Daily Development for Thursday, April 13, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

BANKRUPTCY; CHAPTER 13; MORTGAGES SECURED SOLELY BY PERSONAL RESIDENCE; STRIP DOWN: Third Circuit finds that mortgages that are wholly unsecured in Chapter 13 bankruptcy can be stripped down even though secured solely by personal residence.

McDonald v. Master Financial, Inc. (In re McDonald), No. 991381, ___ F.3d ___, 2000 WL 261061 (3d Cir.) (3/9/00) (Cowen, J.).

At some point (and often at several points) in the course of a bankruptcy court is called upon to review mortgages to determine the degree to which they are supported by value in the security. A mortgage debt that is undersecured has a balance greater than the value in the security property can be "stripped down" under Bankruptcy Code Section 506(a). That portion of the mortgage debt that is supported by value in the security is treated as a secured debt. The creditor's basic security position is protected by the "indubitable equivalent" rule, both during bankruptcy and in any workout. A further, the creditor can recover interest, fees and costs in bankruptcy for the collection of that debt.

The balance of the mortgage debt, however that portion that does not correspond to any value in the property at time of bankruptcy is treated as an unsecured debt and thus can be discharged or restructured in ways that secured debt cannot. Further, interest, fees and costs do not accrue. In nonconsumer bankruptcies, secured creditors may avoid stripdown, but suffer other adverse consequences, by making an 1111b election. But such elections are not available in Chapter 13 bankruptcies.

Secured creditors don't get a "free ride" even as to that portion that is preserved as secured follow a "strip down." Even secured debt can be recast by the bankruptcy court in reorganization. Although the lender may preserve the total debt claim, the term, payments and even interest rate can be changed.

Home lenders expressed concern to Congress about the whole issue of recasting mortgage debt in bankruptcy. They argued that secondary market investors looked at the long term, and a restructuring of debt midway through the life of a note. They convinced Congress that the national interest would be served by special protections in bankruptcy for loans secured solely by the personal residence of the borrower. Congress responded with the adoption of special protection for mortgages secured solely by the debtor's principle residence Section 1322(b)(2) provides that such mortgages can not be altered or modified in a Chapter 13 reorganization.

After the adoption of Section 1322(b)(2), a split arose in the courts concerning the impact of the statute upon undersecured home mortgages. Were they totally immune from modification entirely, even as to the part that was not supported by value in the security at the time of bankruptcy? Or was only the "secured" claim entitled to such protection? The split ultimately was resolved by the Supreme Court in Nobelman v. American Savings Bank, 508 U.S. 324 (1993), which held that undersecured mortgages secured solely by the debtor's personal residence could not be "stripped down," and thus that the whole amount of the debt was protected from modification in a Chapter 13 reorganization.

Now the Third Circuit, adopting a narrow interpretation of the Nobleman decision, has held that the mortgage antimodification provision of section 1322(b)(2) does *not* apply to a wholly unsecured second mortgage on the debtor's principal residence. Accord In re Lam, 211 B.R. 36 (9th Cir. B.A.P.), appeal dismissed, 192 F.3d 1309 (9th Cir. 1999). Although Nobelman held that the antimodification rule prevented a Chapter 13 debtor from modifying even the unsecured portion of an undersecured mortgage, the Third Circuit interprets Nobelman as requiring that section 506(a) be applied in order to determine whether the creditor is a protected holder of a claim secured by the debtor's principal residence. Unlike the undersecured creditor in Nobelman, the holder of a claim that is wholly unsecured has no secured claim under section 506(a).

Comment 1: The finding that there is no value at all for the secured creditor has draconian consequences. Even one dollar of security preserves the entire mortgage claim. The creditor slides through the bankruptcy (although any deficiency claim is lost) and ultimately has the ability to enjoy any upturn in the value of the security. But when the Bankruptcy court determines that there is no value, the creditor goes to the "unsecured creditor's wasteland."

Bankruptcy valuations are a very strange process. Both debtors and creditors find themselves lost in tactical maneuvering as a high value may be good for some purposes but bad for others. Perhaps this schizophrenic aspect of the process contributes to the general dissatisfaction on the part of lenders with the valuation results, which many allege are "tilted" by the court to satisfy the court's view of how the bankruptcy ultimately should be resolved. Now there will be an increased focus on that process by junior lienholders in Chapter Thirteen proceedings.

Comment 2: Would a junior lienholder be wise to pay down the senior mortgage itself to the point that some equity remains so that the junior can claim a secured position? In some cases this might be possible, but to some extent the McDonald court frustrates such schemes by refusing to say when the "strip down" valuation will be made. Is it as of the time of bankruptcy filing, at the time of valuation, at the time of confirmation? We don't know. If the junior pays down the senior after bankruptcy is filed in order to avoid being treated as unsecured, and the court then elects to value the property as of the date of filing, the creditor has just made a donation to the senior, and has done little more.

If the junior anticipates that bankruptcy is imminent, however, and that there is a possibility that bankruptcy valuation will leave the junior's claim in the cold, then paying down the senior is a tactic to consider.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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