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US Supreme Court: Chapter 7 Debtors Cannot Avoid Underwater Liens

on Wednesday, 29 July 2015 in Banking Update

Last month, the United States Supreme Court issued its ruling in Bank of America v. Caulkett — a case deciding whether homeowners can avoid underwater second mortgages through Chapter 7 bankruptcy proceedings. The Court ultimately determined that a Chapter 7 debtor may not void a junior mortgage even when the debt owed on a senior mortgage exceeds the present value of the property.

Section 506(d) of the Bankruptcy Code allows a debtor to void a lien on estate property to the extent it secures a claim against the debtor that is not “an allowed secured claim.” In other words, § 506(d) permits a debtor to strip off a bank’s junior mortgages if the bank’s claim is “not an allowed secured claim.” In Caulkett, the parties disagreed over whether the bank’s claim was a “secured claim” within the meaning of § 506(d). On one hand, the debtor argued that completely underwater second liens should be treated as unsecured because the underwater creditor would receive no sale proceeds if the collateral were liquidated. On the other hand, the bank argued that, even though its lien may not have value, its claim was still secured by property.

In determining that the bank’s claim was secured, the Supreme Court relied on its earlier decision, Dewsnup v. Timm, 502 U.S. 410 (1992). In Dewsnup, the Court confronted a situation in which a Chapter 7 debtor wanted to strip down — or reduce — a partially underwater lien to the value of the collateral. Specifically, in Dewsnup, the debtor sought to reduce her debt of approximately $120,000 to the value of the collateral securing her debt at the time ($39,000). The Court rejected the debtor’s argument that her creditor’s claim was secured only to the extent of the value of the real property on which the lien was fixed. Instead, the Court construed the term “secured claim” in § 506(d) to include any claim secured by a lien. As such, the Court determined that the debtor could not strip down or otherwise void the partially underwater lien.

Although the Caulkett decision is acutely critical of Dewsnup, the Court ultimately followed its reasoning. It held that even if the junior mortgage is completely underwater, a bank’s bankruptcy claim is still a “secured claim” under§ 506(d). As such, a Chapter 7 debtor cannot void a junior lienholder’s underwater mortgage.

The practical effect of the Caulkett decision is that a bank’s underwater junior mortgage lien will survive a Chapter 7 bankruptcy. This means that a bank still has a prospect of recovery post-bankruptcy. For example, since a bank retains its lien, a post-bankruptcy debtor cannot sell the property without paying or otherwise compromising with the underwater lienholder. Further, although the bank is currently underwater, the debtor may eventually pay down (or off) the senior mortgage. In that case, the bank may see recovery as equity in the property increases.

Eric J. Adams

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