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Posts by: Joanna McDonald

Should Underwater Junior Liens Survive Bankruptcy?

This article is an excerpt written for the Distressed Download.  The full article is available here.


On March 24th, the Supreme Court heard oral argument on the consolidated appeals of two decisions from the Eleventh Circuit Court of Appeals, Bank of America v. Caulkett[1] and Bank of America v. Toledo-Cardona.[2]  The appeals address an issue left unresolved by the Supreme Court’s decision in Dewsnup v. Timm:[3] that is, does section 506 of the Bankruptcy Code void, i.e., “strip off” a valid junior mortgage lien in a chapter 7 case if the mortgage loan is completely underwater.  These cases involve the treatment in chapter 7 bankruptcy cases of “undersecured” or “underwater” second-lien home mortgages.  Debtors who have granted such mortgages have no equity in their houses because the houses are worth less than the amount outstanding on the mortgage loans.

In a chapter 7 case, an individual debtor is able to obtain a discharge of his or her debts following the liquidation of the debtor’s non-exempt assets by a bankruptcy trustee, who then distributes the proceeds to creditors.  In Dewsnup, the Supreme Court held that section 506 does not permit an individual chapter 7 debtor to reduce (or “strip down”) a first-lien mortgage loan to the value of the real property where the amount owed is greater than the property value.  Relying on Dewsnup, every circuit court to consider the issue except the Eleventh Circuit has determined that section 506 also does not permit individual debtors to void completely underwater junior mortgage.[4]

Although the housing market has been rebounding in many jurisdictions, there are numerous properties subject to multiple mortgage liens that are worth less than the amount of the first-priority mortgage.  The Supreme Court’s resolution of the Caulkett and Toledo-Cardona cases will either ratify the trend of other circuits, which would benefit junior lenders, or overturn it, which would favor homeowners and first-lien mortgagees. A ruling prohibiting lien stripping also could severely impair the ability of business and individual debtors to use the statutory power to restructure and avoid liens in chapters 11, 12 and 13. Regardless of the outcome, the decision will have widespread ramifications through the secondary housing market.