When battling liens against you, a small business owner may at some point find it necessary to consider filing bankruptcy to protect an exempt asset. Therefore, every small business owner should have an understanding of some bankruptcy basics. However, one specific bankruptcy rule regarding lien elimination can be an important factor if you are a small business owner trying to decide how to finance your business.
The bankruptcy code contains an unusual rule not found in state laws regulating liens, which is termed bifurcation of liens, or "lien stripping." This can be a very significant asset protection tool for debtors in a bankruptcy proceeding.
Under the bankruptcy code, a lien, other than a lien secured solely by a personal residence, is deemed secured only to the extent of the value of the property, at the time of the bankruptcy filing. Any excess balance is deemed unsecured and is "stripped away."
Remember, of the various types of liens, only a secured lien can impair an exemption. Thus, to the extent the loan is deemed unsecured, it cannot impair the debtor's exempt property.
The lien in this situation won't be eligible for elimination and will still be valid, but only to the extent of the full value of the property. Thus, if the lien is of a type that cannot ordinarily be eliminated, the excess of the debt above the value of the property will be discharged.
Note that this rule applies against exempt and nonexempt property, as only the excess above the value of the property is eliminated.
In short, the effect of this provision will usually be to reduce, but not eliminate, liens that impair both exempt and nonexempt assets. Liens in either case will be reduced to an amount equal to the value of the secured property. Therefore, bifurcation can result in significant savings.
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John owns a car with a value of $20,000, which is subject to a lien of $28,000 for a car loan.
In a bankruptcy proceeding, under the bifurcation concept, the lien will be valued at $20,000. The balance of the lien, $8,000, is "stripped" away. This excess is not automatically eliminated. Instead, it is simply no longer secured by the car. However, because the excess is unsecured, it usually will be eliminated in a bankruptcy proceeding.
As a result, the creditor holds a secured loan in the amount of $20,000, and an unsecured loan for $8,000.
Of course, a purchase-money security interest lien cannot be eliminated, even when it impairs an exempt asset. The real value of bifurcation is that John, in all likelihood, will only have to pay back $20,000 of the loan, as unsecured debts are typically discharged in bankruptcy. Thus, John will save $8,000.
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When bifurcation is applied, the choice will be to pay back the secured portion in one lump sum in a Chapter 7 bankruptcy, or over three to five years in a Chapter 13 bankruptcy.
Because most debtors can't raise the required lump sum payment, and do not want to surrender the property to the creditor, bifurcation of liens takes place most often in a Chapter 13 filing.
For many years, courts struggled in deciding how to value property for purposes of lien stripping. Some courts held that the value should be the wholesale value, while other courts ruled that replacement value (a much higher value) should be used.
Recently, the U.S. Supreme Court ruled (to the cheers of creditors) that replacement value must be used because, in most cases, debtors end up keeping the property by paying the stripped down amount of the lien. The appropriate value, the court reasoned, should be replacement value, because this is the cost the debtor would pay if he or she lost the property to the creditor, and then had to replace it.
Bifurcation, or lien stripping, is not available in any state. It is entirely a creature of federal bankruptcy law. (However, in very limited circumstances, a homeowner in some states does not have to pay a deficiency judgment, which occurs when his or her home is lost through foreclosure and a balance remains on the loan after the home is sold.) The deficiency also could be discharged as an unsecured debt in a Chapter 7 bankruptcy proceeding. Note that, in contrast to this narrow exception, bifurcation, when it's available in a bankruptcy proceeding, allows the debtor to strip the lien and keep the property, provided the stripped-down lien is paid.