United States: Supreme Court Says Underwater Junior Liens Survive Bankruptcy

On March 30, we reported on two cases pending before the U.S. Supreme Court: Bank of America v. Caulkett1and Bank of America v. Toledo-Cardona2.  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. Timm3], 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 decision4 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.

Practical Implications

Caulkett is not a change in law.  In fact, each of the circuit courts addressing this issue other than the Eleventh Circuit had determined that, applying Dewsnup, section 506 does not permit individual debtors to void a completely underwater junior secured creditor's right to foreclose on the creditor's collateral.5   Time will tell what impact, if any, the Court's decision will have on the housing market, mortgage lending costs or availability.  In today's slowly recovering housing market, parties should consider the following practical considerations arising from the Caulkett decision.

  • Bankruptcy Fresh Start Limited. For underwater homeowners, the debtor's option for a fresh start just narrowed. While the homeowner will be discharged (relieved) from having to pay creditors holding subordinate liens, the subordinate lien remains in place against the property. Even though the homeowner has no personal liability for the home-equity loan or other second lien financing (in other words, the debt is not enforceable against the homeowner), the subordinate lender can seek to foreclose on the property to recover amounts owed to it. The subordinate lender may seek to extract payment from the homeowner in order to avoid a foreclosure post-bankruptcy even though a successful foreclosure of an underwater subordinate lien will bring it no economic value. Such consent may be conditioned on receiving some payment from the homeowner. Obtaining relief from underwater home equity and other second liens in a bankruptcy case will be available only in chapter 11, 12 or 13 cases, which is often more expensive and time-consuming than a chapter 7 case.
  • Junior Mortgagees Gain Leverage. Lenders holding first or senior mortgage liens may be reluctant to provide relief to homeowners who have underwater junior liens. As a result of Caulkett, consent of home equity or other second lien mortgagees will be required for loan modifications, deeds-in-lieu of foreclosure, short sales or other consensual workouts agreed to by the first-lien mortgagee and the debtor.
  • Cloud on Title. Because underwater junior liens are not discharged in chapter 7 bankruptcy cases, future sales of the property (and the ability to obtain new financing) may be chilled. Lenders and potential purchasers must engage in careful review of the real property title records to ensure that there are no liens on the property. Underwater homeowners may not be able to sell their property absent consent of the subordinate lienholder, and such consent may be conditioned on the homeowner making some payment to the subordinate lienholder. Query whether Caulkett will impact the emerging "rent to own" industry or other programs designed to allow the homeowner to remain in the home after foreclosure. Property acquired through a deed-in-lieu of foreclosure or other consensual workout will not have released subordinate liens of record. In order to ensure clean title, purchasers may require that such sales be conducted only through public foreclosure auctions, and will want to make sure that subordinate lenders are properly parties to and on notice of such foreclosure proceedings.
  • Friendly Foreclosure Sales. If the desire is to remove the cloud on title, query whether the homeowner and the senior mortgage lender would consider conducting under applicable state law (outside of bankruptcy) a "friendly foreclosure" to wipe out an underwater junior lien. A "friendly foreclosure" could entail a negotiated agreement between the senior lienholder and homeowner agreeing to the commencement of a procedure by which the senior lienholder will conduct a judicial foreclosure on consent of the homeowner, provide for the entry of a judgment of foreclosure, for the senior lienholder to conduct a foreclosure sale, and provide for a waiver of the homeowner's right of redemption. Any "friendly foreclosure" would have to be on notice to the subordinate lienholder, and the subordinate lienholder would have the ability to purchase the property at such foreclosure sale. Because courts carefully scrutinize pre-foreclosure negotiated agreements and disfavor waivers (whether before or after default) of borrower's rights to notice or redemption, careful review of applicable state and other law will be required to determine whether a "friendly foreclosure" is an option.
  • Commercial Mortgage Lending May be Impacted. While Caulkett and its companion case, Toledo-Cardona, specifically involved chapter 7 cases for individual debtors, because the Bankruptcy Code provisions interpreted in Dewsnup and Caulkett apply in cases filed under other chapters of the Code, the Court's decision may apply to bankruptcy cases involving corporate entities (partnerships, corporations, limited liability companies and other non-natural persons) with respect to real property subject to a subordinate lien that is retained by (i.e., abandoned to) the bankrupt corporate entity.

Footnotes

1 566 Fed. Appx. 879 (11th Cir. 2014).

2 556 Fed. Appx. 911 (11th Cir. 2014).

3 502 U.S. 410 (1992).

4 The decision was delivered by Justice Thomas and was joined in whole by five of the Justices; three of the justices joined in the opinion except as to a footnote, which noted that Dewsnup has been criticized since its inception.

5 See, e.g., Palomar v. First Am. Bank, 722 F.3d 992 (7th Cir. 2013); In re Talbert, 344 F.3d 555 (6th Cir. 2003); Ryan v. Homecomings Fin. Network, 253 F.3d 778 (4th Cir. 2001).

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