U.S. Supreme Court Resolves Uncertainty Regarding Junior Mortgage Liens in Chapter 7 Proceedings

A recent U.S. Supreme Court case resolves uncertainty as to whether Bankruptcy Code Section 506(d) allows Chapter 7 Bankruptcy debtors to “strip off” (void) junior mortgage liens that are wholly underwater.  That uncertainty has existed for over 20 years since the U.S. Supreme Court’s ruling in Dewsnup v. Timm in 1992, which dealt with partially underwater junior mortgage liens as opposed to wholly underwater liens. 

In Dewsnup, the U.S. Supreme Court confronted a situation in which a Chapter 7 Bankruptcy debtor wanted to “strip down”—or reduce—a junior mortgage lien that was partially underwater.  The debtor relied on Bankruptcy Code Section 506(d), which provides “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” Because her junior lien was partially underwater, the debtor argued that at least a portion of the lien was no longer secured by the real property collateral, and the unsecured portion was void pursuant to Section 506(d) because it was not an allowed secured claim. 

The Court rejected the debtor’s argument, and interpreted 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.  Nevertheless, for over twenty years following Dewsnup, there has been uncertainty regarding whether the holding should be limited to only those cases involving partially underwater junior liens, and several courts continued to allow Chapter 7 debtors to void or “strip off” wholly underwater junior mortgage liens pursuant to Section 506(d). 

Recently, the U.S. Supreme Court resolved the uncertainty in Bank of America, N.A., v. David B. Caulkett, et al.  In that case, Chapter 7 debtors had filed motions to strip off junior mortgage liens that were wholly underwater.  The debtors implored the Court to limit the application of Dewsnup to only those cases involving partially underwater junior mortgage liens.  The Court refused to do so, and confirmed that junior mortgage liens are valid “secured claims” under Section 506(d) and may not be voided, regardless of whether those liens are partially or wholly underwater. 

The likelihood that junior mortgage liens will remain intact following Chapter 7 Bankruptcy proceedings is only one of many factors that lienholders need to evaluate before taking junior deeds of trust as collateral.