Lien Stripping in Chapter 7?

Lien stripping refers to the process of eliminating your junior liens (such as second or third mortgages and home equity lines of credit) from your real estate.  Lien stripping allows you to get rid of the “wholly unsecured” liens on your real estate, including your residence.  It is accomplished through a Chapter 13 proceeding and may not be done in Chapter 7.

The Supreme Court has held that a Chapter 7 debtor may not “strip down” a partially secured lien under the Bankruptcy Code.  Since that holding came down, bankruptcy courts across the country have nearly unanimously held that lien stripping is not available to Chapter 7 debtors, whether said liens are partially secured or wholly unsecured.

That is until a Federal Appeals Court recently decided the case of McNeal v. GMAC Mortgage, LLC, which has already made a huge impact in some parts of the country.  The McNeal court reasoned that, because the Supreme Court disallowed a “strip down” of a partially secured lien and did not address a “strip off” of a wholly unsecured lien, it left the wholly unsecured lien issue open to interpretation.  As a direct result of McNeal, not only are Chapter 7 debtors filing motions to strip liens in Chapter 7 cases, some debtors are even reopening closed Chapter 7 cases to strip off their junior liens.

McNeal has in effect given Chapter 7 debtors leverage in negotiating with their mortgage servicers for loan modifications.  In many cases, borrowers face difficultly modifying their senior lien when they have two or more liens on the property and the junior lienholder refuses to relinquish its lien rights.  In short sales, the junior lienholder would likely withhold its consent for the short sale unless it can recover some price in exchange for releasing its lien.

A local Bankruptcy Appellate Panel has on several instances addressed the issue of whether a Chapter 7 debtor could avoid a wholly unsecured junior lien.  The Panel has held that the Bankruptcy Code does not explicitly confer an avoiding power on a Chapter 7 debtor.  The Panel went on to conclude that the Supreme Court has prohibited the avoidance of liens in Chapter 7, regardless of whether the lien was partially secured or wholly unsecured.  Fortunately, the Bankruptcy Court is not bound by the Panel’s decisions.

In sum, there is a split of authority among bankruptcy courts across the country on the issue of whether Chapter 7 debtors may strip off wholly unsecured liens on real property.  Although our local Bankruptcy Courts are not bound by the McNeal case, it is certainly a step in the right direction.

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