On March 24 2015 the Supreme Court heard oral argument in Bank of America v Caulkett (13-1421).(1) As framed by the petitioner, Bank of America NA, the question presented to the court was whether Section 506(d) of the US Bankruptcy Code "permits a chapter 7 debtor to 'strip off' a junior mortgage lien in its entirety when the outstanding debt owed to a senior lienholder exceeds the current value of the collateral".(2) A lien is "a legal right or interest that a creditor has in another's property, lasting usually until a debt… that it secures is satisfied".(3) A mortgage lien is an interest in real property that secures the right of the mortgage lender (or its successors and assigns) to repayment.(4) A senior lien has priority over other, junior liens on the same property.
The question of stripping off junior liens (and thus the junior creditors' bargained-for protection for repayment) arose in two cases where the bank held a second-priority mortgage lien on a house and the value of the house was less than the amount owed on the first mortgage debt – ie, the house was 'underwater'.(5) Section 506(d) of the Bankruptcy Code states that "[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void".(6) The bank argued that, based on the Supreme Court's decision in Dewsnup v Timm, 502 US 410 (1992), Section 506(d) does not permit a Chapter 7 debtor to 'strip down' the mortgage lien to the current value of the house and that the reasoning in Dewsnup should be extended to cover completely underwater mortgages.(7)
The Chapter 7 debtors in Caulkett framed the question at issue slightly differently, as "whether a claim is an 'allowed secured claim' under Section 506(d) if it is completely unsecured under Section 506(a)".(8) The debtors emphasised the interaction between Sections 506(a) and 506(d) because the former specifies that:
"[a] claim of a creditor secured by a lien on property in which the estate has an interest… is a secured claim to the extent of the value of such creditor's interest in the estate'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."(9)
The debtors' argument is that, given the interaction of the two code sections, a junior mortgage lien on underwater property is unsupported by any value; therefore, the mortgage debt that was – at least notionally – secured by that junior lien is now wholly unsecured under Section 506(a) and the junior lien is now void under Section 506(d).(10)
The debtors, Messrs Caulkett and Toledo-Cardona, both filed Chapter 7 bankruptcy petitions in the Bankruptcy Court for the Middle District of Florida in 2013.(11) At the time of filing, each had two mortgages on his home and in each case the amount of the first mortgage debt alone exceeded the home's value. For example, Caulkett's home was valued at $98,000, while the outstanding balances owed under the first and second mortgages were $183,264 and $47,855 respectively.(12) The bank was the junior lienholder in both cases – it held the rights to the second mortgage liens encumbering the debtors' homes.(13) The debtors moved to void the second mortgage liens on the basis that the value of their homes was underwater and thus did not support those junior liens. The bankruptcy court agreed and voided the liens, and the federal district court affirmed on appeal.(14) On further appeal, the US Court of Appeals for the Eleventh Circuit affirmed the bankruptcy and district courts, stating that it would adhere to its previous rulings, which held that "a wholly unsecured junior lien" – such as those held by the bank – is voidable under Section 506(d).(15)
The bank urged the Supreme Court to reverse the Eleventh Circuit by extending its reasoning in Dewsnup v Timm. Dewsnup was a Chapter 7 case in which the debtors, who owned farmland that had declined in value, sought to have the bankruptcy court value their property at $39,000 – less than the $120,000 debt owed to a secured creditor – and also sought to use Section 506(d) to strip down the secured creditor's lien to the judicially determined value of the property. The Supreme Court held that in such a case, where the lender was partially secured, the debtor could not reduce the mortgage lien to the value of the collateral.(16) Instead, the lien remained with the real property until foreclosure.(17) The court reasoned that pre-Bankruptcy Code practice had liens 'passing through' the bankruptcy case and remaining on the collateral unaffected, and that there was no indication that Congress had intended to change this practice with the enactment of the Bankruptcy Code in 1978.(18) By not voiding the lien, any increase in the value of the property in excess of the property's judicially determined value would therefore accrue to the benefit of the secured creditor, not to the benefit of the debtor or to other unsecured creditors.(19) The bank argued that this reasoning applies equally to junior liens, even when there is no unencumbered value in the property to support those liens.(20)
The Supreme Court in Dewsnup expressly stated, however, that it was limiting its analysis to the facts of that particular case.(21) Post-Dewsnup, courts have generally limited the Dewsnup holding to Chapter 7 liquidations.(22) In addition, some courts have distinguished between 'stripping down' and 'stripping off' a lien, noting that "[i]n bankruptcy terms, a 'strip down' of an undersecured lien reduces the lien to the value of the collateral to which it attaches, and a 'strip off' removes a wholly unsecured lien in its entirety".(23) The Eleventh Circuit is among the courts embracing that distinction and has distinguished its pre-Dewsnup precedent permitting the stripping off of "a wholly unsecured junior lien"(24) from the Dewsnup prohibition against stripping down a partially secured mortgage lien.(25)
At the March 24 oral argument before the Supreme Court, the justices questioned the distinction drawn by the Eleventh Circuit (and supported by the debtors) between completely underwater and partially underwater mortgage liens.(26) They also questioned whether Dewsnup had been correctly decided (encouraged by Justice Scalia, who had dissented in that case) and openly asked whether Dewsnup should be overruled. As Justice Ginsburg noted, "the law would be much more coherent if either Dewsnup applies to the totally underwater as well as partially underwater, or Dewsnup is overruled".(27) Indeed, both Justice Alito and Justice Kagan asked the debtors' attorney why he had not argued that it be overruled.(28) As Kagan observed: "I tell you that my sort of reaction to this case is that these distinctions that you are drawing between partially underwater and fully underwater are not terribly persuasive. But the only thing that may be less persuasive is Dewsnup itself."(29)
To some extent, the justices appeared concerned about underlying policy issues as well.(30) The Caulkett and Toledo-Cardona bankruptcies were driven in part by the fallout from the worldwide financial crisis of 2008-2009.(31) Second mortgages such as those on the debtors' homes have historically been rare outside the years leading up to the financial crisis.(32) In the Chapter 7 context, a house in which there is no non-exempt, non-encumbered value is typically abandoned back to the debtor.(33) Later, outside the bankruptcy context, the debtor and the senior lender may attempt to negotiate a modification to avoid the foreclosure process. The debtors' concerns – echoed by Justice Sotomayor(34) and others – are driven to some extent by the potential spoiler role that a junior lienholder could play after the bankruptcy, when the debtor and the senior lienholder attempt to negotiate a modification to the terms of the senior secured debt.(35)
The court is expected to issue a decision before the end of June, when its current term ends.
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(2) Brief for petitioner at i (January 9 2015). Chapter 7 is the chapter of the code providing for liquidation – the sale of a debtor's non-exempt property and the distribution of the proceeds to creditors. See www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter7.aspx.
(14) "Order Granting Motion to Strip Lien of David B Caulkett", In re Caulkett, 13-05537 (Bankr MD Fla (filed December 11 2013); Bank of America NA v Caulkett, 14-cv-78-Orl-31, 2014 WL 7175386, at *1 (MD Fla February 14 2014).
(20) The bank rests its position partially on a distinction between claims and liens – that is, while the valuation of the property may affect its claim, the lien passes through the bankruptcy and can later be asserted against the collateral if it increases in value. Brief for petitioner at 24-25.
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