June 9, 2015Client Alert

U.S. Supreme Court Takes on Bankruptcy Lien-Stripping

On June 1, 2015, the U.S. Supreme Court held that a Chapter 7 debtor may not void a junior mortgage lien on a home worth less than the amount due on the first mortgage. Bank of America v. Caulkett, Case No. 13-1421 (consolidated with Bank of America v. Edelmiro Toledo-Cardona, Case No. 14-162).

These cases were on review from decisions of the 11th Circuit. In both cases, each debtor had a home subject to both a first and a second mortgage, and in each case, the amount owed on the first mortgage loan was greater than the home’s current market value. After the debtors filed their respective Chapter 7 bankruptcies, they each moved to “strip” the junior mortgage liens from their properties under § 506(d) of the Bankruptcy Code. That section permits a debtor to void a lien on her property “[t]o the extent that [the] lien secures a claim against the debtor that is not an allowed secured claim.” In each case, the Bankruptcy Court granted the lien stripping motion, and the District Court and Court of Appeals for the 11th Circuit affirmed.

The Supreme Court reversed and looked at whether the second mortgage lien claims were “allowed secured claim[s].” They were allowed because either no objection was filed to the claims, or, if there was an objection, the Bankruptcy Court determined that the claims should be allowed. The Supreme Court then went on to explain how to tell if the claims were secured. 

The plain language of Bankruptcy Code § 506(a)(1) provides that “[a]n allowed claim of a creditor secured by a lien on property . . . is a secured claim to the extent of the value of such creditor’s interest in . . . such property,” and “an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” 

However, while the plain language of the statute suggests that the debtors could avoid the junior liens, the Supreme Court pointed to the construction of the term “secured claim” in its Dewsnup v. Timm decision, 502 U.S. 410 (1992). In Dewsnup, the Chapter 7 debtor sought to reduce a partially underwater lien under § 506(d) to the value of the collateral. The Court rejected the lien stripping argument in Dewsnup, defining the term “secured claim” in § 506(d) to mean a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim. Under this definition, § 506(d) can only be used to strip a lien when a claim secured by the lien itself has not been allowed. Because in Caulkett and Edelmiro Toledo-Cardona the bank’s junior mortgage claims were both secured by liens and allowed under § 502, lien stripping could not be applied.

The Supreme Court rejected the debtors’ request that the Court limit Dewsnup to partially – as opposed to wholly – underwater liens. In his footnote, Justice Thomas pointed out that Dewsnup has been the target of criticism but that the debtors “repeatedly insisted that they are not asking us to overrule Dewsnup.” Three justices – Anthony Kennedy, Stephen Breyer and Sonia Sotomayor – declined to join this footnote. Justice Thomas reiterated in his conclusion that the debtors had not asked for Dewsnup to be overruled. Some commentators suggest the opinion invites other litigants to challenge the Court’s ruling in Dewsnup.

The Court’s decision in Caulkett arguably makes it more difficult for debtors to renegotiate their mortgage loans since they will not be able to eliminate an “underwater” lienholder from those negotiations. On the other hand, the decision arguably makes second mortgage loans more available in the marketplace and priced more favorably than if the junior mortgage holders had to worry that their liens could be stripped in bankruptcy as a result of a downturn in real estate prices, or the debtor’s failure to maintain the value of the property sufficiently to support some or all of the second mortgage lien.

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