Daily Development for Tuesday, February 26, 2002

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

BANKRUPTCY; REORGANIZATION; LIENS SECURED BY PRINCIPLE RESIDENCE: Despite Nobleman, where value of residential real estate is less than amount of first lien, junior liens on the property can be "stripped away" and become unsecured claims, as they are not "secured" by residential real estate when no value supports the lien. Sixth Circuit joins growing majority.

In re Lane, 2002 Fed. App. 0049P (6th Cir. 2/07/02)

Although acknowledging that a large number of district court cases, and a leading treatise writer, reach a contrary result, the Sixth Circuit asserts here that it opinion represents the growing majority, supported by Collier on Bankruptcy and decisions in the Second, Third, Fifth, Ninth (BAP) and Eleventh Circuit Courts of Appeal.

The question is whether a junior lienholder on the Debtor's residence will be treated as having a secured interest in a Chapter Thirteen reorganization when there is no value in the property beyond the value of prior liens. The question is vital because the Code provides that the Court cannot approve a bankruptcy that modifies or reschedules any payments on a loan secured by a lien on residential real estate occupied by the Debtor. In Nobleman, 508 U.S. 324 (1993), the Supreme Court held that such loans cannot be modified even if the value of the real estate is insufficient to completely secure the loan. In other words, partially secured liens on debtor occupied residential real estate cannot be "stripped down" to only the secured portion, leaving the unsecured portion to unsecured claim status.

The consequence of Nobleman is that where the value of the residential real is estate is, say, only ten cents more than the amount of a prior secured claim, a junior creditor is completely protected, and the reorganization plan must provide for payment of every penny of the originally scheduled payments. Obviously, this places a significant burden on any reorganization effort, and is not surprising that many bankruptcy mavens and lower courts chaffe under this interpretation of the law.

But the Supreme Court did not address directly the situation that would arise when not even that ten cents is available - when the debt is completely "unsecured" in the sense that the bankruptcy court's valuation of the underlying property indicates that, as of the time of valuation, there is simply nothing there for the lien to reach. One would think that, nevertheless, the philsophy of Nobleman would apply here as well. But those who feel otherwise argue that, in essence, there is no "philsophy" in Nobleman. Rather, they argue, Judge Scaglia's analysis of the problem in Nobleman started and ended with a close, grammatical reading of the Bankruptcy Code. Therefore, they pull out their grammar books themselves and make fine, hair splitting arguments that the statute comes to a different result when there is no security at all.

This case is loaded with such hair splitting, and the editor leaves it to interested readers to track all the argumentation through this and the many other cases dealing with the issue. The bottom line, of course, is where the courts come out. There are a sufficient number of credible authorities on both sides of the issue to conclude that both sides must have a plausible argument, and that ultimately one of these cases will buck up to the Supreme Court. This probably won't happen, however, until some U.S. Court of Appeals somewhere takes the "no strip down" approach. So far, every Court of Appeals to address the issue has stripped down. Here, the court reverses both the bankruptcy court and the district court to do so.

Comment: Nobleman necessarily created the a Hobson's choice. There seems to be unfairness on either side of the line. Clearly, it does seem unfair that a junior lienholder with only a ten cent value will enjoy 100% protection, while one with just ten cents less will be treated as wholly unsecured. But is the unfairness in the treatment of the "secured" creditor, or of the "unsecured" one?

It is likely that the primary motivation of the Congress in drafting the special exception to the "modification" rules was to protect first lien purchase money home lenders (and perhaps refinancings of such loans) because of the significance of readily available mortgage money to finance the "American dream" and keep the economy rolling happily along. It probably would be best to protect these mortgages to completely, and to permit modification, and certainly "strip down" of all others, just as is permitted with other mortgages. Unfortunately, Congress didn't provide language that seemed to the Supreme Court amenable to such an interpretation, and so we have a clumsy and artificial rule here that strikes virtually all observes as prima facie silly. But, as they've been saying in Salt Lake City, "that's short track." Or, translated - sure it's silly - but those are the rules.

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

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