In a recent opinion, the Eleventh Circuit Court of Appeal held that second-priority mortgage liens may be eliminated completely (“stripped off”) in chapter 7 bankruptcy proceedings when the underlying collateral is worth less than the amount of the first-priority mortgage. In re McNeal, Case No. 11-11352, 2012 WL 1649853 (11th Cir. 2012). This ruling represents a significant change in Eleventh Circuit precedent and is in conflict with three other federal circuit court decisions. See, e.g., id. at *2; Ryan v. Homecomings Financial Network, 253 F.3d 778 (4th Cir. 2001); Talbert v. City Mortgage Services, 344 F.3d 555 (6th Cir. 2003); Laskin v. First National Bank of Keystone, 222 B.R. 872 (9th Cir. 1998).
The significance of this ruling can hardly be understated, as practitioners are well aware that numerous properties subject to multiple mortgage liens are worth less than the amount of the first-priority mortgage. Given this state of affairs, debtors in chapter 7 proceedings are likely to vigorously contest collateral valuation in order to potentially eliminate second-priority mortgage liens altogether. Creditors must plan accordingly to protect second-priority liens in valuation proceedings in the Eleventh Circuit.
In re McNeal Explained
The In re McNeal decision considered whether a second-priority mortgage lien could be “stripped off” in a chapter 7 bankruptcy proceeding. The debtor reported in her chapter 7 petition that her home was subject to two mortgage liens. The parties did not dispute that the fair market value of the property was less than the amount of the first-priority mortgage lien.
The parties agreed that the second-priority mortgage lien was an “allowed” claim that was wholly unsecured under sections 502 and 506(a) of the Bankruptcy Code. The debtor argued that, because the second-priority lien was wholly unsecured, it was void under section 506(d).
The Eleventh Circuit noted that other circuit courts faced with this issue have uniformly determined that a chapter 7 debtor could not strip off a wholly unsecured junior lien in the manner urged by the debtor. In re McNeal, at *2 (citing Ryan v. Homecomings Financial Network, 253 F.3d 778 (4th Cir. 2001); Talbert v. City Mortgage Services, 344 F.3d 555 (6th Cir. 2003); Laskin v. First National Bank of Keystone, 222 B.R. 872 (9th Cir. 1998)). The courts holding that chapter 7 debtors could not strip off unsecured second-priority liens relied on the U.S. Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992), as support for their position. Ryan, 253 F.3d at 779; Talbert, 344 F.3d at 556; Laskin, 222 B.R. at 876. In Dewsnup, the Court held that a chapter 7 debtor could not “strip down” a partially secured lien under section 506(d). Dewsnup, 502 U.S. at 417. The Ryan, Talbert, and Laskin decisions extended the reasoning of the Dewsnup court to conclude that chapter 7 debtors also could not strip off unsecured second-priority liens. Ryan, 253 F.3d at 779; Talbert, 344 F.3d at 556; Laskin, 222 B.R. at 876.
Despite the contrary line of case law in other circuits, the Eleventh Circuit determined that Dewsnup is distinguishable from strip-off cases and should be followed only to the extent that it governs attempts by debtors to strip-down undersecured loans. In re McNeal, at *2. Therefore, Dewsnup was not controlling authority on the facts of In re McNeal. Id.
The Eleventh Circuit then cited Folendore v. United States Small Business Administration, 862 F.2d 1537 (11th Cir. 1989), as the proper controlling authority. In Folendore, the Eleventh Circuit determined that an allowed claim that is wholly unsecured is voidable under section 506(d). Folendore, 862 F.2d at 1538-39. After the Dewsnup decision, a line of bankruptcy court cases in the Eleventh Circuit – including the underlying bankruptcy court decision in In re McNeal – treated Folendore as having been abrogated by Dewsnup. In re McNeal, 2010 WL 1753376, at 2-5 (Bankr. N.D. Ga. 2010); In re Swafford, 160 B.R. 246, 249 (Bankr. N.D. Ga. 1993); In re Windham, 136 B.R. 878, 882 n. 6 (Bankr. M.D. Fla. 1992). Despite this line of case law, the Eleventh Circuit has now declared that Folendore is the governing law in the Eleventh Circuit. Creditors and debtors should plan accordingly.
Consequences for Creditors
One practical effect of In re McNeal is that valuation proceedings in chapter 7 bankruptcies are poised to become heavily contested by both creditors and debtors in any case where the value of the underlying collateral might be less than the amount owed on a first-priority mortgage lien.
To illustrate this scenario, consider a case where a property is encumbered by a first mortgage in the amount of $325,000.00 and a second mortgage in the amount of $50,000.00. Under In re McNeal, if the property owner files for chapter 7 and the court determines that the “fair market value” of the property is $320,000.00, the second mortgage can be “stripped off” by the bankruptcy court. Before the In re McNeal opinion, this could not be done in the Eleventh Circuit. If, however, the court determines that the “fair market value” of the property is $330,000.00, the second mortgage cannot be “stripped off” and will remain in place.
Valuation litigation will therefore take on a much greater importance for creditors in chapter 7 proceedings, as the judicially-determined value of the underlying collateral will be determinative of whether a creditor’s allowed second-priority mortgage lien will be eliminated in its entirety. Any “close calls” of collateral valuation will become high-stakes battles of appraisals with the fate of second-priority liens at stake.
The In re McNeal opinion acknowledged that the position taken by the Eleventh Circuit is in conflict with decisions from other circuits that have addressed the same issue. Due to the circuit split and the significance of this issue for debtors and creditors alike, the U.S. Supreme Court will likely weigh in to settle the matter. In the interim, In re McNeal is the law of the land in the Eleventh Circuit. Creditors should therefore plan accordingly by anticipating attempts by debtors to strip off second mortgages in chapter 7 proceedings.
Ausley & McMullen
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Ausley & McMullen