11th Circuit Court of Appeals
11th Circuit Court of Appeals (Jason Bennitt)

On June 18, the U.S. Court of Appeals for the Eleventh Circuit issued its opinion in Wells Fargo Bank v. Scantling, 13-10558, holding that a Chapter 20 bankruptcy debtor could strip off valueless junior liens on her principal residence despite being ineligible for a discharge in her Chapter 13 bankruptcy case.

Chapter 20 is a colloquialism; it refers to a debtor who files a Chapter 13 case after receiving a discharge in a Chapter 7 case.

Bankruptcy Code Section 1328(f) provides that a debtor who received a discharge in a bankruptcy case commenced within the previous four years is ineligible for a discharge in the new Chapter 13 case. This statute rendered Tahisia Scantling ineligible for a discharge in her Chapter 13 case.

Another section of the Bankruptcy Code provides that a Chapter 13 plan must provide that a creditor holding a “secured claim” will retain its lien until the earlier of the receipt of payment in full of the underlying debt or entry of the Chapter 13 discharge, which typically occurs at the end of the case after the debtor has made all of the payments required by the Chapter 13 plan.

Because Scantling was ineligible to receive a Chapter 13 discharge, it would seem that her plan would have to provide that her lender would receive full payment of her debts underlying the mortgages on her home. In fact, many courts have held exactly that way.

Wells Fargo held three mortgages on Scantling’s home. She and Wells Fargo agreed that the value of her home was less than the amount she owed on her first mortgage; accordingly, Wells Fargo’s junior mortgages had no value to support them.

Scantling argued that because there was no value supporting Wells Fargo’s junior lien claims, they were unsecured claims. Accordingly, she maintained Wells Fargo was not entitled to the statutory protections afforded holders of secured claims. The bankruptcy court agreed and stripped off the junior mortgage liens, conditioned upon Scantling completing her Chapter 13 plan payments.

Bankruptcy Two Step

There is a deep split of authority among federal courts as to whether a Chapter 20 debtor ineligible for a discharge in the Chapter 13 case can strip off valueless liens. But now the majority view that such a strip-off is appropriate has the support of two circuits—the Fourth and Eleventh—which will likely be persuasive authority for lower courts in other circuits.

The primary effect of the Eleventh Circuit’s ruling on appeal from a decision by U.S. District Judge Harvey Schlesinger is that a debtor who has obtained a Chapter 7 discharge need not wait four years from the date of filing her Chapter 7 case to file a Chapter 13 case through which she would seek to strip off valueless liens on a principal residence.

But there are issues that should be considered before embarking on a Chapter 13 in this context. The most important one is whether the individual has regular income to be able to make monthly payments for up to five years. Also, a lender might move to get the Chapter 13 case dismissed as having been filed in bad faith if it appears that the debtor had pre-planned to do a two-step Chapter 7 followed by a Chapter 13 specifically to avoid the liens.

If the Chapter 13 case is filed close on the heels of the concluded Chapter 7 and there are no other circumstances that would explain the need for the subsequent Chapter 13, then a case for bad faith is more easily made.

Future Equity

Finally, the homeowner should consider whether the amount of the debt owed on the junior liens is large enough to make it worth the time, expense and negative ramifications associated with filing personal bankruptcy.

Orders allowing strip-off of valueless liens are predicated upon completion of the debtor’s Chapter 13 plan.

A Chapter 20 debtor who successfully completes her plan and obtains strip-off of valueless liens may then have the opportunity to recapture value in her residence.

This can happen in two ways. Assuming the market value of the home does not continue to erode, if the homeowner diligently pays her first mortgage, over time she will thereby create equity. And if market values improve rapidly, just holding the home will add to the new equity beyond the principal pay down inherent in the monthly mortgage payments.

This might well have the salutary effect of reducing the number of foreclosures because owners of underwater homes might think twice about simply abandoning their homes and all the socioeconomic baggage that process entails.