The United States Supreme Court Addresses Common Bankruptcy Practices
The United States Supreme Court recently handed down two decisions that bring an end to formerly-routine bankruptcy practices. The first decision addressed a Chapter 13 trustee’s distribution to creditors of the debtor’s post-petition earnings following the conversion to a Chapter 7 bankruptcy. The second decision dealt with the tactic of “lien stripping” where a creditor’s security interest is extinguished by the bankruptcy court upon a finding that the value of the collateral is insufficient to satisfy the creditor’s secured claim. In Harris v. Viegelahn, 135 S. Ct. 1829 (2015), the Supreme Court addressed the issue of whether a debtor was entitled to the return of post-petition earnings – held by the Chapter 13 trustee but not yet distributed to creditors – following the conversion to a Chapter 7 proceeding. The Supreme Court reversed the lower court’s decision and held that “a debtor who converts to Chapter 7 is entitled to return of any postpetition wages not yet distributed by the Chapter 13 trustee.”
The debtor, Charles Harris III, had initially filed a Chapter 13 bankruptcy petition in 2010 and was indebted to multiple creditors, including Chase Manhattan on a home loan. The bankruptcy court confirmed Harris’ Chapter 13 plan, which included a provision to withhold $530 per month from his post-petition earnings to be used by the Chapter 13 trustee towards the Chase loan arrears.
However, shortly after the plan was approved, Harris again fell behind on his payments to Chase, who in turn obtained permission from the bankruptcy court to foreclose on Harris’ property. Despite the foreclosure, the trustee continued to receive $530 per month from Harris’ postpetition wages. In 2011, Harris exercised his statutory right and converted his bankruptcy to Chapter 7. Approximately a week after the conversion, the Chapter 13 trustee, who by then had accumulated over $5,500 from Mr. Harris’ postpetition wages, disposed of these funds by distributing them to the debtor’s outstanding creditors. Harris then filed a motion with the bankruptcy court for a refund arguing that the Chapter 13 trustee lacked the authority to make any distribution after the Chapter 7 conversion.
In reaching its decision, the Supreme Court noted the important differences between Chapters 13 and 7, and that upon conversion to Chapter 7, the Chapter 13 trustee’s services are immediately terminated. As stated by the Court, section 348(f) provides that, outside of a conversion done in bad faith, the governing statutes limited a Chapter 7 estate to the property belonging to the debtor as of the date the original Chapter 13 petition was filed. A debtor’s postpetition wages would not fall within that description. The Court also found that since the Chapter 13 trustee’s services were terminated immediately upon the conversion to Chapter 7, the Chapter 13 trustee was “stripped of authority” to make any post-conversion distributions to creditors. And under Rule 1019 of the Federal Rules of Bankruptcy Procedure, the distribution of funds to creditors pursuant to a “defunct Chapter 13 plan is not an authorized wind-up task.” Therefore, the post-petition wages held by the Chapter 13 trustee should have been returned to the debtor upon the Chapter 7 conversion.
In a victory for lenders, the Supreme Court’s other bankruptcy decision, Bank of America, N.A. v. Caulkett, 135 S. Ct. 1995 (2015), effectively brought an end to the practice known as “lien stripping” in Chapter 7 cases. Lien stripping occurs when a junior mortgage lien is extinguished by the bankruptcy court upon a finding that the secured property’s value is less than the amount of the lien. Section 506(d) of the Bankruptcy Code provides: “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” In Caulkett, the parties did not question that the claim at issue was “allowed,” but they did disagree as to whether the bank’s claim, as the junior lienholder, was “secured” within the meaning of section 506(d). The debtor contended that where the subject property was “under water” and liquidation of the property would not yield sufficient funds to provide any payment to the junior lienholder, then such a lien could not be considered “secured” under the code.
In response, the Supreme Court conceded that, under the such circumstances, the Code did suggest that the bank’s claim was not secured. However, in the 1992 decision of Dewsnup v. Timm, the Supreme Court had previously adopted a statutory construction of the term “secured claim” that precluded a Chapter 7 lien stripping. In Dewsnup, the Court defined the term “secured claim” in section 506(d) to mean “a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim.” This was based on the Court’s conclusion that where a claim has been allowed pursuant to section 502, and was secured by a lien that included recourse to the underlying collateral, then such claim could not be voided under section 506(d). As a result of the definition provided in Dewsnup, the bank’s claims in Caulkett, which were both secured and allowed under section 502, could not be voided through “lien stripping.”
Additionally, the Supreme Court rejected the debtor’s request to limit the holding in Dewsnup to situations where the lien is only partially underwater, as opposed to a completely underwater lien, as in Caulkett. The Court noted that limiting the term “allowed secured claim” to junior liens that have “some” value would simply be an artificial restriction that is not supported by the statutory definition. Such a distinction would result in situations where a junior lien would not be stripped if the collateral was valued at one dollar more than the existing senior lien, but could be voided where the same property was valued at one dollar less. Noting the “constantly shifting value of real property,” the Court concluded that such a limitation could lead to arbitrary results, and that such a rule should not be imposed by the Court.
In sum, the Supreme Court's decision in Caulkett protects mortgage liens in Chapter 7, whether such liens are partially (Dewsnup) or totally (Caulkett) underwater. By extension of the Court’s reasoning in Caulkett, secured mortgage lenders may find similar success in Chapter 13 cases.