On March 30, we reported on two cases pending before the U.S. Supreme Court: Bank of America v. Caulkett[1] and Bank of America v. Toledo-Cardona[2]. Each involved chapter 7 bankruptcy cases in which the debtors had no equity in their homes because the houses were worth less than the amount outstanding on the senior mortgage loans—that is, the second lien-lenders were “unsecured” or totally “underwater”.
In a chapter 7 case, an individual debtor is able to obtain a discharge of his or her debts, but the debtor’s non-exempt assets are liquidated by a bankruptcy trustee, who then distributes the proceeds to creditors. In Dewsnup v. Timm[3], the Supreme Court held that Bankruptcy Code § 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 ($119,000) is greater than the property value ($39,000). Caulkett and its companion case addressed whether the outcome should be different where the debtor seeks to void (or “strip off”) a second lien mortgage that is wholly underwater.
On its decision announced on June 1, the Supreme Court found the question effectively controlled by its prior holding in Dewsnup. Noting that the debtors had not asked it to overrule Dewsnup, the Court held by unanimous decision[4] that a debtor in a chapter 7 bankruptcy case may not void second mortgage liens under Bankruptcy Code section 506(d) when the debt owed on a senior mortgage lien exceeds the current value of the collateral. The Court rejected respondents’ attempts to limit Dewsnup’s interpretation to partially underwater mortgages, concluding that there was no principled way to distinguish those from wholly underwater mortgages within the terms of the Bankruptcy Code. In Dewsnup, the Court defined an “allowed secured claim” under section 506(d) as “claim supported by a security interest in property, regardless of whether the value of that collateral would be sufficient to cover the claim”. Thus, section 506(d) voids underwater liens only where the underlying debt is invalid under applicable law.