The U.S. Court of Appeals for the Ninth Circuit, in a case of first impression, recently held that section 1328(f) of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which bars so-called “Chapter 20” debtors from receiving a discharge at the conclusion of their Chapter 13 reorganization if they received a Chapter 7 discharge within four years of filing the petition for Chapter 13 relief, does not prevent a debtor from voiding a secured creditor’s lien under section 506(d) of the Bankruptcy Code.

A copy of the opinion is available at: Link to Opinion.

In 2007, husband and wife debtors filed for bankruptcy protection under Chapter 7 of the Bankruptcy Code. They received a discharge of their unsecured debts in 2009. The next day after receiving the discharge, the debtors filed a second bankruptcy proceeding under Chapter 13 of the Code, seeking to restructure the debt on their primary residence.

There were two mortgages on the unit. The first mortgagee filed a proof of claim, to which the debtors objected on the basis that the mortgagee failed to attach a copy of the promissory note to its proof claim.

The mortgagee failed to respond to the debtors’ objection to its proof of claim.  In November 2009, the bankruptcy judge entered an order disallowing the claim.

In April 2010, the debtors filed an adversary proceeding, seeking to void the first mortgagee’s lien pursuant to section 506(d) of the Bankruptcy Code, which provides that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such claim is void.”

The bankruptcy court held a hearing the following month, at which it advised the first mortgagee that it needed to address the disallowance order. Despite this, almost 18 months passed before the first mortgagee filed a motion for reconsideration of the disallowance order. Finding no legal basis excusing the delay, the bankruptcy court denied the motion to reconsider the disallowance order.

The debtors moved for summary judgment in the adversary proceeding. The first mortgagee responded, arguing that it would be improper and unfair to void its lien due to a mere failure to respond, relying upon the Seventh Circuit’s decision in In re Tarnow, 749, F.2d 464 (7th Cir. 1984), which held that because a secured creditor is not required to file a proof of claim at all and may rely on its lien for payment of the debt, voidance of the lien under section 506(d) is a “disproportionately severe sanction” for a late-filed claim.

After a hearing, the bankruptcy court ruled that despite the case law standing for the proposition that a secured creditor need not participate in a Chapter 13 case without imperiling its lien, the text of Bankruptcy Code section 506(d) provides that a lien securing a disallowed claim can be avoided.  The court distinguished Tarnow, reasoning that it involved a late-filed claim, while in the case at bar, the first mortgagee filed a timely claim, which was then disallowed. It then ordered that upon debtors’ completing the Chapter 13 plan, the first mortgagee’s deed of trust would be void and cancelled.

The Chapter 13 case proceeded to the plan confirmation stage, with the bankruptcy court ultimately approving the debtors’ eleventh amended plan in April 2012. The confirmed plan voided the first-position lien, but reinstated the second-position lien.

The first mortgagee appealed to the U.S. District Court for the Western District of Washington, which affirmed the bankruptcy court’s orders, reasoning that it lacked jurisdiction over the disallowance order and the order denying reconsideration because the first mortgagee did not timely appeal those orders. The district court also denied the debtors’ request for attorney’s fees.

The first mortgagee then appealed the district court’s order affirming the bankruptcy court’s order permanently voiding its lien to the Ninth Circuit. The debtors cross-appealed the denial of their request for fees.

Several months after filing the appeal, the debtors completed their Chapter 13 plan. Before the closure of the case and consequent permanent voiding of the first mortgagee’s lien, the first mortgagee moved for an emergency stay of the bankruptcy court’s order closing the case, which the Ninth Circuit granted pending the outcome of the appeal.

Court Says Bankruptcy Court Properly Voided Lien

On appeal, the Ninth Circuit first addressed a question of first impression — i.e., whether the bankruptcy court properly voided the first mortgagee’s lien under section 506(d) of the Bankruptcy Code.

After analyzing the statutory text, the Court concluded that “[t]he most straightforward reading of the text suggests that if a creditor’s claim has not been ‘allowed’ in the bankruptcy proceeding, then ‘such lien is void.’ ”  In so ruling, the Ninth Circuit noted that Congress, by enacting section 506(d), made clear that its “manifest purpose is to nullify a creditor’s legal rights in a debtor’s property if the creditor’s claim is ‘not allowed,’ or disallowed.”

The Court reasoned that the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992), which held that a Chapter 7 debtor could not void an under-secured lien because the claim had been fully “allowed” under section 502, supported its interpretation of section 506(d).

The Ninth Circuit noted that “Dewsnup’s holding clarifies that § 506(d)’s voidance mechanism turns on claim allowance,” and that “section 506(d) does not void liens on the basis of whether they are secured under section 506(a), but on the basis of whether the underlying claim is allowed or disallowed.”  The Court concluded that because the first mortgagee’s “claim was disallowed, § 506(d) leaves [it] with ‘a claim against the debtor that is not an allowed secured claim,’ and therefore its lien is void.”

The Court then considered the novel “Chapter 20” question of whether the lien would be resurrected upon completion of the Chapter 13 plan or was permanently voided.

The Court pointed out that in 2005, Congress enacted BAPCPA in part “to correct perceived abuses of the bankruptcy system … [and] provide greater protections for creditors … [including] reforms ‘prohibiting abusive serial filings and extending the period between successive discharges.” One of these new provisions is § 1328(f), which prohibits the bankruptcy court from granting a discharge of the debts included in a Chapter 13 plan “if the debtor has received a discharge in a case filed under chapter 7, 11, or 12 … during the 4-year period preceding the date of the order for relief ….”

The Court noted that whether debtors who are ineligible for a discharge under § 1328(f) of BAPCPA can permanently void a lien has divided courts within the Ninth Circuit, and that the two other courts of appeals and three bankruptcy appellate panels that have addressed the question have all concluded that so-called “Chapter 20 debtors may void liens irrespective of their eligibility for a discharge.”

The Court rejected, as resting upon a “fatal flaw,” the first mortgagee’s argument that because the debtors were ineligible for a discharge under § 1328(f), their case must either be converted to a Chapter 7 liquidation or dismissed “for cause,” both of which would resurrect the lien that was voided under § 506(d).

The fatal flaw was that the language relied upon by the borrowers and lower courts in the Ninth Circuit’s earlier decision in In re Leavitt, 171 F.3d 1219 (9th Cir. 1999), that a Chapter 13 case could end only through a “discharge pursuant § 1328, conversion to a Chapter 7 case pursuant to § 1307(c) or dismissal of a Chapter 13 case ‘for cause’ under § 1307(c)” was dictum. The Court explained that “Leavitt imposed no ‘rule’ that a Chapter 13 case must end in conversion, dismissal, or discharge, and the Bankruptcy Code is devoid of any such requirement.”

By way of example, the Ninth Circuit pointed out that the Bankruptcy Code “contemplates closure of a case pursuant to § 350(a), which provides that ‘[a]fter an estate is fully administered and the court has discharged the trustee, the court shall close the case.’ With closure, no conversion, dismissal, or discharge is necessary.”

The Court reasoned that “[f]undamentally, a discharge is neither effective nor necessary to void a lien or otherwise impair a creditor’s state-law right of foreclosure” because a discharge only enjoins a creditor from collecting a debt personally against the debtor and does not affect an otherwise valid, pre-petition lien. It follows logically that there is no reason to make the Bankruptcy Code’s in rem modification or voidance provisions contingent upon a debtor’s eligibility for a discharge, when discharges do not affect in rem rights.”

Thus, the Ninth Circuit joined the Fourth and Eleventh Circuits “in concluding that Chapter 20 debtors may permanently void liens upon the successful completion of their confirmed Chapter 13 plan irrespective of their eligibility to obtain a discharge…” holding that the debtors’ “ineligibility for a discharge does not prohibit them from permanently voiding [the first mortgagee’s] lien.”

The Court next turned to whether the voiding of the first mortgagee’s lien violated the bank’s right to due process. The first mortgagee argued that Federal Rule of Bankruptcy Procedure 7001(2) “requires actions determining the ‘validity, priority, or extent of a lien’ to be brought in an adversary proceeding, which imposes certain notice requirements on plaintiffs.” Although the debtors did file an adversary proceeding and moved for summary judgment seeking to void the first mortgagee’s lien, the first mortgagee argued that the lien was actually voided by the earlier disallowance order. In addition, the debtors never mentioned that they intended to void the lien in their 2009 objection to the first mortgagee’s proof of claim.

The Court rejected both arguments, relying upon the Supreme Court’s decision in United Student Aid Funds, Inc. v. Espinosa, 559 U.S. 260 (2010), which held that a student loan creditor’s due process rights were not violated because it received actual notice of the debtor’s proposed Chapter 13 plan, which provided for repayment of the principal but discharge of the accrued interest, and the creditor filed a proof of claim reflecting both, but failed to object to the proposed plan’s discharge of interest or the debtor’s failure to bring an adversary proceeding to determine the debt’s dischargeability.

The Ninth Circuit reasoned that under Espinosa, once the first mortgagee received notice of the debtors’ objection to its proof of claim, “it was deemed to have notice that its claim might be affected and it ignored the ensuing proceedings to its peril.” The district court’s ruling that the bankruptcy court afforded the first mortgagee due process was affirmed.

Court Holds Chapter 13 Petition Was Filed in Good Faith

Finally, the Court addressed whether the bankruptcy court erred in ruling that the debtors’ Chapter 13 petition was filed in good faith. It began by explaining that “[a] Chapter 13 petition may be dismissed “for cause,” pursuant to § 1307(c) of the Bankruptcy Code, if it was filed in bad faith.”

Citing its decision in Leavitt, which set out four factors that a bankruptcy court must consider as part of the “totality of the circumstances” in determining whether a debtor acted in good faith, the Court rejected the first mortgagee’s argument that the Chapter 13 petition was filed in bad faith because it was filed while the earlier Chapter 7 case was still technically open in order to stop the state court foreclosure action.

Although the Ninth Circuit had previously held that successive filings did not constitute bad faith per se, it had never addressed whether simultaneous filings should be treated differently.

Rejecting the per se rule adopted by the Seventh Circuit, the Court agreed with the Eleventh Circuit’s more flexible “fact-sensitive good faith inquiry” test in In re Saylors, 869 F.2d 1434 (11th Cir. 1989),which “concluded that a per se rule against filing a Chapter 13 proceeding while a Chapter 7 case remained open (although the discharge had been issued) ‘would conflict with the purpose of Congress in adopting and designing chapter 13 plans.’ ” The Court reasoned that “[b]ecause nothing in the Bankruptcy Code prohibits debtors from seeking the benefits of Chapter 13 reorganization in the wake of a Chapter 7 discharge, we see no reason to force debtors to wait until the Chapter 7 case has administratively closed before filing for relief under Chapter 13.”

The Ninth Circuit concluded that “the bankruptcy court did not err in finding that the petition and plan were filed in good faith.”

The bankruptcy court’s order voiding the lien, the order confirming the plan and the order implementing the plan were affirmed.

As to the debtors’ cross-appeal on the issue of attorney’s fees, the Court held that “the district court lacked jurisdiction to determine whether the [debtors] were entitled to attorneys’ fees because this issue was not addressed, in the first instance, by the bankruptcy court,” vacated the district court’s denial of fees and instructed the district court to remand the matter to the bankruptcy court to determine whether the debtors were entitled to attorney’s fees.