June 23, 2015
Authored by: Brian Walsh and Laura Hughes
On June 1, 2015, the Supreme Court released its opinion in Bank of America, N.A. v. Caulkett, No. 13-1421, 575 U.S. ____ (2015), in which it held that a Chapter 7 debtor may not void a junior mortgage under Section 506(d) of the Bankruptcy Code merely because the debt owed on a senior mortgage exceeds the present value of the property and the creditor’s claim is secured by a lien and allowed under Section 502. For now, this opinion cuts off a Chapter 7 debtor’s ability to “strip off” an underwater junior lien.
In Caulkett, the debtor had two mortgage liens on his home; Bank of America held the junior lien. The amount owed on the senior mortgage exceeded the value of the home, rendering Bank of America’s junior mortgage fully “underwater,” or with no current economic value. Generally, where the value of a creditor’s interest in its collateral is zero, a creditor’s claim cannot be a “secured claim,” and the lien securing the junior mortgage can be voided in a Chapter 7 case.
The authority for this voiding procedure lies in Section 506 of the Bankruptcy Code. Under Section 506(a), “[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.” 11 U.S.C. § 506(a)(1). Under Section 506(d), “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” 11 U.S.C. § 506(d). Based on this understanding of Section 506, the Caulkett debtor argued that Bank of America’s junior lien should be void.
But in a 1992 opinion, Dewsnup v. Timm, 502 U.S. 410 (1992), the Supreme Court adopted a different construction of the term “secured claim” that focused on two things: (1) the validity of the creditor’s perfected security interest in its collateral; i.e., Does the lender have a valid lien? and (2) whether the creditor’s claim was “allowed” under Section 502, which governs the allowance of claims in bankruptcy cases; i.e., did the lender file a proper claim in the bankruptcy case, and did anyone object? Notably, the Dewsnup construction of “secured claim” did not take into consideration the collateral’s value.
The Supreme Court in Caulkett explained that it was bound by the Dewsnup construction. Accordingly, the debtor could not void Bank of America’s junior mortgage because the mortgage was (1) secured by valid a lien and (2) supported by an allowed claim to which no party had objected.
In a footnote, which Justices Kennedy, Breyer, and Sotomayor declined to join, the Court acknowledged that “[f]rom its inception, Dewsnup . . . has been the target of criticism.” This is because it appears to be at odds with the plain language of Section 506. In addition, Dewsnup has generally not been applied to Chapter 13 cases, where the stripping off of underwater liens is common, and debtors can rely on other similar sections of the Bankruptcy Code.
On the other hand, preserving a junior lien is especially important during times of depressed real estate prices. Once a creditor’s lien has been stripped, upon the sale of the property—even where the value of the property has later appreciated—the junior mortgage creditor gets nothing, and the benefit goes to the debtor. Under Caulkett, the lender is not harmed by a temporary drop in real estate prices, as it may retain its lien even if the property appears to be completely underwater. Chapter 7 debtors like the one in Caulkett may argue that, under Dewsnup and now Caulkett, they are unduly burdened by a lender’s lien, and that the “fresh start” they hoped a bankruptcy case would afford them is diminished.
But the Court emphasized that it wasn’t asked to overrule Dewsnup, and the Court concluded that, under Dewsnup, a Chapter 7 debtor may not void a junior mortgage lien under Section 506(d) merely because the debt owed on a senior mortgage lien exceeds the value of the collateral. With the Court appearing to have left open the possibility of revisiting its Dewsnup decision, it is likely that this contentious issue will remain in play.