Dewsnup v. Timm

Supreme Court Says Underwater Junior Liens Survive Bankruptcy

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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.

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Should Underwater Junior Liens Survive Bankruptcy?

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

Introduction

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.

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