Unsecured Mortgages in Chapter 13 bankruptcy

In our current falling real estate market, Shenwick & Associates has been receiving many calls regarding saving homes from foreclosure. One possible solution may be Chapter 13 bankruptcy. In a Chapter 13 bankruptcy, an individual with regular income can retain their property and make installment payments to their creditors over a period of three to five years, if they have unsecured debt of less than $336,900 and secured debt of less than $1,010,650.

Due to declining real estate values, many homeowners (over 7.5 million, according to a recent CNN Money report) are “underwater”-in other words, the value of their property (the collateral) is less than the balance due on their mortgages. In 2001, the Second Circuit Court of Appeals held in Pond v. Farm Specialist Realty et al. (In re Pond), 252 F. 3d 122 (2d Cir. 2001), that an unsecured mortgagee’s interest in a Chapter 13 debtor’s principal residence is voidable where there is insufficient equity in the property to cover any portion of their lien.

The debtors, Richard and Lorrie Pond, filed for bankruptcy under Chapter 13 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of New York. The Court held a hearing and determined that the debtors’ residential property was valued at $69,000. The Court also determined that there were four liens on the property, which had to be discharged in the following order of priority: (1) $1,505.18 for real property taxes; (2) $48,995.63 for the mortgage of the Farmers Home Administration; (3) $20,000 for the mortgage of the New York State Affordable Housing Corporation; and (4) $10,630.58 for the mortgage of Farm Specialist Realty and Charles Livingston, Jr. (the Defendants). The first three liens amounted to an encumbrance of $70,500.81, so the Ponds’ property had insufficient equity to cover any portion of the Defendants’ lien.

The Ponds then commenced an adversary proceeding to dissolve the Defendants’ lien under Section 1322(b)(2) of the Bankruptcy Code, which provides:

“A Chapter 13 plan may modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor's principal residence . . . .” (emphasis added)

The Ponds argued that the Defendants' lien was wholly unsecured under Section 506 of the Bankruptcy Code, which provides:

“An allowed claim of a creditor secured by a lien on property in which the estate has an interest . . . is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property, . . . and is an unsecured claim to the extent that the value of such creditor's interest . . . is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor's interest.”

The Bankruptcy Court held that defendants' lien could not be modified because, even though there was insufficient equity to cover any portion of the lien, the underlying security interest was the Debtors’ principal residential property, and, therefore, the lien was protected from modification under Section 1322(b)(2).

The U.S. District Court for the Northern District of New York reversed, holding that the statutory prohibition against modification does not apply to a holder of a wholly unsecured lien under Section 506, because such a lien is not "secured" by a residential property within the meaning of Section 1322 (b)(2). According to the District Court, the Defendants' lien was wholly "unsecured" under Section 506(a) because there was no equity in the Ponds’ property to cover the lien; therefore, the lien was not protected under the antimodification exception of Section 1322(b)(2) and could be voided.

The Defendants challenged this holding on appeal, and the 2nd Circuit Court of Appeals affirmed the District Court.

In its discussion of its holding, the Court reviewed the Supreme Court’s holding in Nobelman v. American Savings Bank, 508 U.S. 324 (1993), in which a Chapter 13 debtor sought to split a creditor's undersecured residential mortgage lien into a secured lien and an unsecured lien, so that only the secured portion of the mortgage was protected under the antimodification exception of Section 1322(b)(2).

The Supreme Court rejected that proposal, holding that, as long as some portion of the lien was secured by the residence, the creditor was a holder of "a claim secured only by . . . the debtor's principal residence," and its rights in the entire lien were protected under the antimodification exception. Accordingly, the debtors' Chapter 13 plan could not void the unsecured component of the creditor's mortgage lien.

However, the Nobelman opinion left open the issue presented in this case- namely, whether its holding extended to a holder of a wholly unsecured homestead lien. The issue has sharply divided Bankruptcy and District Courts, but the majority view (which the District Court adopted in this case, and the Second Circuit Court of Appeals affirmed) is that the antimodification exception of Section 1322(b)(22) applies only where a creditor's claim is at least partially secured under Section 506(a).

For more information about how Chapter 13 bankruptcy can protect your home, please contact Jim Shenwick.