A “lien” is an interest, taken by a creditor, in the real or personal property of the debtor, for the purpose of securing a debt or a loan. Liens can be voluntary, such as home mortgages, or involuntary, such as a judgment or a tax lien. Lien holders, or “secured creditors,” are guaranteed repayment of the debt or loan, even when the debtor files for bankruptcy. Thus, lien rights survive bankruptcy, but only to the extent that the lien is not “stripped down” or avoided.
Chapter 13 Bankruptcy in General
A debtor whose liabilities exceed their assets may seek to file for protection against their creditors under U.S. bankruptcy laws. Most individuals that declare bankruptcy file under Chapter 7. Chapter 7 basically involves the collection and sale of the debtor’s non-exempt assets, with the proceeds being used to pay off their creditors. Most of the remaining debts are discharged.
However, certain qualified debtors, with a regular income, may file for Chapter 13 reorganization. Chapter 13 is highly advantageous in that it allows debtors to keep all of their assets. In a Chapter 13 proceeding, the debtor structures a three to five year “plan” under which they propose to pay off all or most of their debts using their current income. The plan must then be submitted to and confirmed by the bankruptcy court. Typically, only a portion of the debtor’s unsecured debts (i.e., those not secured by a lien or other collateral) will be paid, while other unsecured debts will be discharged when the last payment has been tendered.
Lien Stripping in Bankruptcy
Liens are used to secure debts by allowing the creditor to retain an interest in the debtor’s real or personal property. However, the U.S. Bankruptcy Code provides that the lien only secures the claim to the extent of the value of the creditor’s interest. In other words, if the lien or interest is worth more than the actual value of the property, the creditor’s secured claim is only as good as the value of the property. Any leftover claim is unsecured. In a Chapter 13 bankruptcy, the Code allows the debtor to “bifurcate” or divide liens into secured and unsecured claims. The unsecured claim is then eligible to be “stripped” off and discharged.
A common example of lien stripping involves auto loans. For example, suppose a debtor still owes $12,000 on a vehicle, but the vehicle itself is currently worth only $10,000. The creditor holds a $10,000 secured claim (the actual value of the car) and a $2,000 unsecured claim (the remainder). If the debtor files for Chapter 13 bankruptcy, they might be able to strip the $2,000 unsecured claim off the value of the asset and have it discharged (eliminated).
Limitations on Lien Stripping
To the extent that a lien exceeds the value of the debtor’s property, it may be “stripped” in a Chapter 13 bankruptcy. The Chapter 13 plan must not only reflect the proposed stripping of the lien but must also explicitly provide for a full payment of the secured portion of the debt. A creditor may object to the plan and the court may or may not confirm the plan over the creditor’s objection. However, while the Bankruptcy Code allows a Chapter 13 plan to modify the rights of secured creditors, it prohibits stripping of liens secured only by an interest in the principal residence of the debtor.
Furthermore, Section 1325 provides that if a creditor has a purchase-money lien on a motor vehicle that was acquired for personal use, that debt cannot have been incurred within the preceding 910 days (2 ½ years) of the date the bankruptcy petition was filed. For any other “thing of value,” the debt cannot have been incurred within the preceding year. This section is referred to as the “Hanging Paragraph.”
Dealing Debts Secured by Property in Bankruptcy
A debtor that files for bankruptcy under any chapter generally has three options with regard to the property, or collateral, that secures their debt. The debtor may choose to redeem the debt, reaffirm the debt or surrender the property to the creditor. For example, if the debtor owes money on their car and files for bankruptcy, they may redeem their loan by paying off the creditor in full with a single cash payment. The debtor may also reaffirm the debt by agreeing to waive any discharge on the car loan that a bankruptcy would provide and continuing to make regular payments. Finally, the debtor may surrender the vehicle to the creditor who may then sell the asset to recover all or a portion of their claim. In the final scenario, any unpaid balance is “stripped” and may be discharged.
The Hanging Paragraph for “910 Creditors” does not apply to surrendered vehicles. A majority of courts have held that the Hanging Paragraph allows “a debtor [to] surrender a 910 vehicle in full satisfaction of their indebtedness to the creditor and, therefore, no deficiency claim [would be] allowed.” In re Vanduyn
Valuing Property for Purposes of Lien Stripping
Subsection 2 has been added to Section 506(a) of the Bankruptcy Code. That section overturns the cases that permitted the value of the asset to be the wholesale value in favor of the retail value:
(2) If the debtor is an individual in a case under Chapter 7 or 13, such value with respect to personal property securing an allowed claim shall be determined based on the replacement value of such property as of the date of the filing of the petition without deduction for costs of sale or marketing. With respect to property acquired for personal, family, or household purposes, replacement value shall mean the price a retail merchant would charge for property of that kind considering the age and condition of the property at the time value is determined.
However, the new valuation must take into account the property’s age and condition at the time of the value determination.
Bankruptcy Courts Use “Replacement Value” for Chapter 13 Cram-Downs
Three valuation standards used by bankruptcy courts include:
- Replacement value – the price a willing buyer in the debtor’s trade, business, or situation would pay a willing seller to obtain property of like age and condition
- Foreclosure value – what the creditor could realize if it sold the estate’s interest in the property according to the security agreement through repossession and sale
- Hybrid – the midpoint between replacement value and foreclosure
Section 506(a)(2) incorporates the holding of a 1997 U.S. Supreme Court case that ruled that where a Chapter 13 debtor seeks to cram-down the value of the secured claim to equal the actual value of the asset, they must use the replacement value when they seek to retain use of the property.
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