Daily Development for
Wednesday, February 17, 1999

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

These reports and comments are contributed by Jim Stillman of the Los Angeles Bar, the Quarterly Report Bankruptcy Reporter.

Preliminary editor's comment: In bankruptcy, generally speaking, secured creditors are given priority status as to their security interests. The general rule in bankruptcy is that "Liens Ride Through" under the Reform Act of 1978, as they did under pre-Code law. The Supreme Court so held in In re Dewsnup, were it disapproved of the practice of "stripping down" liens, a process that occurred when the bankruptcy court held that the creditor's lien was forever "void" (under section 506(d)) to the extent the debt exceeded the judicially determined value of the collateral.

The following two cases show what's become of the antistripping rule of Dewsnup, in the particular circumstance of home loans. First, note how bankruptcy courts evade Dewsnup by finding that a junior lien can be stripped, not "down," but "off" where the judicial valuation shows that there is no equity for the junior lienor at the time of bankruptcy.

But residential lenders prevailed upon the Congress to give them special treatment. Amendments to Chapter 13 and Chapter 11 provide that a loan secured "only" by the debtor's primary residence cannot be modified at all in bankruptcy. This includes both "stripping down" and rescheduling. So the residential mortgagee can enjoy the security protection of any increase in the value of the property during or post bankruptcy.

Our second case study pertains to this safe harbor Congress enacted for home loans: according to Notice how the following bankruptcy courts steer around this rule, just as handily as they do around Dewsnup.

The concept of a specially privileged type of creditor, generally speaking, is not part of the Bankruptcy scheme, and it is not surprising that bankruptcy judges are somewhat hostile to the "velvet box" treatment afforded to residential mortgage lenders.

BANKRUPTCY; AVOIDANCE OF LIENS; LOANS SECURED BY PRINCIPLE RESIDENCE: "STRIPPING OFF" UNSECURED LIEN: Although the junior mortgagee's lien encumbered only the debtor's principal residence, and thus was not subject to modification by force of section 1322(b)(2), the lien was subject to complete avoidance by force of section 506(a), where there was no equity in the property at all for the junior lienor.

In re Johnson, 226 B.R. 364 (D. Maryland. 1998).

Acknowledging the split among bankruptcy courts on the issue, the District Court decided to hold with the majority, which have determined that the protections of the section 1322(b)(2) depend on the lienor having some "rights" in the collateral to begin with. A wholly unsecured junior lienor has no "rights" and if the court did not strip off the junior, section 1322(b)(2) would require payment in full!

Reporter's Comment: Hence, the strategy for such a junior lienor in bankruptcy - depending on the values involved - would be to pay down the senior lien just enough so that the junior is a dollar or two secured. Also, long experience in workouts proves, contrary to the language in this opinion, that a wholly unsecured junior lienor enjoys a bundle of "rights" under state law, rights than may be parlayed into a tidy recovery from other parties who want to get on with, or stop, the foreclosure.

BANKRUPTCY; AVOIDANCE OF LIENS; LOANS SECURED BY PRINCIPLE RESIDENCE; "STRIP DOWN" OF LIENS; HOME MORTGAGE: Where the collateral includes the debtor's principal residence, but, because it is a duplex, does not consist "only" of the debtor's principal residence, as required by section 1322(b)(2), The creditor's claim will be allowed only to the extent of the value of the collateral, under Section 506(a).

In re Maddaloni, 225 B.R. 277 (D. Conn. 1998).

The Bankruptcy Court was correct in applying the strict meaning of the word "only" in Section 1322(b)(2) to the facts of this case (the family rented the unit next door). The District Court rejected the "line drawing" approach used in In re Bunson, 201 B.R. 351, 34254 (Bankr. W.D.N.Y. 1996), which holds that the applicability of Section 1322(b)(2) should depend on the intended primary use of the property as viewed by the loan parties.

Reporter's Comment: Bunson, like the instant case, involved a duplex. To buttress its holding, the District Court cited to a another case involving a duplex, In re Del Valle, 1867 B.R. 347 (Bankr. D. Conn. 1995) and a case involving a triplex and one involving a fourplex in each of which section 1322(b)(2) was found not to apply.

If there is to be no "line drawing" at all, then what about the case of a true inlaw apartment? What if the parents have (finally) decided to collect monthly rent from their stay at home 28 year-old?

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

Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.