise in bad faith, will be tolerated.[229]
To summarize, in chapter 7 cases, ML2 has a place in the appreciation value waterfall. In chapter 13 cases, however, ML2 can be stripped off, thereby enriching D or perhaps the unsecured creditors. Which of these benefit from the strip-off? We now supply a most complicated answer.
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Part III will appear in the next issue of the American Bankruptcy Law Journal and will cover allocation of appreciation value in homesteads between the debtor and unsecured creditors in chapter 13 and in converted chapter 7 cases.