Posted in: BARG Receivership Law Updates

LIEN STRIPPING: WHY DOES IT OCCUR AND HOW DOES IT WORK?

Few people are familiar with the term lien stripping.  Therefore, an example of when lien stripping would be utilized can be illustrated through the following example of insufficient equity.  If in 2010, a set of parents drafted a will granting $1,000,000 to their four children upon their deaths, each child would be entitled to $250,000.  However, what if when the parents died in 2020 there was only $500,000 left in the Estate?  Obviously, each child cannot receive the $250,000 they expected to receive, so what should be done?

A fairly reasonable answer would be to split the amount resulting in each child receiving $125,000.  However, perhaps the oldest child thinks she should receive $250,000 and her three siblings’ three children should split the remaining $250,000 three ways.  Perhaps the youngest child stayed home to take care of the parents in their final years and believes he should be entitled to $250,000, so the remaining three siblings should split the $250,000 three ways between themselves.  Or maybe the second child was estranged from the family and the three siblings do not think he should receive anything, which would allow the three siblings to split the $500,000 three ways instead of four ways.  In summary, the possibilities are endless, but the facts are simple, there is not enough to pay everyone what they expected to receive.

Insufficient equity to fully pay off creditors is a common occurrence with problem assets that are placed into bankruptcy or receivership proceedings.  Therefore, a process called lien stripping is used to allow a bankruptcy trustee or court receiver to sell an over encumbered property free and clear of liens.  For example, if a receiver sells a problem property for $1,000,000, but it has $1,700,000 in liens, the receiver can strip the liens from the property to effectuate the sale.  Thereafter, the $1,000,000 in sale proceeds is used to pay the $1,700,000 in liens, as well as the receiver fees, which are entitled to super-priority over pre-existing liens.  (City of Sierra Madre v. SunTrust Mortgage Inc. (2019) 32 Cal. App. 5th 648, 661.)  Although the creditors will not be fully compensated, because there is insufficient equity from the sale proceeds to fully pay the liens, the lienholders will receive some compensation.  However, the court will determine how the sale proceeds are distributed to the lien holders.

One of the first cases to deal with lien stripping occurred in New York City and involved a sugar refinery.  The Judicial Opinion was written in 1935 by the legendary Judge Learned Hand.  (Spreckels v. Spreckels (1935) 79 F.2d 332, 333.)  The case involved a failing sugar refinery that had $10,657,566 in liens against it and cost $15,000 a month to run, but sold at a receivership sale for $1,200,000. ( Id at 334. ) Under these facts there was insufficient equity to pay off all the liens and the debt was growing at a rate of $180,000 per year.  Therefore, the Court determined the asset was wasting away and if it was not sold in a hurry nobody would get anything.  (Id at 335-336.)  As a result, the Court, using its equitable powers, stripped the liens from the property, which allowed the property to be sold.  (Id. at 335-336.)  Thereafter, the proceeds from the sale were distributed according to equitable principals.  (Id. at 335-336.)

Using Judge Hand’s decision in Spreckels, the United States Legislature enacted a lien-stripping statute for bankruptcy cases in 1979.  11 U.S.C. 363(f).  Clearly, in bankruptcy cases, insufficient equity almost always exists to pay off all the creditors, but in order for assets to be liquidated into cash they must be sold.  However, the assets cannot be sold unless the liens are stripped.  Therefore, 11 U.S.C. 363(f) is a statute that is often used in bankruptcy matters.   (In re NAMCO Capital Group, Inc. (C.D.Cal. June 7, 2011, No. CV 10-0766 GAF) 2011 U.S.Dist.LEXIS 65607; see also In re Nashville Senior Living, LLC 407 B.R. 222, 231 (6th Cir. BAP 2009.)  There are countless other cases that authorize a bankruptcy trustee to sell a property free and clear of liens pursuant to 11 U.S.C. 363.

The issue of lien stripping is so common and of such importance that the United States Supreme Court even analyzed the issue in 1992. ( Dewsnupp v. Timm (1992) 502 U.S. 410, 417.)

California courts have recently made two major decisions in support of lien stripping. The first involved the appointment of a Health and Safety Receiver over a nuisance property whose owner had filed for bankruptcy.  (City of Riverside v. Horspool (2014) 223 Cal. App. 4th 670, 674-675.)  The receiver then sought to sell the property but needed to strip l​iens to do so.  Id at 684.  The property owner argued that the automatic stay prevented a sale of the property and precluded lien stripping.  Id at 675-676.  However, the Court ruled that the states police power superseded the automatic stay pursuant to 11 U.S.C. 362(b)(4).  Id at 676. Therefore, the receiver could sell the property free and clear of liens.  (Id at 684.)

Lien stripping is an essential mechanism used by bankruptcy trustees and receivers. Without lien stripping, receivers and bankruptcy trustees would be rendered ineffective because when the appointment of a receiver or the filing of bankruptcy occurs there is usually insufficient equity to pay off the creditors.  Therefore, the only way to resolve the issue is to sell the property and obtain something, then distribute a portion of what the lien holder is entitled to once the lien is stripped.  Lien stripping is an effective method to effectuate positive results and it is often employed by receivers and bankruptcy trustees.