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First Challenge to McNeal Reveals Lien Stripping Challenges for Chapter 7 and 13 Debtors

Posted in Bankruptcy, Commercial Lending, Debt and Judgment Collection

Nearly five months after McNeal was decided by the Eleventh Circuit, a challenge has arisen within the Eastern District of New York, which has historically been fertile ground for bankruptcy law. In Wachovia Mortgage v. Smoot, the court rejected a debtor’s attempt to strip off a wholly unsecured junior mortgage in a Chapter 7 proceeding, and in doing so reinforced the majority of courts from which McNeal departed.

For lenders and creditors not familiar with the Eastern District of New York, the result in Smoot is especially significant, as the same court in 2009 had allowed a Chapter 7 debtor to avoid its wholly unsecured claim. This unpublished decision in In re Lavelle had been one of the only other opinions in the nation to allow lien stripping in Chapter 7 proceedings before McNeal.

Smoot’s analysis is directly in line with the pre-McNeal decision within the Eleventh Circuit, exemplified by Judge Jennemann’s opinion in In re Hoffman, which held that Congress did not intend to provide Chapter 7 debtors the right to avoid an allowed secured claim, even if that claim were not secured by any value in the collateral.

Perhaps as important as the rejection of McNeal’s lien-stripping allowance was the strong distinction that Smoot made between lien modifications in Chapter 7 and 13 cases. As discussed in the “Chapter 20” post below, the Eleventh Circuit has allowed Chapter 13 debtors to strip off wholly unsecured junior mortgages since the 2000 decision of In re Tanner. The Second Circuit followed suit in 2001, in the case of In re Pond.  Because debtors have been successful stripping off in Chapter 13 cases, many have attempted to adopt Tanner, Pond and their progney to support Chapter 7 stripping.

The court in Smoot correctly held that this argument overlooked the “unique statutory predicate of Chapter 13” – specifically, that Pond & Tanner rely upon § 1322(b)(2) to strip off the wholly unsecured junior mortgage. This is important because there is no analogue to the anti-modification language in § 1322(b)(2) under Chapter 7. Thus, a debtor cannot rely upon a permissive lien strip in a Chapter 13 to support a strip in a Chapter 7, as the debtor had in Lavelle.

Although McNeal did not directly rely upon Lavelle or Chapter 13 case law, Smoot serves to further isolate McNeal’s position in the consumer creditor landscape. Further, Smoot provides clear and succinct guidance to subsequent courts who are faced with a Chapter 7 debtor attempting to invoke Chapter 13 jurisprudence to strip a lien.

Ultimately, Smoot is good news for lenders and other creditors, even outside the Eastern District of New York, as it illustrates once more the majority position that even wholly unsecured junior liens should survive the Chapter 7 liquidation.