A recent client alert from the law firm Weil, Gotshal & Manges LLP
had a discussion of a recent bankruptcy case (In re Boukatch) which dealt with a homeowner-couple's use of the so-called "Chapter 20" bankruptcy
maneuver to successfully lien strip a wholly underwater 2nd mortgage from their residence.
- One year after obtaining a discharge in a Chapter 7 case, the individual debtors in Boukatch filed a Chapter 13 case. In each case, the debtors identified two liens against their residence: a first lien held by Wells Fargo and a second lien held by MidFirst Bank. In the subsequent Chapter 13 bankruptcy, the debtors identified MidFirst’s second and wholly underwater lien and asserted that MidFirst held an “empty lien” because the debtors’ personal liability had been discharged in their previous Chapter 7 case. Accordingly, the debtors filed a motion seeking to avoid MidFirst’s lien. Although no one (including MidFirst) objected to the motion, the United States Bankruptcy Court for the District of Arizona denied the lien-stripping motion, on the grounds that a “Chapter 20” debtor who is not receiving a discharge is not permitted to strip off liens.
On the debtors’ appeal from that order, the Bankruptcy Appellate Panel for the Ninth Circuit held that a “Chapter 20” debtor can strip off a wholly underwater junior lien even though the debtor is not receiving a discharge. The Boukatch panel discussed three different approaches used by courts considering this issue:
1) Stripping off a wholly underwater lien in a Chapter 20 case is impermissible because lien stripping is tantamount to a de facto discharge, which is not permitted in a Chapter 20 case.
(2) Chapter 20 lien stripping is permissible in theory, but the parties’ prepetition rights are reinstated by operation of law after the Chapter 13 plan has been consummated, unless the claim is discharged or paid in full. Therefore, the lien avoidance can never be permanent. These courts have reasoned that Chapter 13 cases end either through conversion, dismissal or discharge, and if a Chapter 13 case is dismissed or converted prior to the successful completion of all plan payments, any avoided liens are reinstated.
(3) Chapter 20 lien stripping is permissible because nothing in the Bankruptcy Code prevents it. This group of courts has held that the specific Bankruptcy Code mechanism that voids the lien is plan completion, rather than the discharge of the debtor, and that a successful Chapter 20 case would not be dismissed or converted but rather would end in an administrative closing. Accordingly, these courts have found that because the Bankruptcy Code sections that reverse any lien avoidance are only implicated if a Chapter 13 case is converted or dismissed, those provisions do not apply so long as debtors make all the payments under their Chapter 13 plans. In other words, the lien stripping is not dependent upon the debtor receiving a discharge but rather is dependent on the debtor successfully making all of the plan payments.
The Boukatch panel joined “the growing consensus of courts” that follow the third approach. The panel held that nothing in the Bankruptcy Code prevented the debtors from stripping off a wholly underwater lien against their principal residence, notwithstanding that the debtors were not eligible for a discharge. The panel made a distinction between discharge – which would have enjoined the creditor from enforcing the debt against the debtor personally but would not have released the lien from the debtor’s property – from avoiding the lien. The panel concluded that the Bankruptcy Code does not prevent individual debtors from stripping off a wholly underwater lien in their Chapter 13 plan. The only way the lien would not be avoided would be if the debtors failed to complete all of the payments required under their Chapter 13 plan and the case was subsequently converted or dismissed. Accordingly, the panel reversed the bankruptcy court’s decision to deny the lien-stripping motion.