back

September 30, 2015

Best Practices: U.S. Supreme Court Ends Lien Stripping of Junior Mortgages in Liquidation Cases

by Victor A. Diaz

“There’s no getting blood out of a turnip.” Captain Frederick Marryat

A recent line of cases by the Court of Appeals for the Eleventh Circuit held that second-priority mortgage liens could be eliminated completely as part of a liquidation under Chapter 7 of the Bankruptcy Code where the collateral is worth less than the amount owed under the first mortgage, i.e. “underwater.” In re Caulkett, 566 Fed. Appx. 879 (2014) (per curiam); In re Toledo-Cardona, 556 Fed. Appx.911 (2014) (per curiam). The practice, commonly known as “lien stripping,” allows a debtor in bankruptcy to void a junior mortgage if the mortgage is underwater – a reality not uncommon during the recent financial crisis. These cases had a detrimental impact on commercial lenders, including those participating in SBA loan programs, who rely heavily on junior mortgage liens as part of their secondary collateral and to comply with SBA’s collateral requirements.

Section 506(d) of the Bankruptcy Code states, “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” Debtors persuaded federal bankruptcy courts to conclude that if the value in the collateral was insufficient to satisfy the first mortgage lienholder, then second position lienholders were in effect “unsecured” creditors. The Eleventh Circuit on appeal affirmed the holdings of the lower bankruptcy courts.

This past summer, in a unanimous decision, the United States Supreme Court reversed the ruling of the Eleventh Circuit. Bank of America, N.A. v. Caulkett, 135 S.Ct. 1995 (2015). Relying on the Court’s prior decision in Dewsnup v. Timm, 502 U.S. 410 (1992), the Court held that a debtor in a liquidation proceeding may not void an underwater mortgage on the basis that the value of the property is not sufficient to cover the claim. The Supreme Court reasoned that while portions of the Bankruptcy Code suggests that “underwater mortgages” are “unsecured claims” inasmuch as the value of the collateral is less than the amount of the claim, for purposes of “voiding” or “stripping down” a junior mortgage, the term “secured” means a claim supported by a valid security interest in the property, regardless of whether the value of that property would be sufficient to cover the claim. Id.

Speaking for the Court, Justice Thomas concluded:

“[a] debtor in a Chapter 7 bankruptcy proceeding may not void a junior mortgage lien under ยง506(d) when the debt owed on a senior mortgage lien exceeds the current value of the collateral.” Id.

Recent history demonstrates real estate values can fluctuate and indeed decline. The Supreme Court’s decision provides respite to weary lenders who had little by way of recourse when the equity in their collateral diminished. For more information on secondary collateral issues, please contact Victor at 407-667-8811 or at vdiaz@starfieldsmith.com.