In a post-housing crisis economy, many homeowners, facing a plummet in home values, found themselves trapped in homes that are worth less than the amount they owe bank. Those homeowners have sought refuge in Chapter 7 bankruptcy proceedings, attempting to strip down the first mortgage and leaving many junior lienholders holding nothing but the bag—until now. In a big win for lenders, the U.S. Supreme Court recently ruled that a debtor in a Chapter 7 bankruptcy proceeding cannot void a second mortgage, when the debt owed on the first mortgage exceeds the current value of the collateral. See Bank of America, N.A. v. Caulkett, 135 S. Ct. 1995 (2015). The decision reverses an interpretation of the Bankruptcy Code in Florida bankruptcy courts—an interpretation further affirmed by the Eleventh Circuit—which allowed a Chapter 7 debtor to strip off and void a mortgage lien that is wholly underwater.
In Caulkett, the debtor filed for Chapter 7 bankruptcy, and the debtor owned a house encumbered by a first and second mortgage. Because the amount owed on first mortgage was greater than the current market value of the home, the bank holding the second mortgage would receive nothing if the property were sold at that time. Thus, the second mortgage lien was wholly underwater. The debtor moved to void the second mortgage under § 506 of the Bankrupcty Code, which provides, “To 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). The U.S. Bankruptcy Court for the Middle District of Florida allowed the debtor to “strip off” (or void) the second mortgage. On appeal, the Eleventh Circuit affirmed. The U.S. Supreme Court reversed the Eleventh Circuit and held that the debtor may not void the second mortgage under the Bankruptcy Code.
The lower courts relied on an interpretation of the Code, which suggested that the second mortgage holder was not secured. Specifically, Section 506(a)(1) provides that “[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.” (Emphasis added.) In this case, the value of the second mortgage holder’s interest was zero, ostensibly rendering the entire lien unsecured.
However, the Supreme Court had previously interpreted the term “secured claim” under § 506(d) of the Code in Dewsnup v. Timm, 502 U.S. 410 (1992). In Dewsnup, a Chapter 7 debtor sought to “strip down” a partially underwater lien under § 506(d) to the value of the collateral. Specifically, the debtor wanted to reduce her debt of approximately $120,000 to the value of the property securing the debt, which was $39,000. The Court in Dewsnup defined the term “secured claim” in § 506(d) to mean any claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim. Thus, the Court did not allow the debtor to strip down the lien. In other words, a lien may only be voided under § 506(d) when the lien is not allowed. Id., at 416.
In sum, Dewsnup prohibited stripping down a partially underwater mortgage, while the Caulkett decision extends that prohibition to prevent debtors from stripping off a wholly underwater mortgage. While this decision comes as no surprise, it will undoubtedly have an effect on bankruptcy filings. Specifically, debtors can still seek refuge in Chapter 13 bankruptcy proceedings to strip off a second mortgage. This decision will likely divert many debtors from Chapter 7 and may result in a rise in Chapter 13 filings. This distinction is particularly important for lenders: Chapter 13 debtors must complete an organized payment plan before the lien may be stripped off.
The Caulkett decision is a big win for lenders, shifting the bargaining power away from distressed homeowners and allocating it to second mortgage holders in a loan workout. Second mortgage holders will now have more leverage in short sale negotiations. Additionally, junior lienholders can take a “wait and see” approach in hopes that housing values will increase, restoring value to once-valueless mortgages. Such a proposition may make a second mortgage foreclosure worth consideration. Of course, lenders should be prepared to assert objections to debtors’ continued attempts to strip off a second mortgage in Chapter 7, as this new decision makes stripping a second mortgage impossible. In all, Caulkett gives a lender many more options to consider in valuing and enforcing its second mortgage.