In Bank of America v. Caulkett, No. 13-1421, 575 U.S. __ (2015) and Bank of America v. Toledo-Cardona, No. 14-163, 575 U.S. __ (2015), the Supreme Court of the United States recently held that a Chapter 7 debtor cannot void a junior mortgage, where the value of the collateral securing the debt is less than the outstanding indebtedness owed on the first mortgage. In essence, even though a junior lien may be wholly unsecured, Section 506(d) of the Bankruptcy Code (the “Code”) does not permit the debtor to void the lien. Moreover, these Supreme Court decisions resolved a conflict amongst many courts across the country, both at the Bankruptcy Court and Circuit Court levels.
Section 506(d) of the 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.” 11 U.S.C. § 506(d) (2015). By its terms, an allowed claim generally has been construed to mean (with certain exceptions not relevant here) a claim to which no objection has been made or a claim that is adjudicated as allowed despite a party objecting to the claim. See 11 U.S.C. § 502(a)–(b).
Significantly, Caulkett and Toledo-Cardona involved substantially similar facts. Both debtors had two mortgage liens on their homes and the mortgages held by Bank of America were both subordinate liens. Furthermore, the total outstanding indebtedness the debtors owed to the senior lenders exceeded the fair market value of the property. In this posture, the liens held by Bank of America were characterized as “totally underwater.”
In 2013, both debtors filed petitions for relief under Chapter 7 of the Code. Likewise, they each moved to void or “strip off” the junior liens, relying on Section 506(d) of the Code. In both cases, the Bankruptcy Court granted the debtors’ motions, which were subsequently affirmed by the District Courts and the Eleventh Circuit. The Supreme Court of the United States granted certiorari to consider “whether a debtor in a Chapter 7 bankruptcy proceeding may void a junior mortgage under 11 U.S.C. § 506(d) when the debt owed on the senior mortgage exceeds the present value of the property.” Caulkett, No. 1341, slip op. at 1 (2015).
Notably, in Caulkett and Toledo-Cardona, there was no dispute regarding whether Bank of America’s claims were allowed. Instead, the crux of the dispute, and the focus of the Supreme Court’s opinion, centered on the definition of a “secured claim” for purposes of Section 506(d).
As an initial matter, the Supreme Court noted that Section 506(a) of the Code appeared to provide support for the debtors’ position. In this regard, Section 506(a) (1) states that “[a]n allowed claim of a creditor secured by a lien on property . . . is a secured claim to the extent of the value of such creditor’s interest in . . . such property . . . and . . . an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” 11 U.S.C. § 506(a). As a result, the Supreme Court acknowledged that a straightforward textual application of Section 506(a) appeared to support the conclusion that a claim cannot be classified as secured if the value of the creditor’s interest in the collateral is zero. However, the Supreme Court emphasized that it had previously considered this textual application and had rejected it in Dewsnup v. Tim, 502 U.S. 410 (1992).
In Dewsnup, the Supreme Court held that a Chapter 7 debtor could not reduce or “strip” down a partially underwater lien to the value of the collateral securing the claim. In reaching this conclusion, the Dewsnup Court found that pursuant to Section 506(d), a ”secured claim” is simply “a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim.” Caulkett, No. 1341, slip op. at 4. Moreover, if a claim is “allowed” and otherwise “secured with recourse to the underlying collateral, it does not come within the scope of 11 U.S.C. §506(d).” Id. (citing Dewsnup, 502 U.S. at 415, 417-20).
Among other arguments, the debtors attempted to persuade the Court that Dewsnup should be limited to the facts of that case, mainly instances involving partially secured or under-secured liens. Caulkett, No. 1341, slip op. at 5. Additionally, the debtors also posited that the definition of “secured claim” could be redefined to mean “any claim that is backed by collateral with some value,” but the Supreme Court ultimately rejected both arguments. Id. The Supreme Court refused to limit Dewsnup’s general application and it also declined to adopt an alternative definition of “secured claim” than what was already decided by prior Supreme Court precedent. In its final analysis, the Supreme Court held that the construction of “secured claim” under Dewsnup mandated the conclusion that a Chapter 7 debtor cannot void a wholly unsecured junior mortgage lien.
In light of this decision, lenders and the banking industry can be reassured that wholly underwater junior liens generally will not be stripped off in a Chapter 7 bankruptcy case. Previously, Chapter 7 debtors in various jurisdictions had success with voiding junior liens where the property was underwater. Caulkett and Toledo-Cardona are particularly significant because as the value of real property fluctuates over time, the value of a junior lien can change when the property increases in value. As a result, debtors will not be able to obtain a windfall by taking advantage of the value of their real property at the time of the filing of the Chapter 7 petition.