Mortgage lien stripA very recent opinion from the Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”) establishes the legitimacy of something I have been doing in Chapter 20 cases.  It’s nice to know I was right all along.  This post brings you up to speed on the good news for debtors in the BAP case.  A bit of background will help to put the case into its proper perspective.

If you are new to bankruptcy practice, and have given the Bankruptcy Code a cursory glance, you might think I am out of my mind referring to a Chapter 20 bankruptcy in the tile to this post.  After all, the Code doesn’t even have a Chapter 20.  (Whether or not I am out of my mind is best left to the many voices in my head to determine.  What did you say?  Are you calling my dog a liar?)  The term, “Chapter 20” is used by bankruptcy attorneys to refer to a Chapter 7 followed by a Chapter 13.  Since 7 + 13 = 20, Chapter 20 is used as a short hand.


I.  Reasons For Doing A Chapter 20


Since Chapter 7 discharges most debts without the debtor having to make any payments to creditors, why would anyone want to do a Chapter 20?  One reason lies in 11 U.S.C. § 109(e)’s debt ceilings (I have corrected the dollar amounts, which haven’t been updated at the linked site for quite some time.):

Only an individual with regular income that owes, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts of less than $383,175 and noncontingent, liquidated, secured debts of less than $1,149,525, or an individual with regular income and such individual’s spouse, except a stockbroker or a commodity broker, that owe, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts that aggregate less than $383,175 and noncontingent, liquidated, secured debts of less than $1,149,525 may be a debtor under chapter 13 of this title.

Based on this Code section, if a debtor has more than $383,175 in noncontingent (i.e., doesn’t depend on a triggering event for its validity), liquidated (i.e., the dollar amount of the debt is certain), unsecured (i.e., there is no collateral securing the debt) debt, then Chapter 13 is unavailable.

Since Chapter 7 has no debt ceilings (though it does have income ceilings, which can be made precise using 11 U.S.C. § 707(b)), the debtor can first do a Chapter 7 to get rid of as much unsecured debt as possible, and then do a Chapter 13 to deal with debts that weren’t discharged in the prior Chapter 7, or to catch up on a delinquent mortgage.


II.  Secured Debts In Chapter 7


A.  Secured Debts


Some vocabulary is helpful to understanding the treatment of secured debts in a Chapter 7 bankruptcy.  A simple example will suffice to set the stage.  When a person takes out a loan to purchase a car, two important things happen:


1.  In Rem Claims


First, the creditor gets a security interest in the car, meaning that if the debtor doesn’t make the payments, the creditor can repossess the car.  Thus, the creditor has a claim against the car.  In law, this kind of claim is known as an in rem claim – a claim against a thing.


2.  In Personam Claims


Second, if the creditor repossesses the car after a loan default and resells it for less than the debtor owes, the debtor is personally liable for the post-resale deficiency, and the creditor can sue the debtor to collect it.  Thus, the creditor has a claim against the debtor – the person.  In law, this kind of claim is known as an in personam claim – a claim against a person.


B.  Bankruptcy’s Effect On In Personam Liability


In any bankruptcy, if a debt is of the dischargeable variety then the bankruptcy discharge wipes out the in personam claim against the debtor – even if the debt was a secured debt.

However, if the debt in question was a secured debt, then the bankruptcy discharge does not extinguish the in rem claim against the collateral.  In other words, the debtor will not end up with a free car or house as a result of bankruptcy.

This means that if the debtor receives a discharge and subsequently defaults on the secured debt, the creditor can repossess the collateral securing the debt.  However, if the creditor resells the collateral for less than the current balance on the loan, the debtor has no personal liability on the shortfall.  This fact is very important to the understanding of the recent BAP case I mentioned at the beginning of the post.

By the way, if the collateral is NOT real estate, the creditor can insist that the debtor resurrect the in personam liability as a condition for keeping the collateral.  This resurrection process is called reaffirmation.  For a detailed discussion of reaffirmation, please see my December 15, 2011, post.  Although the Bankruptcy Code allows a creditor to insist on reaffirmation if the collateral is not real estate, a debtor is not required to reaffirm a mortgage debt.  And in the Central District of California, most of the judges will not approve a mortgage reaffirmation agreement unless the terms of the reaffirmation are a significant improvement over the pre-reaffirmation terms.


III.  The BAP Case: Free v. Malaier


A.  Stripping Off A Wholly Unsecured Second Mortgage


Suppose that the current value of a Chapter 13 debtor’s home is less than the current balance on the first mortgage, making the second mortgage de facto unsecured.  Then the debtor can strip off the wholly unsecured second mortgage pursuant to In re Zimmer, 313 F.3d 1220 (9th Cir. 2002) and treat the stripped off debt as unsecured for Chapter 13 plan purposes.  (Unfortunately, the second mortgage cannot be stripped off in a Chapter 7 bankruptcy.  See Bank of America, NA v. Caulkett, 135 S. Ct. 1995 (2015).)

Now suppose the Chapter 13 debtor went through a Chapter 7 prior to filing the Chapter 13.  Then the in personam liability on the second mortgage was discharged in the Chapter 7.  What happens to the unsecured stripped off lien in the Chapter 13?  Does the unpaid balance go into calculating either the unsecured debt, or the secured debt, for 11 U.S.C. § 109(e) purposes?  Does the debtor have to pay something on the debt through the Chapter 13 plan?  These questions are answered in Free v. Malaier, BAP No. WW-14-1395-JuKiF (B.A.P. 9th Cir. Dec. 17, 2015).


B.  The Effect Of A Prior Chapter 7 On The Stripped Off Second Mortgage


In Free the debtors received a Chapter 7 discharge, and then filed a Chapter 13, intending to strip off two wholly unsecured junior mortgages.  The Chapter 13 Trustee moved to dismiss the case based on his assertion that the debtors’ unsecured debts exceeded the 11 U.S.C. § 109(e) unsecured debt ceiling.  The Trustee argued that the wholly unsecured junior mortgages were unsecured debt for § 109(e) purposes.  The Bankruptcy Court agreed with the Trustee and dismissed the case.  The debtors appealed to the BAP.


1.  The Discharged Mortgages Are Not Unsecured Debts


The BAP reversed the Bankruptcy Court based on the fact that the Trustee’s last name was too difficult to pronounce.  (Wait a minute.  That can’t be right.  People mispronounce my last name all the time and I win my cases.)  Let’s take a closer look at the actual opinion.

The Court began by noting that since the in personam liability was discharged in the prior Chapter 7 bankruptcy, the creditors were estopped from collecting the discharged debt from the debtors personally:  “Simply put, no creditor can demand payment on a discharged debt, and the debtors have no personal liability to pay such a debt.”  Free, at 7.

And while in rem claims survive the Chapter 7 discharge, “the discharge bars any claims that are not secured.  Thus, applying the statutory definitions to the words of § 109(e), debts that were discharged in chapter 7 are not ‘unsecured debts.’”  Id.  Thus, the Court concluded that the discharged mortgage debts could not be included in the § 109(e) unsecured debt analysis.


2.  Lien Stripping In A Chapter 20


11 U.S.C. § 1328(f)(1) provides:

[T]he 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— . . . in a case filed under chapter 7 . . . of this title during the 4-year period preceding the date of the order for relief under this chapter.

Therefore, since the typical Chapter 20 debtor is ineligible to receive a Chapter 13 discharge, some judges refused to permit Chapter 20 debtors from stripping off wholly unsecured second mortgages.  However, the Ninth Circuit recently gave its imprimatur to lien strips in Chapter 20 in HSBC Bank USA v. Blendheim (In re Blendheim), 803 F.3d 477 (9th Cir. 2015).

Therefore, the Frees could strip off the wholly unsecured junior mortgages in their Chapter 13 case.  What would happen to the mortgage holders’ claims if they did?

The Free Court held:

It makes no sense that a creditor whose in personam claim is unenforceable in any other context due to the § 727 discharge should fare better in the subsequent chapter 13 case.

Free, at 14.

Therefore, the debtors could strip off the wholly unsecured junior mortgages and make no provision for paying those creditors anything in the Chapter 13 plan.


IV.  The Chapter 18 Difference


Things are a bit different in a Chapter 18 ― a Chapter 7 followed by a Chapter 11 (admittedly quite rare, but not entirely impossible) ― because of 11 U.S.C. § 1111(b)(1)(A), which provides in relevant part:

A claim secured by a lien on property of the estate shall be allowed . . . the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse, unless . . .

This means that under § 1111(b) the debtor’s in personam liability can be resurrected at the election of the creditor.  As a result, Chapter 18 is much less attractive than Chapter 20.


V.  Conclusion


If you are a debtor in the Central District of California, and want to get some relief from your creditors, contact an extremely knowledgeable and highly skilled bankruptcy attorney to guide you through the process.