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Published: 2008-03-26

Unsecured Second Mortgage Not Protected by Anti-modification Provision of Chapter 13



Recently the United States Court of Appeals for the Third Circuit held that a second mortgage on a chapter 13 debtor's primary residence is not immune from modification if the junior mortgage is wholly unsecured by any remaining value in the residence. As a general rule, a chapter 13 debtor may modify the rights of most holders of secured claims. For example, a creditor who holds a secured interest in a chapter 13 debtor's automobile or a mortgage on a chapter 13 debtor's store may have that claim bifurcated into a secured and unsecured claim, each entitled to different treatment under the debtor's chapter 13 plan.

Protected from modification, however, is the creditor that holds a claim secured only by a security interest in real property that is the debtor's primary residence. Under section 1322(b)(2) of the Bankruptcy Code, the creditor that holds such an interest cannot have its claim modified or reduced by the debtor's chapter 13 plan so long as there is some value in the debtor's principal residence. This provision is known as the "antimodification clause" of section 1322(b)(2).

Courts have questioned the extent to which a mortgage must be secured before the antimodification clause applies. The short answer is, so long as there is some equity value in the debtor's primary residence, the entire value of the mortgagee's claim passes through chapter 13 unscathed. But what about a second mortgage on that same home? Is it subject to modification? Or does it, too, pass unaffected through chapter 13? And what becomes of a second mortgage when there is not enough equity in the home to fully satisfy the first, let alone the second, mortgage holder?

In McDonald v. Master Financial, Inc., the Third Circuit concluded that a second mortgage that was wholly unsecured was not protected by chapter 13's antimodification provision. The debtors, the McDonalds, claimed that the value of their home was only $126,400. The balance on the first mortgage was $127,633.33. The balance on the second mortgage, held by Master Financial, was $46,846.42. The McDonalds asserted that the second mortgage was wholly unsecured because the sale of their home would leave a shortfall of $1,233.33 for the first mortgage holder and would leave nothing at all for Master Financial. For this reason, the McDonalds sought to modify the claim of Master Financial in their chapter 13 plan.

The bankruptcy court determined that, under chapter 13, the rights of an unsecured second mortgagee were identical to those of an undersecured first mortgagee. The bankruptcy court strictly construed the antimodification language of section 1322(b)(2), holding that the second mortgage was still "a claim secured by a security interest in real property that is the debtor's primary residence" even if there was not enough equity in the debtor's home to satisfy any of Master Financial's claim. Therefore, the bankruptcy court held that the second mortgage could not be modified under the McDonalds' chapter 13 plan. The district court agreed with this analysis, and the McDonalds appealed to the Third Circuit, which reversed the lower court.

Secured and Unsecured Claims under Chapter 13

The Third Circuit's decision began with an analysis of the United States Supreme Court's decision in Nobelman v. American Savings Bank. In Nobelman, the Supreme Court held that a chapter 13 debtor who had a single mortgage with an outstanding balance greater than the value of the debtor's home could not treat the mortgage as secured only to the extent of the value of the debtor's home and modify the remaining amount. Justice Thomas, writing for the majority in Nobelman, stated that the full amount of the mortgage survived and could not be modified under the debtor's chapter 13 plan, even though the house was worth less than the amount of the outstanding mortgage.

Threshold Valuation under Section 506(a) - Is There Any Equity Value in the Debtor's Home?

In Nobelman, Justice Thomas wrote that it is "correct to look to Section 506(a) for a judicial valuation of the collateral to determine the status of the bank's secured claim." Section 506(a) of the Bankruptcy Code bifurcates undersecured claims into two parts: secured claims and unsecured claims. Under section 506(a), a claim is a "secured" claim only to the extent of the value of the collateral. The portion of the claim that exceeds the value of the collateral is deemed an "unsecured claim." In Nobelman, the Supreme Court concluded that if the debtor's home at least partially secures the mortgagee's claim, then the bank is considered "secured" for purposes of section 1322(b)(2). The bank in Nobelman was secured because the debtor's home, although worth less than the full amount of the outstanding mortgage, still had some value. Thus, under section 1322(b)(2), none of the bank's rights could be modified under the debtor's chapter 13 plan.

Nobelman did not address what happens in a case where a second or junior mortgage is wholly unsecured, as might occur when a chapter 13 debtor's home is fully encumbered by prior liens. The McDonald court observed that the Ninth Circuit is the only other appellate court that has applied the reasoning in Nobelman to a situation involving a wholly unsecured mortgage. In In re Lam, the Ninth Circuit held that a wholly unsecured mortgage holder does not have the protections of the antimodification clause under section 1322(b)(2). Like Nobelman, Lam also applied section 506(a) to determine the status of the bank's claim. Finding that there was no value in the home to cover the mortgage claim, the Lam court concluded that the bank was not the holder of a secured claim for purposes of section 1322(b)(2). In McDonald, the Third Circuit concluded that where a court determines under a section 506(a) analysis that there is no existing value to which a bank's lien can attach, it follows that the bank is wholly unsecured and does not have a secured claim for purposes of the antimodification clause.

The McDonald court noted that, while the antimodification clause uses the term "claim" rather than "secured claim" and, therefore, applies to both secured and unsecured parts of a mortgage, the antimodification clause still states that the claim must be "secured only by a security interest in the debtor's principal residence." If a threshold valuation of a bank's claim under section 506(a) determines that the bank is not in any respect the holder of a claim secured by the debtor's residence, then the bank is wholly unsecured and does not enjoy the protection of the antimodification clause. If, on the other hand, a valuation determines that any part of the bank's claim is secured, then the entire claim will be considered "secured" and will not be subject to modification under section 1322(b)(2).

The McDonald court supported its holding by stating that the legislative intent behind the antimodification clause was to encourage the flow of capital into the home lending market. This protection does not extend to the second mortgage lender because second mortgages are rarely used to purchase a home. Extending the protection of the antimodification clause would have little impact in encouraging home building and purchasing. Thus, second mortgage lenders are very much like other general creditors and, therefore, like other general creditors, they should be subject to having their claims modified.

Conclusion

The McDonald court did not so much break new ground as apply established precedent to a new situation. The McDonald court merely continued the line of reasoning set forth in Nobelman. The Supreme Court has held that there must be a threshold determination under section 506(a) of the Bankruptcy Code as to whether the debtor's principal residence, the bank's collateral, has any existing value to cover the bank's secured claim. If there is any value in the residence to secure any part of the bank's claim, then the entire value of the bank's claim passes unscathed through chapter 13. In contrast, if there is no value in the home, then the bank cannot hold a secured claim for purposes of section 1322(b)(2). It remains to be seen whether other circuits will adopt the McDonald court's reasoning, or whether another split in the circuit courts will send the issue back to the Supreme Court for further disposition.

McDonald v. Master Financial, Inc., 205 F.3d 606 (3d Cir. 2000).
Nobelman v. American Sav. Bank, 508 U.S. 324, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993).
In re Lam, 211 B.R. 36 (9th Cir. BAP), appeal dismissed, 192 F.3d 1309 (9th Cir. 1999).