Ninth Circuit Rules Junior Lien Discharged in Chapter 7 Bankruptcy Cannot Be Included When Determining Chapter 13 EligibilityThe Ninth Circuit Bankruptcy Appellate Panel (“BAP”) has ruled that debts discharged in a prior Chapter 7 bankruptcy cannot be included when determining a debtor’s eligibility for Chapter 13 relief.

The case — In re Free — involved debtors whose home was valued at $425,000 in their Chapter 7 schedules. The home secured three debts that totaled more than $900,000. The first lien holder was owed more than the value of the home. After receiving a Chapter 7 discharge, the debtors sought to strip off the two unsecured subordinate liens by filing Chapter 13.

The Chapter 13 trustee moved to dismiss the case, contending that the two unsecured subordinate liens should be included in determining eligibility, which would make the debtors ineligible for Chapter 13 relief. The bankruptcy court sided with the trustee and dismissed the case. The debtors appealed.

Upon appeal, the Ninth Circuit BAP considered the definitions of “debt” and “claim” in section 101 of the Bankruptcy Code. The BAP found that since debt is defined as liability on a claim, and claim is defined as a right to payment, “there is no ‘unsecured debt’ unless a creditor has the ‘right to payment’ on an unsecured basis.”

The result of the debtors’ Chapter 7 discharge, the BAP reasoned, was that they no longer had personal liability for the unsecured subordinate liens. Therefore, the liens could not be included in determining the debtors’ eligibility for Chapter 13 relief.

The BAP also addressed two prior U.S. Supreme Court decisions in Chapter 13 lien stripping efforts by debtors: Dewsnup v. Timm and Bank of America v. Caulkett. In Dewsnup, the Court held that a Chapter 7 debtor couldn’t strip down a partially unsecured lien to the value of the collateral. In Caulkett, the Court extended its Dewsnup holding to wholly unsecured junior liens.

The BAP noted that, since those two decisions, litigants have argued debtors that first file Chapter 7 and receive a discharge and then file Chapter 13 to strip off remaining claims are acting in bad faith. The BAP said that it refused to consider this issue since it was not raised in the appeal, but said that such an argument should be raised by filing a motion to dismiss a Chapter 13 filing as a bad faith filing, not to determine the eligibility of a debtor to file for Chapter 13 relief.

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