The U.S. Supreme Court decided on Monday, June 1, 2015, that Chapter 7 debtors may not rid themselves of second-mortgage liens in cases where, at the time of the bankruptcy, the first mortgage is undersecured. The decision reverses two Eleventh Circuit rulings that would have made such liens disappear under Section 506(d) of the Bankruptcy Code.
The Court ruled in favor of Bank of America, N.A. against two debtors’ attempt to strip second liens on their homes. The Justices’ opinion turned on their interpretation of Section 506(d)—whether it operates to void liens based on the current value of collateral and can apply to liens that are wholly underwater rather than partially secured. The debtors argued that the rule allows Chapter 7 debtors to void certain liens on their homes. But the opinion, drafted by Justice Clarence Thomas and unanimous other than one footnote with which three justices would not concur, noted that there is little support for the notion that Section 506(d) should apply differently if a lien is partially versus wholly underwater. Justice Thomas further stated that the debtors’ interpretation would leave “an odd statutory framework” as it relates to so-called lien stripping, noting that “[g]iven the constantly shifting value of real property, this reading could lead to arbitrary results.”
Lien stripping relates to the tension between first and second mortgage lenders after a bankruptcy filing. For first-lien lenders, voiding a junior lien makes it easier to sell a property and collect on their secured claim without having to negotiate with a second-priority lender.
The high court’s ruling should benefit commercial lenders, as many feared that a decision against the bank could endanger second liens on corporate debts and, potentially, inflate the price of credit across the economy as a whole. Furthermore, underwater homes can appreciate after bankruptcy, and many expressed concern that lenders would be unable to capture that increased value if their inferior liens could be wiped out under Section 506(d).
At oral arguments, the justices signaled that they shared many of the same concerns about automatically eliminating junior liens, including whether such a decision would chill the desire of lenders to extend second-lien credit to homeowners. Justice Kennedy told an attorney for the debtors that “[i]t’s hard for me to think that a decision in your favor wouldn’t, in a sense, hurt borrowers because the market for a second [mortgage] is going to dry up or become much more expensive.”
The cases are Bank of America v. Caulkett, case number 13-1421, and Bank of America v. Edelmiro Toledo-Cardona, case number 14-163, in the U.S. Supreme Court.