On June 1, 2015, the United States Supreme Court handed down its opinion in the case of Bank of America, N.A. v. Caulkett. In this case, the Court unanimously decided that a debtor in chapter 7 bankruptcy cannot “strip off” a junior lien that is fully underwater at the time the bankruptcy case is filed. This ruling benefits lenders holding junior liens on real property.
In Caulkett, the Court consolidated cases involving debtors David Caulkett and Edelmiro Toledo-Cardona. Both chapter 7 debtors successfully used Section 506(b) of the Bankruptcy Code to “strip off” a junior mortgage on property where the debt secured by the first mortgage exceeded the value of the property. The junior lienholders appealed the lower court’s decision and the Eleventh Circuit Court of Appeals affirmed.
Section 506(d) of the Bankruptcy Code provides
To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless—
(1) such claim was disallowed only under section 502(b)(5) or 502(e) of this title; or
(2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title.
The Court provided that a plain reading of Section 506(d) seemed to favor the debtors’ position that the definition of “secured claim” in 11 U.S.C. §506(d) should mirror the definition in 11 U.S.C. §506(a)(1). However, the Court’s prior ruling in Dewsnup v. Timm, 502 U.S. 410 (1992) previously defined “secured claim” as used in Section 506(d) and resolved the issue to the contrary. In Dewsnup, the Court found that a junior lien on property where the property value was not enough to fully satisfy the junior lien could not be “stripped down” under Section 506(d) to the value of the property.
In Dewsnup, the Court reasoned that the definition of “secured claim” in Section 506(d) was ambiguous and thus that if a claim “has been ‘allowed’ pursuant to §502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of §506(d).” The Court applied this definition in Caulkett and held that “Dewsnup defined the term ‘secured claim’ in Section 506(d) to mean a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim.” After application of this definition to Section 506(d), a lien can only be “stripped off” if the claim is one not allowed under Section 502.
This decision is an important win for lenders. In its amici curiae brief filed with the Court, the American Bankers Association estimated that nearly $40 billion in loans secured by junior mortgages are presently outstanding. Lenders now will be affected less in chapter 7 bankruptcies in periods when real property values decrease.