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us supreme courtUnited States: US Supreme Court Hands Lenders A Victory On Underwater Mortgages article from 06/17/15


The US Supreme Court has unanimously held that a debtor cannot void a wholly underwater second mortgage in Chapter 7 bankruptcy proceedings. The decision comes in the consolidated cases of Bank of America, N.A. v. Caulkett, No. 13-1421, and Bank of America, N.A. v. Toledo-Cardona, No. 14-163.

The issue before the Court focused on the intersection of two parts of Section 506 of the Bankruptcy Code. Section 506(a) provides that a creditor’s claim is a “secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property.” In other words, it is a secured claim for an amount equal to the present value of the collateral, and is an “unsecured claim” for the remainder. Section 506(d) provides 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.”

Lower courts were divided over whether a Chapter 7 debtor with multiple mortgages can void, or “strip off,” a junior mortgage lien in its entirety under Section 506(d) when the value of the senior mortgage lien exceeds the current value of the property—that is, when the junior lien is entirely underwater. In Dewsnup v. Timm, 502 U.S. 410 (1992), the Supreme Court held that a Chapter 7 debtor could not “strip down” a partially underwater lien to the present value of the collateral, but the Court did not address whether the same rule applied to a lien that was entirely underwater lien. In the combined cases at issue, the Eleventh Circuit had limited Dewsnup to partially underwater liens, holding that Chapter 7 debtors may strip off a wholly underwater junior mortgage lien; the Fourth, Sixth and Seventh Circuits had reached the opposite conclusion.

The Supreme Court reversed the Eleventh Circuit. In an opinion written by Justice Thomas, the Court acknowledged that a “straightforward reading of the statute” favored the Eleventh Circuit’s interpretation. Because the value of a wholly underwater junior lien is “zero,” it is unsecured within the meaning of Section 506(a). And given that Section 506(d) uses the same term—”secured claim”—as Section 506(a), “one would think” that the wholly underwater lien would also be unsecured, and thus voidable, within the meaning of Section 506(d).

The Court concluded, however, that Dewsnup “forecloses this textual analysis.” Dewsnup “defined the term ‘secured claim’ in § 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.” Under this reading, the function of Section 506(d) “is reduced to ‘voiding a lien whenever a claim secured by the lien itself has not been allowed'” under the Bankruptcy Code. Because the bank’s claims in these cases were “both secured by liens and allowed under” the Bankruptcy Code, they could not be “voided under the definition given to the term ‘allowed secured claim’ by Dewsnup.”

The Court also rejected the debtors’ arguments that Dewsnup should be limited to partially underwater liens. The Court noted that treating a junior lien that is one dollar shy of being completely underwater differently from a junior lien that is wholly underwater “could lead to arbitrary results.” The Court suggested that the policy arguments proposed by the debtors were better addressed to Congress.

Finally, the Court’s result was grounded in a practical understanding of the volatility in real estate markets. Because of “the constantly shifting value of real property,” a junior mortgage can be underwater one day but substantially or fully secured even a few months later. That has happened again and again as many regional markets have rebounded so sharply that the underwater mortgages that were common only a few years ago have become increasingly rare. The Court’s decision keeps junior lenders’ interest in mortgaged property live until the asset is liquidated, rather than allowing debtors to shed that interest while their junior liens happen to be underwater.

While the result in Caulkett favors lenders, they should be alert to the possibility that the Court may revisit Dewsnup in the future. The Court’s opinion noted in a footnote that, “[f]rom its inception, Dewsnup … has been the target of criticism,” citing among other sources Justice Scalia’s dissent in Dewnsup itself and Justice Thomas’s separate opinion (joined by Justice Scalia) in Bank of America Nat. Trust and Sav. Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 463 & 3 (1999), which criticized the “methodological confusion created by Dewsnup.” Yet the continued vitality of Dewsnup was not before the Court because “the debtors ha[d] repeatedly insisted that they are not asking us to overrule Dewsnup.” Tellingly, only three Justices (Kennedy, Breyer and Sotomayor) declined to join the footnote, suggesting that the majority of the Court may be open to overruling Dewsnup in a later case.

Originally published June 16, 2015

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