In an opinion issued on June 1 in a case entitled Bank of America, N.A. v. Caulkett, the United States Supreme Court answered a question that has split lower courts since the Supreme Court decided Dewsnup v. Timm in 1992. The question answered in Caulkett was whether a debtor in a Chapter 7 bankruptcy case can “strip off” a lien on the debtor’s property if the bankruptcy court determines that the lien is worthless, leaving the former secured creditor with an unsecured claim that can be discharged. The Supreme Court’s answer is no.

The decisions in both Caulkett and Dewsnup are based on the language of Bankruptcy Code Section 506. Section 506(a) provides that “An allowed claim of a creditor secured by a lien on property…is a secured claim to the extent of such creditor’s interest…in such property…and is an unsecured claim to the extent that the value of such creditor’s interest…is less than the amount of such allowed claim.” Section 506(d) provides that “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void...”

When a creditor’s collateral is worth less than what it is owed, Section 506(a) has the effect of converting what would normally be regarded as a single claim, a claim secured by a mortgage, for example, into two claims for bankruptcy purposes; a secured claim for the value of the collateral and an unsecured claim for the remainder of the claim. A creditor who made a $400,000 mortgage loan before the real estate market crashed in 2008 and whose collateral is now worth $300,000 for example, would have a $300,000 secured claim and a $100,000 unsecured claim for bankruptcy purposes.

Both Dewsnup and Caulkett involved second mortgages. In Dewsnup, the debtor’s property was worth more than the amount of the first mortgage, but not as much as the two mortgages combined. In Caulkett, the debtor’s property was not even worth as much as he owed on his first mortgage. The holder of the second mortgage was entirely “underwater.”

The debtor in Dewsnup attempted to “strip down” the amount of the second mortgage lien from the $120,000 amount owed to $39,000, the amount by which the value of the debtor’s property exceeded what he owed on his first mortgage. The debtor argued that the holder of the second mortgage had “an allowed secured claim” for only $39,000 under Section 506(a) and that since the remaining $81,000 of the second mortgagee’s claim was not an “allowed secured claim,” Section 506(d) operated to “void” the lien for the excess.

In Dewsnup, the Supreme Court characterized the phrase “allowed secured claim” in Section 506(d) as ambiguous. On the one hand, it could mean a claim allowed as a secured claim under Section 506(a) as the debtor argued. On the other hand, it could also mean an allowed claim for which there was some form of security, whether the security was adequate or not. Applying the rule of statutory construction that Congress should be presumed to intend to continue the practice under prior law unless statutory language shows a contrary intent, the Supreme Court said that since the practice under prior law had been that liens “rode through” a bankruptcy case regardless of the value of the collateral and Section 506 did not demonstrate Congressional intent to change that practice because the Section was ambiguous, the debtor in Dewsnup could not strip down the creditor’s lien.

In the intervening 23 years, a number of courts held that Dewsnup only barred debtors from stripping down undersecured liens. These courts reasoned that since the Dewsnup court interpreted “allowed secured claim” in Section 506(d) to mean an “allowed claim” for which there was some security, the holding in Dewsnup only applied when the creditor’s lien had some value. According to these courts, if the creditor’s lien was entirely underwater, then its claim was not “secured” under Section 506(a) and its lien could be stripped off.

Other courts, however, interpreted Dewsnup as applying regardless of the how much collateral was worth as long as the creditor had a mortgage, deed of trust, or security interest so that its claim would be regarded as “secured” in the non-bankruptcy context. In the view of these courts, whether a claim was secured depended on whether the creditor had bargained for collateral, not on what the collateral was worth.

In Caulkett, the Supreme Court resolved the split in views. After noting that the debtors in Caulkett had not requested that the Court overrule Dewsnup even though the Dewsnup decision had “been the target of criticism” “from its inception, “ the Court said that Dewsnup interpreted “allowed secured claim” in Section 506(d) to mean “any claim secured by a lien and allowed.” “Because the Bank’s claims are both secured by liens and allowed” in the Caulkett case, it followed that the Bank’s claims were not “void” under Section 506(d) and could not be stripped off.

The Caulkett Court was not swayed by the argument that an entirely underwater creditor’s claim was not secured by a lien because the lien was worthless, unlike the creditor in Dewsnup whose lien was worth $39,000, characterizing a definition of “secured claim” that depended on collateral value as “artificial.” Echoing lower courts that had interpreted Dewsnup to preclude stripping off liens, the Caulkett Court said:

Under the debtors’ approach, if a court valued collateral at one dollar more than the amount of a senior lien, the debtor could not strip down a junior lien under Dewsnup, but if it valued the collateral at one dollar less, the debtor could strip off the entire junior lien. Given the constantly shifting value of real property, this reading could lead to arbitrary results. To be sure, the Code engages in line-drawing elsewhere, and sometimes a dollar’s difference will have a significant impact on bankruptcy proceedings… But these lines were set by Congress, not this Court.

The Court’s characterization of a definition of secured claim based upon collateral value as “artificial” is questionable, given that Section 506(a) expressly makes whether a claim is a secured claim hinge upon “the value of such creditor’s interest” in collateral. Nevertheless, the Caulkett decision is in line with the Supreme Court’s consistently expressed preference for having market forces, not bankruptcy judges, decide economic issues. The underwater creditor whose lien rides through bankruptcy will still get nothing if the first mortgage holder forecloses and nobody bids more for the collateral than the amount owed on the first mortgage. If the debtor tries to sell the property to avoid foreclosure and the underwater second mortgage holder torpedoes the sale by demanding more to release its lien than the debtor, the first mortgagor, and the purchaser are willing to pay, the second mortgage holder will still face foreclosure by the first mortgage holder and the extinguishment of its lien. However, Caulkett insures the holders of second liens that their opportunity to realize something for their liens will not be taken away simply because a bankruptcy judge determines that their liens are worthless.