On Monday, the Supreme Court reaffirmed the principle that junior “underwater” residential mortgage liens can “pass through” a bankruptcy case unaffected.

In Bank of America, N.A. v. Caulkett, the Supreme Court held that the Bankruptcy Code does not allow an individual chapter 7 debtor to void (or “strip off”) a junior creditor’s lien from property where the property is worth less than the senior mortgage lien, so long as the junior creditor holds an allowed secured claim. Given the enormous secondary mortgage market (for both residential and commercial loans), this decision** sends a stabilizing message to the market.

Background

The facts in Caulkett are simple. The case involved two separate individual chapter 7 debtors. Each debtor owned a home encumbered by a senior and a junior mortgage lien. Because the amount of the senior mortgage liens exceeded the market value of the homes, the junior mortgage liens were “wholly underwater.”

Relying on Section 506(d) of the Bankruptcy Code—which provides that a lien can be voided if the corresponding claim is not an allowed secured claim—the debtors each sought to strip off the junior mortgage liens entirely from the properties. The bankruptcy courts agreed, the junior liens were voided, and the decisions were affirmed on all levels of appeal . . . until the Supreme Court reversed.

The Decision

The Supreme Court first observed that the debtors had presented what appeared to be a “classic case” of statutory interpretation: Section 506(a) states that a claim secured by a lien on property is secured only to the extent of a creditor’s interest in that property. The debtors had argued that, without any unencumbered value to secure the junior mortgage liens, the junior mortgage liens were not secured claims and thus could be voided entirely under Section 506(d).

The unfortunate twist for the debtors, however, was that the Supreme Court decided not to apply a strict interpretation of Section 506(d), but would rely on its 1992 decision in Dewsnup v. Timm, which had “foreclose[d] this textual analysis.”

In Dewsnup, the Supreme Court defined the term “secured claim” in the context of Section 506(d). A secured claim is that which is “supported by a security interest, regardless of whether the value of that property would be sufficient to cover the claim.” When a secured claim is then determined to be “allowed” under the Bankruptcy Code, Section 506(d) does not apply. The holding in Dewsnup thus prevents a debtor from stripping down a first mortgage lien to the value of the collateral.

Applying that definition of secured claim to the junior mortgage liens in Caulkett, the Supreme Court easily reached its decision. The junior lender’s corresponding claims were “secured” because they were supported by security interests (the mortgage liens), and all parties had agreed that they were “allowed” under the Bankruptcy Code. Thus, the debtors could not void the junior mortgage liens under Section 506(d).

Stability, Yes, But with Some Questions

The Supreme Court noted, somewhat repeatedly, that the debtors in Caulkett did not ask the Supreme Court to reverse Dewsnup. Indeed, in a footnote, the Supreme Court even acknowledged that Dewsnup had been “the target of criticism” since its ruling over 23 years ago. (Justices Kennedy, Breyer, and Sotomayor declined to join that footnote.) Would the result have been different had the debtors made such a request? Would the Supreme Court have overturned Dewsnup had it been asked? Another question not addressed in the decision is whether a chapter 7 debtor can move to strip the junior lien if it impairs the debtor’s ability to claim state or federal exemptions.

Although these questions and others remain, the Supreme Court did reject the debtors’ argument to limit Dewsnup to partially underwater liens, as opposed to wholly underwater liens, as the instant case presented. The Supreme Court observed that adopting that distinction would result in “an odd statutory framework.” For instance, if a bankruptcy court valued the collateral at one dollar more than the senior mortgage lien, then a debtor could not void the junior mortgage lien, whereas with a value of one dollar less, the debtor could strip off the entire junior mortgage lien. Recognizing the ever-shifting value of real property, the Supreme Court predicted that this reasoning “could lead to arbitrary results.”

Also, Caulkett involved debtors in chapter 7 cases; the decision did not address lien-stripping in chapter 11 cases. Although courts have applied Dewsnup in chapter 11 cases, it is too soon to tell whether lower courts will distinguish Caulkett or apply it to prevent a chapter 11 debtor from stripping off junior underwater liens.

Still, our lender clients should take solace in this decision as Dewsnup is not going away, and, for the near future, neither are the junior underwater liens (so long as they relate to allowed secured claims).