On June 1, 2015, in a unanimous decision,* the U.S. Supreme Court ruled in Bank of America, N.A. v. Caulkett that debtors in Chapter 7 liquidation bankruptcies cannot void or “strip off” wholly underwater junior mortgages. This decision marks a huge victory for the mortgage lending industry.
The facts of the case are fairly common nowadays in light of the housing crash. Like many Americans, the Debtors own a home encumbered by two mortgages. The amount of the senior mortgage is greater than the value of the property. The lender holds the junior mortgage, which is completely underwater. The Debtors filed Chapter 7 bankruptcy and moved to void the junior mortgage held by the lender pursuant to section 506(d) of the Bankruptcy Code. The Debtors argued that the lender did not hold a secured claim because there was no value in the property above the first mortgage to secure their lien. In other words, the Debtors wanted to use the Chapter 7 bankruptcy process to get rid of their second mortgage on their house on the basis that the mortgage was wholly unsecured.
The fairly short opinion focused on the statutory language in section 506(d). Pursuant to 11 U.S.C. § 506(d), a debtor can void (“strip off”) a lien on property if the underlying claim is not an “allowed secured claim.” The parties in the case agreed that the lender held an “allowed claim,” but disagreed if the lender, as a wholly underwater junior lienholder, held a “secured claim for purposes of 506(d).”
The Court held that the lender does hold a secured claim. The Court relied on its previous analysis of the same Code provision in the 1992 case, Dewsnup v. Timm. In Dewnsup, the Court held that a debtor in Chapter 7 could not reduce a partially unsecured junior mortgage to the amount of the value of the property securing the lien because the creditor held an “allowed secured claim.” The claim was “allowed” because the creditor filed a claim and the debtor did not object to the claim. The claim was “secured” because it was secured by a lien, i.e., a mortgage. Under the Court’s analysis in Dewsnup, the term “secured claim” in section 506(d) did not include a valuation analysis. The case upheld the historical understanding that liens typically “ride through” bankruptcy.
The opinion is not without its controversies. Dewsnup itself has always been controversial, as pointed out by the Court in the footnote (discussed below). Critics, like the debtors, point out that the Court’s definition of “secured claim” contradicts the definition of “secured claim” set forth in section 506(a). Section 506(a) states that an allowed claim of a creditor secured by a lien on property…is secured to the extent of the value…” of the creditor’s interest in the property. This very Code section is what determines whether claims are secured or unsecured in Chapters 11, 12, and 13. In those other types of bankruptcies, debtors value claims and then modify certain liens all of the time. However, those chapters of the Bankruptcy Code, unlike Chapter 7, have separate code provisions that allow a debtor to “strip off” or “strip down” liens when there is no value to secure them. It is nevertheless controversial that “secured claim” can have different meanings in different subsections of one section of the Bankruptcy Code.
The good news for lenders is that debtors will not be allowed to strip off wholly underwater mortgages in Chapter 7 cases, as they have been doing for the last couple of years in the Eleventh Circuit. To be sure, Chapter 13 debtors can still strip off underwater junior liens, but it takes longer (3-5 years) and most debtors are unable to make it through a plan to discharge. Chapter 7 cases are relatively short - between 3-6 months - and debtors are not required to make any payments to creditors, as they are in reorganization cases. So while a debtor may discharge the underlying personal liability for the loan in Chapter 7, banks with underwater junior mortgages can hang out and wait for the market to bounce and hope for recovery when the debtor sells the property or refinances.
The bad news is that the Court’s opinion includes a cryptic footnote that may come up in the future. In that footnote, Justice Thomas emphasizes that the debtor respondents in the case have not asked the court explicitly to overrule Dewsnup, but rather they asked the Court to limit its application to partially underwater mortgages (which the court refused to do). While the footnote seems harmless on its face, it begs the question, what will the Court do if and when someone does ask them to overrule Dewsnup? You can bet that someone will try soon.
*Justice Thomas authored the opinion. Justices Roberts, Scalia, Alito, Ginsberg, and Kagan joined. Justices Kennedy, Breyer, and Sotomayor joined but not as to the footnote in the opinion.