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Bar News - July 15, 2015

Federal Practice & Bankruptcy: US Supreme Court Reverses Second Mortgage Cases That Had Given Hope to Struggling Homeowners


Two bankruptcy cases from the 11th Circuit, Bank of America v. Caulkett and Bank of America vs. Toledo-Cardona (collectively “Caulkett”), had given some hope to struggling homeowners with second mortgages that were completely underwater.

The 11th Circuit Court of Appeals held that Chapter 7 debtors may void a junior mortgage under 11 U.S.C. § 506(d) if the junior mortgage is completely underwater. Affirming these decisions would have resulted in tremendous benefit to Chapter 7 debtors seeking a fresh start. However, citing a controversial decision, Dewsnup v. Timm, the United States Supreme Court reversed the 11th Circuit Court of Appeals and held that wholly unsecured mortgages cannot be voided in a Chapter 7 bankruptcy case.

At issue were two sections of Section 506 of the Bankruptcy Code. Section 506(d) provides that “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.”

The parties in Caulkett did not dispute that the claims held by Bank of America were allowed. Instead, the dispute centered on the requirement that the claims be “secured” claims. Section 506(a)(1) provides that “[a]n allowed claim of a creditor secured by a lien on property… is a secured claim to the extent of the value of such creditor’s interest in… such property,” and “an unsecured claim to the extent that the value of such creditor’s interest… is less than the amount of such allowed claim.” The debtors argued that, applying the definition of “secured” under Section 506(a)(1), Bank of America was unsecured and, therefore, its lien was void under Section 506(d).

The problem the debtors faced was the precedent set by the Supreme Court in 1992 in Dewsnup v. Timm. In Dewsnup, the bank was only partially secured (the debt was $120,000 and the value of the land was $39,000). Therefore, the debtors sought to reduce the value of the lien to the value of the land. The Court created two meanings for the words “secured claim” under § 506 and held that a debtor could not strip down an undersecured lien to the value of the collateral by distinguishing between the same phrase “allowed secured claim” used in both subsection (a) of Section 506 and subsection (d) of Section 506.

To get around Dewsnup, the debtors in Caulkett sought to limit Dewsnup to cases where the junior lien is under-secured. This argument seemed to have traction during oral argument. Several Justices voiced concern with the practical impact of not voiding the unsecured liens.

Justices Sonia Sotomayor and Anthony Kennedy both noted that second mortgage-holders with nothing to gain from a foreclosure could still block a negotiated settlement in a bankruptcy that would benefit the debtor-borrowers and the first mortgage holders. Justice Sotomayor stated that bankruptcy is supposed to give debtors a fresh start, and “if you’re able to hold up that fresh start, that is the concern.”

Caulkett is an interesting read. Writing for the Court, Justice Clarence Thomas questioned the Dewsnup analysis several times, mentioned three different times that the debtors did not ask the Court to overrule Dewsnup and, in a footnote joined by three justices, noted that Dewsnup is frequently criticized.

Referring to the rule of statutory construction that identical words in the same act are intended to have the same meaning, the Court states: “Under that straightforward reading of the statute, the debtors would be able to void the Bank’s claims.” But that glimmer of hope was dashed, as the Court states that, “unfortunately,” the Dewsnup opinion “forecloses this textual analysis.”

In rejecting the debtors’ attempt to distinguish Dewsnup, the Court held that doing so would “leave an odd statutory framework in place.” For example, a second lien on property with a dollar of equity would not be stripped under the debtors’ argument, while a lien on a property with a dollar less of equity would be stripped. “Given the constantly shifting value of real property, this reading could lead to arbitrary results.”

Hinting again at is skepticism of Dewsnup, the Court stated, “Even if Dewsnup were deemed not to reflect the correct meaning of § 506(d), the debtors’ solution would not be either.” Accordingly, the Court declined to “adopt the artificial distinction” the debtors proposed between an undersecured lien and an unsecured lien and reversed the 11th Circuit Court of Appeals.

Until Dewsnup is overruled, the options for debtors are limited. Unsecured junior mortgages may be stripped in a Chapter 13 case. However, a Chapter 13 case involves higher fees, requires a commitment period of 36-60 months, and the debtor usually has to pay something to unsecured creditors who might receive nothing in a Chapter 7 case.

In contrast, the decision was a victory for junior lien-holders. Even though the real estate market has recovered, there are still many unsecured liens remaining from the real estate boom. Those liens will continue to survive a Chapter 7 bankruptcy, so long as the claims are allowed.

Given the Court’s concerns with Dewsnup expressed at oral argument and in the opinion, it is unlikely that this is the last we have heard of this issue.

Sabrina C. Beavens

Sabrina C. Beavens is a partner at Iurillo Law Group in Portsmouth. Beavens also practices in the firm’s St. Petersburg, Fla., office. She focuses on bankruptcy, business and real estate law.

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