A speedometer with needle plunging down past word Bankrupt

Bankruptcy practitioners routinely advise secured creditor clients to file protective proofs of claim in bankruptcy proceedings despite those clients’ ability to ignore bankruptcy proceedings and decline filing claims without imperiling their lien due to the protections afforded by state law foreclosure rights.[1] But a recent Ninth Circuit decision is causing attorneys and clients to reconsider whether this traditionally conservative approach is simply too risky in Chapter 13 cases. HSBC Bank v. Blendheim (In re Blendheim), No. 13-35412, 2015 WL 5730015 (9th Cir. Oct. 1, 2015).

The Blendheims filed for Chapter 13 relief after receiving a Chapter 7 discharge, making them what is commonly referred to as “Chapter 20” debtors. Holding a first-position lien secured by the Blendheims’ West Seattle condominium, HSBC filed a timely proof of claim, to which the Blendheims filed an objection. HSBC did not respond, and hearing no response, the court entered an order disallowing HSBC’s claim. HSBC was served with the order, but continued to take no action until several months later when the Blendheims filed an adversary proceeding seeking, among other things, to void HSBC’s first-position lien pursuant to Bankruptcy Code § 506(d). Section 506(d) provides that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.”

Citing HSBC’s timely filed proof of claim, receipt of service of the Blendheims’ objection, and full and fair opportunity to contest the disallowance of its claim but simply choosing not to, the Ninth Circuit distinguished its decision from Fourth, Seventh, and Eighth Circuit precedent holding that bankruptcy courts may not use § 506(d) to void liens whose claims have been disallowed on the sole basis that their proofs of claim were untimely filed. Rather, the panel concluded that while “[v]oidance of a lien posed a more drastic consequence than simple disallowance of HSBC’s claim in the bankruptcy proceeding” because “voiding the lien would eliminate HSBC’s state-law right of foreclosure,” HSBC’s refusal to defend its lien was tantamount to forfeiting its claim.

Finding that the lien was properly voided under § 506(d), the Ninth Circuit next examined whether any provisions of the Bankruptcy Code functioned to reinstate the previously voided lien at the conclusion of the Blendheims’ Chapter 13 proceeding. HSBC argued that a discharge was necessary to obtain the benefits of lien voidance because, apart from conversion or dismissal, discharge was the only mechanism available to bring a Chapter 13 case to close in a manner that makes lien voidance “permanent.” But the court disagreed, noting that while Chapter 13 cases commonly “conclude” with conversion to Chapter 7, dismissal, or discharge, the Blendheims’ case presented “a novel ‘Chapter 20’ question.”

Under a plain reading of Bankruptcy Code § 350(a),[2] the panel determined closure did not require conversion, dismissal, or discharge. The panel further reasoned that because bankruptcy discharge, by definition, affects only in personam liability, it has never served as the historical means for ensuring that the Bankruptcy Code’s various mechanisms for modifying or voiding a creditor’s in rem rights remained in place at the conclusion of the plan.

Thus, ineligibility for a discharge does not prohibit the permanent voidance of a lien under § 506. Joining the Fourth and Eleventh Circuits,[3] the Ninth Circuit thus concluded that Chapter 20 debtors – while otherwise ineligible for a discharge under 11 U.S.C. §1328(f)[4] – may still utilize Chapter 13’s lien-voidance mechanism on completion of their Chapter 13 plans.

Going forward, secured creditors should consider the implications of filing a proof of claim in Chapter 13 cases. To be sure, if creditors do decide to file claims, they should vigorously defend the claims to avoid losing lien rights.

[1] See U.S. Nat’l Bank in Johnstown v. Chase Nat’l Bank of N.Y.C., 331 U.S. 28, 33 (1947).

[2] Bankruptcy Code § 350(a) provides that “[a]fter an estate is fully administered and the court has discharged the trustee, the court shall close the case.”

[3] See Wells Fargo Bank, N.A. v. Scantling (In re Scantling), 754 F.3d 1323, 1325 (11th Cir. 2014), abrogating In re Gerardin, 447 B.R. 342 (Bankr. S.D. Fla. 2011) (holding that Chapter 20 debtors could not permanently strip off wholly unsecured junior liens) and In re Quiros-Amy, 456 B.R. 140 (Bankr. S.D. Fla. 2011) (same)); Branigan v. Davis (In re Davis), 716 F.3d 331, 337-38 (4th Cir. 2013). See also In re Cain, 513 B.R. 316, 322 (6th Cir. BAP 2014); Fisette v. Keller (In re Fisette), 455 B.R. 177, 186-87 (8th Cir. BAP 2011).

[4] In 2005 Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act, which included an amendment barring Chapter 20 debtors from receiving a discharge at the conclusion of a Chapter 13 reorganization if they received a Chapter 7 discharge within four years of filing for Chapter 13 relief. See 11 U.S.C. § 1328(f).