The doctrine of reasonableness holds that, in a bankruptcy proceeding, the bankruptcy filer (debtor) may be allowed to request certain forms of relief or adjustment of debt legally owed if there are reasonable arguments for doing so that result in a fair outcome for all parties.
Debtors have taken this leeway and used it to try and pare down — or completely set aside — creditors’ interests in property that was supposed to act as security for a loan. In effect, a debtor who is “upside down” or “underwater” on the amount they owe for their property can use this fact to their advantage. Because unsecured debts are supposed to be discharged at the end of a bankruptcy filing, the fact that they owe more on the property than it is worth could, theoretically, be used as a justification to reduce the amount owed on secured property to equal the fair market value of a sale of that property.
Creditors may, justifiably, be upset to hear that the people who owe them money may be able to use this power — informally called a “strip down” of a mortgage or lien. Fortunately, they may be able to prevent or at least influence the outcome of such a decision, reducing their losses while seeking to protect their interests in the property affected by a lien.
If you are a lender to someone who is filing for bankruptcy and are concerned about their ability to remove a lien or reduce its value, reach out to our New Mexico creditors’ rights attorneys today. New Mexico Financial & Family Law has extensive experience handling bankruptcy cases, and our familiarity with the laws and common procedures allows us to provide you with a strategy for seeking the best outcome possible, given each unique situation.
Find out more about how we can help creditors like you when you call (505) 503-1637 or contact us online to speak with an experienced bankruptcy lawyer in your area.
A “strip down” is a very powerful provision in the bankruptcy code that can help a debtor reduce
or eliminate certain secured debt, including mortgages and car loans.
The concept is that a debt that is secured by collateral that is worth less than the debt is only partially secured and partially unsecured. In bankruptcy court, in a variety of contexts, a court may determine that a certain vehicle is worth (for example) $25,000, but there is $50,000 owed against it. Then the court could order that the debtor has to pay back only $25,000, plus a reasonable rate of interest.
In effect, the claim on a loan related to the vehicle is split, or bifurcated, into secured and unsecured portions. The secured portion remains under lien and has to be paid back. The remaining unsecured portion may be subject to a repayment plan, or it may be completely “stripped away,” hence the common term strip down.
When equity for a single piece of property is used as the basis of multiple loans, there may be multiple liens on the same property when the owner goes into bankruptcy proceedings. Junior loans, such as a “second mortgage” or “home equity line of credit (HELOC),” are subordinate to the original mortgage if it is not yet paid off.
If the amount owed on the original mortgage exceeds the market value of the property, minus equity, then there is no equity remaining to act as security for the junior loan. In the past, courts allowed for junior loans to be “stripped down” completely to unsecured status when the property was completely underwater — effectively making them “stripped off” completely from the debt the petitioner was required to repay and, thereby, effectively removing all interest held by the lien.
However, a 2015 U.S. Supreme Court decision (Bank of America v. Caulkett) determined that the language used to justify a strip off misinterpreted §506 of the U.S. Bankruptcy Code, barring the use of strip offs entirely in Chapter 7 cases, except in situations where the debt is made invalid because of fraud.
A strip off could still potentially come into effect during a Chapter 11, Chapter 13, or Chapter 20 case, though, the Caulkett decision notwithstanding.
Because they are no longer permitted in Chapter 7 cases, which make up the majority of bankruptcy filings, strip downs and strip offs have become much more rare since the 2015 Caulkett decision.
Nevertheless, lenders may find themselves worried about their ability to enforce their lien and secure their own financial interests in cases where the debtor is filing for Chapter 13, Chapter 11, or Chapter 20 bankruptcy.
Below, we have listed some of the most effective defensive strategies lenders can wield with the help of an experienced bankruptcy lawyer representing them.
The value of the property affected by a lien is the key issue in a strip down or strip off. These actions are only available when the property in question becomes undersecured or completely unsecured because the value of the balance owed greatly exceeds the fair market value of the asset.
Undervaluation of assets, therefore, could provide debtors with an advantage — the lower the asset is priced, the bigger the chance that their debt is considered undersecured or unsecured.
However, the creditor has a right to be heard when the value of the property is determined. Moreover, the courts have ruled that the property must be valued as if it had sold at a fair, commercially reasonable, sale at the time.
The debtor is not allowed to both keep the property and devalue the lien by deducting the costs of a hypothetical auction. Further, the debtor has the burden of proving the value.
Creditors can file an adversary proceeding to contest the valuation method used to determine the asset’s value, instead urging for a valuation closer to actual fair market value (FMV). Determining an appropriate valuation method, to the satisfaction of the bankruptcy court, can be challenging, so creditors must be prepared to legally justify the price they arrive at, especially when it is compared directly to the initial price determined by the debtor or their trustee.
Depending on the action being considered, debtors may not be able to request a strip down so long as they still hold an appreciable level of non-exempt equity in the property. Otherwise, they will be compelled to either liquidate the property or otherwise generate funds in order to offset the value of the property they intend to keep.
Requesting a reassessment of the debtor’s current position for the property, therefore, can provide options for creditors seeking to prevent the use of a strip down.
Some Chapter 11 proceedings will result in secured creditor liens “riding through” the reorganization in order to still remain valid once the petitioner emerges from bankruptcy.
For example, one court case (Acceptance Loan Co., Inc. v. S. White Transportation Inc.) determined that a secured creditor’s inaction throughout the course of Chapter 11 proceedings meant that their lien could “ride through” the case and not be affected by the other actions taken during it. This finding relies on an interpretation of §1141(c) that states that a creditor must “participate” in a bankruptcy in order for its lien to be made void.
As part of a reorganization or liquidation plan, the bankruptcy court can authorize the sale of a property “free and clear of liens or other interests,” per §363 of the bankruptcy code. In order for such a sale to proceed, both the debtor and the lien-holder have to consent, and the sale must be otherwise permitted under state and federal law. The sale price must also exceed the total value of the liens that would otherwise affect the property.
Once a sale pursuant to §363 is concluded, the lien then attaches to the proceeds of the sale, allowing the lien-holder to recover their interests. Agreeing to such a sale can put a lender in a tight spot, however, so it is advisable to refer to an attorney for guidance on whether to consent to such a sale and how to protect your interests during the course of remaining bankruptcy proceedings.
When a “strip-down” is contemplated, it is often accompanied with a request
to change the interest rates. Bankruptcy courts can change interest rates on certain debt in
certain instances. The creditor has a right to be heard on what the appropriate interest rate
should be, based on relevant market factors and measures of reasonableness.
Since Chapter 13 bankruptcies are the most likely situation where a strip down is requested, lenders at least have some power to influence the outcome by joining the creditors’ committee. This committee has the power to propose, approve of, or dispute plans for repayment. A lien-holder’s participation on this committee could allow them to protect their own legal interests, while trying to seek a fair and equitable outcome for all others involved.
Having an attorney represent your interests during a bankruptcy can make a substantial difference in the final outcome of the case.
Sometimes a “strip-down” may be contemplated in a legal document that an ordinary person might not fully understand. If the creditor is not represented by a competent creditors’ rights attorney, the debtor could obtain the result of unfairly devaluing a lien, thereby reducing the total debt, and paying an unfair interest rate.
New Mexico Financial & Family Law pledges to serve its clients throughout the course of bankruptcy proceedings, especially when our representation can mean the difference between repayment and being left with no options.
When you are ready to discuss your case and prepare for someone with your lien on their property to file bankruptcy, we are here to listen. Find out more about your legal rights and options when you call (505) 503-1637 or contact us online to book a consultation.
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