Anthony Mccready, Strip-off: What Is the Correct Procedure to Avoid a Wholly Unsecured Junior Mortgage?

• Publication year: 2011

STRIP-OFF: WHAT IS THE CORRECT PROCEDURE TO AVOID A WHOLLY UNSECURED JUNIOR MORTGAGE?

INTRODUCTION

When the housing market began to collapse in 2007,1 the application of the rarely used rule for stripping2 junior mortgages3 in chapter 13 cases became an important issue in bankruptcy.4 “Strip-off”5 entitles the bankruptcy estate to avoid a wholly unsecured6 junior mortgage on a debtor’s principal residence.7 For twenty years prior to the housing crisis, home values consistently and

predictably increased over time,8 and banks considered mortgage-backed securities a very safe investment.9 During this time the value of a debtor’s home usually exceeded the value of the holder’s claim on both the debtor’s

first and junior mortgage.10 However, the recent economic situation produced a rapid decline in housing prices that could continue into the foreseeable

1. Richard D. Thomas, Comment, Tipping the Scales in Chapter 11: How Distressed Debt Investors Decrease Debtor Leverage and the Efficacy of Business Reorganization, 27 EMORY BANKR. DEV. J. 213, 216 (2010).

2. See, e.g., W. HOMER DRAKE, JR. ET AL., CHAPTER 13 PRACTICE AND PROCEDURE § 9C:5 (2010)

   (“Because a plan may impose such modification of a secured claim over the creditor’s objection, this treatment is commonly referred to as ‘cramdown’; the consequent effect on the lien is referred to as ‘lien stripping.’”).

3. BLACK’S LAW DICTIONARY 1103 (9th ed. 2009) (defining “junior mortgage” as “[a] mortgage that is

   subordinate to another mortgage on the same property”).

4. Elizabeth M. Abood-Carroll, Are Adversary Proceedings Necessary to Strip Mortgagees’ Liens in Chapter 13?: Analyzing Supreme Court’s Answer in Espinosa v. United Student Aid Funds, AM. BANKR. INST.

   J., July–Aug. 2009, at 14, 14.

5. DRAKE ET AL., supra note 2, § 9C:5 (“[E]limination of a lien due to the lack of any value in the encumbered property to support a secured claim is referred to as a ‘strip off.’”).

6. “Wholly unsecured” means the value of the encumbered property is less than the entire amount of the junior claim after value is accessed to the senior claim. See, e.g., Pond v. Farm Specialist Realty (In re Pond), 252 F.3d 122, 124 (2d Cir. 2001) (citing 11 U.S.C. § 506(a) (2000)).

7. Tanner v. FirstPlus Fin., Inc. (In re Tanner), 217 F.3d 1357, 1359–60 (11th Cir. 2000).

8. Two graphs using the Composite 10 and Composite 20 indices show housing prices generally trending upwards from 1987 to January 2007. Press Release, Standard & Poors, Home Prices Continued to Decline in November 2011 According to the S&P/Case-Shiller Home Price Indices (Jan. 31, 2012), http://www.standardandpoors.com/indices/articles/en/us/?articleType=PDF&assetID=1245328085691.

9. See Jason Cox et al., Why Did the Credit Crisis Spread to Global Markets?, U. IOWA CENTER FOR

   INT’L FIN. & DEV., 1–3 (Mar. 2010), http://blogs.law.uiowa.edu/ebook/sites/default/files/Part_5_2.pdf.

10. See Alex Ulam, Why Second-Lien Loans Remain a Worry, AMERICAN BANKER (May 2, 2011, 3:16 PM), http://www.americanbanker.com/specialreports/176_5/second-lien-loans-remain-worry-1036731-1.html.

future.11 Subsequently, as the country entered into the economic tailspin now known as the Great Recession,12 foreclosure rates skyrocketed.13

Before the mortgage crisis, homeowners commonly mortgaged their homes multiple times to extract most of the equity in their properties,14 causing mortgage payments to become a higher percentage of their income.15 Many homeowners’ incomes have fallen during the recession;16 not being able to keep up with their loan payments, many have ended up defaulting on their

mortgages.17 Homeowners who are unable to pay their debts may file chapter

13 bankruptcies in an attempt to retain their homes.18 Chapter 13 allows debtors to keep their primary residences and strip off junior mortgages exceeding the current value of the debtors’ homes.19 The debtor is obligated to repay the first mortgage and any junior mortgages, on a priority basis, up to the fair market value of the home.20 Any wholly unsecured junior mortgage can be

thus stripped off. Given the current economic situation, strip-off is an extremely powerful tool for debtors.21

1. Robert J. Shiller, Why Home Prices May Keep Falling, N.Y. TIMES, June 7, 2009, at BU4, available at http://www.nytimes.com/2009/06/07/business/economy/07view.html (“Home prices in the United States have been falling for nearly three years, and the decline may well continue for some time.”).

2. David Line Batty, Dodd-Frank’s Requirement of “Skin in the Game” for Asset-Backed Securities May

   Scalp Corporate Loan Liquidity, 15 N.C. BANKING INST. 13, 13 (2011) (“The economic devastation [that began in 2007] has come to be known as the Great Recession because it has had far-reaching economic and societal effects not felt since the Great Depression which inspired its name.”).

3. See Ronald Mann, Op-Ed, A New Chapter for Bankruptcy, N.Y. TIMES, Mar. 12, 2010, at A27,

   available at http://www.nytimes.com/2010/03/12/opinion/12mann.html (“Almost 5 percent of mortgage loans are now in foreclosure, an increase of more than 85 percent since the beginning of 2008, and more than 10 percent of credit card accounts are delinquent.”).

4. Richard L. Ngo, The Proper Valuation Date of Residential Property for a § 506(a) Lien Strip, AM.

   BANKR. INST. J., July–Aug. 2010, at 14, 14 (“Prior to the foreclosure crisis, financing was, to put it lightly, easy to obtain. It was not uncommon for homeowners to mortgage their homes two, three, even four times in order to pull out all of their equity in the property.”).

5. See Nick Timiraos, Linkage in Income, Home Prices Shifts, WALL ST. J., Aug. 17, 2011, at A2,

   available at http://online.wsj.com/article/SB10001424053111904253204576512532609819142.html (“For the

   U.S. as a whole, home prices were around 2.9 times incomes from 1985 to 2000. But during the housing boom, values increased at a much faster rate than incomes. The price-to-income ratio peaked at around 5.1 in 2005.”).

6. Memorandum from Heather Boushey et al., Center for American Progress, New Census Data Reveals

   Decreased Income and Health Coverage 5 (Sept. 17, 2010), available at http://www.americanprogress.org/ issues/2010/09/pdf/census_poverty_memo.pdf (“Family income has fallen by 5.3 percent since the [Great] [R]ecession began, compared to a 2 percent decline over the early 2000s recession and a 3.4 percent decline over the early 1990s recession.”).

7. See Mann, supra note 13, at A27.

8. Id.

9. See infra Part I.

10. See Ngo, supra note 14, at 14.

However, bankruptcy courts disagree on whether an adversary proceeding22 is required to strip off a junior mortgage secured by a debtor’s principal residence.23 The majority of bankruptcy courts holds that a strip-off does not require an adversary proceeding.24 These courts allow strip-off by a contested

matter such as a Bankruptcy Rule25 3012 motion or the chapter 13 plan confirmation process.26 Alternatively, the minority of bankruptcy courts holds the opposite view and requires an adversary proceeding pursuant to Rule 7001(2).27 Some jurisdictions have even taken steps to avoid the issue altogether. The Eastern District of Michigan, for instance, enacted Guideline 12, which requires a debtor to initiate an adversary proceeding in some

situations to strip off a junior mortgage.28

This Comment argues in favor of the position taken by a majority of bankruptcy courts that strip-off does not require an adversary proceeding. To strip off, a debtor must file a motion separate from the plan confirmation pursuant to Rule 3012.29 The United States Supreme Court recently ruled on the issue of adversary proceeding requirements in bankruptcy.30 In United Student Aid Funds, Inc. v. Espinosa, the Court decided two important issues applicable to whether strip-off requires an adversary proceeding: (1) the

Supreme Court’s decision in Mullane v. Central Hanover Bank & Trust Co.

22 Collier on Bankruptcy addresses adversary proceedings, explaining that:

Adversary proceedings are separate lawsuits within the context of a particular bankruptcy case and have all of the attributes of a lawsuit, including the filing and service of a formal complaint and application, with certain modifications, of the Federal Rules of Civil Procedure, as provided in Part VII of the Bankruptcy Rules.

10 COLLIER ON BANKRUPTCY ¶ 7001.01 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2011).

1. David Lloyd & Ariane Holtschlag, Chapter 13 Strip-Off of Junior Mortgages: Not Whether, but How Under Current Law, AM. BANKR. INST. J., July–Aug. 2009, at 12, 68.

2. See, e.g., In re Robert, 313 B.R. 545, 549 (Bankr. N.D.N.Y. 2004); In re Millspaugh, 302 B.R. 90, 103

   (Bankr. D. Idaho 2003).

3. “Bankruptcy Rule” or “Rule” refers to the Federal Rules of Bankruptcy Procedure whereas “FRCP” refers to specific provisions of the Federal Rules of Civil Procedure.

4. In re Millspaugh, 302 B.R. at 103 (“[A] chapter 13 debtor may, in his plan or in a separate (and usually

   preconfirmation) motion, seek to strip off a creditor’s wholly unsecured lien through a valuation process under

   § 506(a) and Rules 3012 and 9014.”); see also In re Sadala, 294 B.R. 180, 185 (Bankr. M.D. Fla. 2003).

5. See, e.g., Pierce v. Beneficial Mortg. Co. of Utah (In re Pierce), 282 B.R. 26, 28 (Bankr. D. Utah 2002) (stating that the plain language of Rule 7001(2) requires an adversary proceeding to achieve strip-off); see also In re Chukes, 305 B.R. 744, 744–45 (Bankr. D.D.C. 2004).

6. E.D. MICH. LBR Guideline 12.

7. See In re Bennett, 312 B.R. 843, 847–48 (Bankr. W.D. Ky. 2004) (holding that strip-off can be achieved through motion).

sets the constitutional requirement for due process in bankruptcy;31 and (2) res judicata32 can bar the appeal of a confirmed plan even though an adversary proceeding was not initiated as required by the Bankruptcy Rules.33 The Supreme Court’s decision in Espinosa reinforces this Comment’s interpretation that a motion is required for a strip-off.34

The significance of this procedural issue in a strip-off cannot be overemphasized given the current economic climate.35 The...