Chapter 7 Debtors Cannot Strip Off Junior Liens on Underwater Home Loans, United States Supreme Court Rules

This morning, the United States Supreme Court ruled that debtors in Chapter 7 bankruptcy cases cannot “strip off,” or completely void, junior mortgages that—based on the value of the property and the amount of claims secured by senior mortgages—are completely underwater. This ruling eliminates a potential means for Chapter 7 debtors to maximize the relief associated with their discharge and provides junior lienholders with leverage in loss mitigation discussions between the debtor and the senior lienholder.

In its ruling today, the Court relied on its prior opinion in Dewsnup v. Timm, in which the Court held that a Chapter 7 debtor cannot “strip down,” or reduce, a junior mortgage lien that is partially underwater. The Court reasoned in Dewsnup that if a claim is “allowed” pursuant to Section 502 of the Bankruptcy Code and is secured by a lien with recourse to the underlying collateral, it cannot be deemed partially unsecured under Section 506 of the Bankruptcy Code. Today, the Court concluded that there was no reason to deviate from the Dewsnup opinion when a valuation might indicate that the junior lien is completely underwater:

Dewsnup’s construction of “secured claim” resolves the question presented here.  Dewsnup construed the term “secured claim” in § 506(d) to include any claim secured by a lien and . . . fully allowed pursuant to § 502. Because the Bank’s claims here are both secured by liens and allowed under § 502, they cannot be voided under the definition given to the term “allowed secured claim” by Dewsnup.

The ruling today continues the distinction between Chapter 7 and Chapter 13 with respect to permissible treatments of junior mortgage liens. Notably, in Chapter 13 cases, debtors may strip off junior liens by motions or separate adversary proceedings. However, the lien strip does not take effect until the debtor’s successful conclusion of the Chapter 13 case and entry of a discharge order. Accordingly, given the historically low success rates in Chapter 13, there always is the possibility that the lien strip never would take effect. The scenario is different, however, in Chapter 7 cases, where the debtor has no obligation to commit disposable income to repay creditors and where the debtor might receive a discharge within a few months of filing for bankruptcy.

As for the potential impact on lenders and borrowers, today’s ruling could trigger a shift in bankruptcy filings from Chapter 7 to Chapter 13 in those instances where the debtors see significant value in stripping off junior mortgages. The ruling also may have a chilling effect on loss mitigation negotiations in Chapter 7 cases, given the potential “veto” power that junior lienholders may have in discussions between the debtor and senior lienholder. In any event, the ruling removes the potential for valuation battles during what normally is a fairly straightforward and expeditious Chapter 7 proceeding.

Resources:

Bank of America v. Caulkett, Case Number 13-1421

Bank of America v. Edelmiro Toledo-Cardona, Case Number 14-163