The Supreme Court’s recent decision in Bank of America, N.A. v. Caulkettaddressed one of our favorite topics: lien-stripping.  In Caulkett, the Supreme Court reversed the Eleventh Circuit’s decision allowing individual chapter 7 debtors to “strip” junior liens on their homes when the first priority liens were underwater.  Relying on Dewsnup v. Timm, the Supreme Court unanimously held that section 506(d) of the Bankruptcy Code does not allow the debtor to “strip” a junior creditor’s lien, where the junior creditor’s claim is an allowed secured claim. 

Background:

The debtors in question each had two mortgage liens on their respective residences.  Bank of America held the junior mortgage lien on each residence.  The amount owed to the senior mortgagor was greater than the current market value of each home, rendering the junior liens of Bank of America completely underwater.  The debtors each filed for bankruptcy under chapter 7.  In their bankruptcies, the debtors sought to avoid the junior mortgage liens under section 506(d), which provides that to the extent that a lien secures a claim which is not an allowed secured claim, the lien in question is void.  The respective bankruptcy courts granted the motion, and in each case the district court and the Eleventh Circuit affirmed the bankruptcy court’s decision.  Bank of America appealed to the Supreme Court.

The Supreme Court’s Decision:

The Supreme Court first acknowledged that under an arguably straightforward reading of the Bankruptcy Code, the debtors would have been able to avoid the liens of Bank of America. Specifically, section 506(a)(1) provides that an allowed claim is a secured claim to the extent of the value of the creditor’s interest in the property securing the claim, and is an unsecured claim to the extent that the value of the creditor’s interest in the property is less than the amount of the allowed claim.  Stated differently, if the value of a creditor’s interest in the property is zero, the claim would be an unsecured claim within the definition of section 506(a)(1).  Section 506(d) also uses the phrase “allowed secured claim” so it would be logical for the phrase to have the same meaning in both subsections.

The Supreme Court, however, had already adopted a different interpretation of the phrase “secured claim” for the purposes of section 506(d) in Dewsnup, where the Supreme Court rejected the chapter 7 trustee’s attempt to strip a partially underwater lien down to the value of the collateral.  In Dewsnup, the Supreme Court defined the term “secured claim” in section 506(d) to mean a claim that was “supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim.”  Accordingly, the Supreme Court held here that because the claims in question were secured by liens and allowed under section 502, they could not be voided under section 506(d) even when completely underwater.

A number of different amicus briefs were filed on both sides of the lien-stripping debate.  A group of amici, including the LSTA, asserted that affirming the Eleventh Circuit decision and allowing lien-stripping in the chapter 7 context could have unintended consequences for the commercial loan market, impact the holders of “inferior” liens and could dampen the appetite of lenders to lend on a junior basis.  In particular, the LSTA pointed to the “destabilizing effects of an adverse decision in these cases on the $40 billion-dollar market for commercial loans secured by inferior liens.”  On the other side, the National Association of Consumer Bankruptcy Attorneys and the AARP urged the Supreme Court to allow lien-stripping.  This group of amici argued that lien avoidance was central to the overall operation of the Bankruptcy Code, and in particular in the reorganization chapters, and that affirming the Eleventh Circuit would be consistent with a plain reading of section 506.

The Court noted repeatedly that the debtors did not ask for Dewsnup to be overruled, but rather only requested that the Court limit Dewsnup’s application to situations where the liens in question were only partially underwater.  The Court declined to adopt this proposed distinction between wholly and partially underwater liens on the grounds that applying this approach would leave an “odd statutory framework” in place, under which, if a court valued the collateral at a dollar more than the amount of the senior mortgage, the debtor could not strip down the lien, whereas if the court valued the collateral at one dollar less than the amount of the senior mortgage, the debtor could strip off the entire junior lien.  The Supreme Court expressed concern that, given the frequently changing value of real property, adopting the debtors’ distinction could lead to arbitrary results.  The Court remarked that even if Dewsnup were deemed to reflect an incorrect interpretation of section 506(d), the debtors’ proposed solution would not be any more correct.

Interestingly, in addition to the Court’s frequent references to the fact that the debtors had not asked the Court to overrule Dewsnup, the Court added a footnote explaining the criticism that Dewsnup has received.  Three of the nine justices who joined in the opinion explicitly did not join this footnote.  This difference of opinion of the justices (as to a footnote!) in an otherwise unanimous decision appears to highlight the importance of this footnote.  Given that six justices joined in the Dewsnup criticism footnote, perhaps those justices would have overturned Dewsnup had the debtors so requested.  Did the debtor make a strategic error in not seeking that it be overruled?  Was the Court inviting someone else to do that?  Is the eventual overruling of Dewsnup now an inevitability?

Implications for Chapter 11 Cases:

What does Caulkett mean for chapter 11 cases?  In general it is accepted that a debtor in a chapter 11 case can avoid the liens of secured creditors.  Some courts, however, have disallowed lien-stripping in chapter 11 cases, or otherwise ruled that liens should “ride through” the bankruptcy.  In In re Batista-Sanechez, for example, the United States Bankruptcy Court for the Northern District of Illinois relied in part on section 506(d) to distinguish claim disallowance from lien avoidance and disallowed a secured creditor’s untimely-filed proof of claim, while allowing the creditor to retain its lien.  The majority of courts permitting lien-stripping in the chapter 11 context do not rely on section 506(d), however, but rather point to different statutory hooks – such as the cram down provisions for chapter 11 plans, the right of a class of creditors to make an election under section 1111(b), and section 1123(b)(5), which permits modification of the rights of holders of secured claims (except for those claims secured solely by a debtor’s  principal residence).

Another group of decisions interpret the Bankruptcy Code to prevent lien-stripping and allow the liens of secured creditors to “ride through” in a chapter 11 bankruptcy if they have not participated in the chapter 11 case in any way, despite the language of section 1141(c) of the Bankruptcy Code, which provides that “except otherwise provided in the plan or in the order confirming the plan, after confirmation of a plan, the property dealt with by the plan is free and clear of all claims and interests of creditors . . .”  In Acceptance Loan Co., Inc. v. S. White Transportation Inc. (In re S. White Transportation, Inc.), for example, the Fifth Circuit held that a secured creditor who took no steps to preserve its claim or lien in a chapter 11 case, despite receiving actual notice of the bankruptcy, could enforce its lien postpetition on the grounds that liens “ride through” a bankruptcy and are not affected thereby, despite section 1141(c).  The Fifth Circuit and courts holding similarly have interpreted section 1141(c) to require a creditor to “participate” in the bankruptcy case before its lien can be voided.

Given these decisions regarding both lien-stripping and whether liens ride through a chapter 11 case, and the fact that the Caulkett decision does not discuss lien-stripping in the chapter 11 context, there is unlikely to be any dramatic change in the way liens are currently treated in chapter 11 cases.