Weltman Successfully Overturns Lien Avoidance Decisions in New York

Weltman successfully overturned a line of cases in the Eastern District of New York Bankruptcy Court that routinely allowed debtors to remove wholly unsecured mortgages in a Chapter 7 bankruptcy proceeding. In the case of In re: Smoot, 465 B.R. 730 (Bankr. E.D.N.Y., 2011), the District Court reversed two bankruptcy decisions that allowed this practice.

In Smoot, the bankruptcy court ruled that the second mortgages held by the creditors were wholly unsecured based upon the value of the property.  The bankruptcy judge ruled that the creditors' liens were void and should be removed from the property.  In reversing these decisions, the District Court relied upon the U.S. Supreme Court's case, Dewsnup v. Timm 502 U.S. 410 (1992).  The District Court held that pursuant to the Supreme Court's ruling in Dewsnup, it does not matter if the second mortgage is fully unsecured or merely under-secured in a Chapter 7 bankruptcy case.  The liens should pass through bankruptcy unaffected.  The Supreme Court in Dewsnup reasoned that the debtor and creditor bargained for a consensual lien which would stay with the real property until foreclosure.  The Supreme Court also held that any increase in value of the real property should accrue to the benefit of the creditor, not the debtor or other unsecured creditors.

The Eastern District of New York Court in Smoot also made a distinction between a Chapter 7 and a Chapter 13 bankruptcy case.  In a Chapter 13 case, a debtor contributes all disposable income for three to five years to repay creditors.  The Smoot Court acknowledged that lien stripping in a Chapter 13 furthers the purpose and intent of repayment to creditors and that lien stripping a wholly unsecured mortgage should be allowed as an incentive to file the Chapter 13 case.  In contrast, a Chapter 7 bankruptcy proceeding is considered a liquidation and does not encourage the debtor to repay creditors.  Therefore, the avoidance of a wholly unsecured mortgage is not applicable in a Chapter 7 case.

The Smoot decision reverses the practice of lien stripping wholly unsecured mortgages in Chapter 7 bankruptcy cases in the Eastern District of New York.  Most other jurisdictions are consistent with this opinion.  However, the Eleventh Circuit, which includes the bankruptcy courts in Florida, Georgia and Alabama, allow mortgages to be avoided in Chapter 7 bankruptcy proceedings.  Weltman addressed this issue in an earlier client advisory 11th Circuit Dilutes Dewsnup dated May 31, 2012. Go here to view that client advisory: http://www.weltman.com/publications/client-advisories/?i=484&NH.