CLIENT ALERT: Supreme Court Rules Second Mortgages are NOT Voidable in Chapter 7 Bankruptcy
By: Marty B. Ellis
On June 1, 2015, in two consolidated cases (Bank of America, N. A. v. Caulkett and Bank of America, N. A. v. Toledo-Cardona), the Supreme Court of the United States ruled that in a bankruptcy liquidation Chapter 7 proceeding, the debtor cannot void a second mortgage when the value of the mortgaged property (typically, and in both of these cases, the debtor’s residence) is worth less than the first mortgage secured by the property.
I. Loan Collateral Partially or Wholly “Underwater”:
Lien “Strip Down” versus Lien “Strip Off”
Prior to 1992, individual Chapter 7 debtors routinely sought to reduce their mortgage liens where the unpaid balance of the mortgage exceeded the value of the residence (i.e., the property was “partially underwater”). Under the Bankruptcy Code, an undersecured creditor with an “allowed” claim (that is, a claim with no legal infirmities that is entitled to be paid out of the bankruptcy estate) really has two claims: a secured claim in an amount equal to the value of the creditor’s collateral and an unsecured claim for the remainder. For example, a lender holding a $500,000 mortgage claim secured by real estate worth $300,000 would have a secured claim for $300,000 and an unsecured deficiency claim for $200,000. Moreover, the same section of the Bankruptcy Code that provides for bifurcating the lender’s claim into secured and unsecured portions also provides that, to the extent a lien secures a claim that is not an allowed secured claim, that lien is void.
Therefore, a homeowner in bankruptcy could request the court to value the debtor’s residence at less than the full amount owed on the mortgage; if the court did so, the debtor would then seek to void the creditor’s lien to the extent that the unpaid balance of the lien exceeded that court-determined value – a procedure informally referred to as “stripping down” the lien. The debtor might then pay that “stripped-down” value and extinguish the lien. Of course, if the court had undervalued the property or the property later appreciated in value, the debtor, not the lender, benefited from the additional value.
Where a debtor’s residence carried both a first and a second mortgage, but the value of the residence was less than the amount of the senior lender’s claim (i.e., the property was “wholly underwater”), debtors would use Chapter 7 of the Bankruptcy Code to value the junior lender’s secured claim at zero – effectively “stripping off” altogether the junior lien on the property.
II. The Supreme Court Decision
The Court’s decision this week, which directly relied on its 1992 decision (Dewsnup v. Timm), has changed all of this. In Dewsnup, the Court had ruled that when the amount of a mortgage lien is greater than the market value of the property at issue, the Bankruptcy Code does not allow courts to reduce the lien’s value to the property’s market value. Dewsnup involved a “partially underwater” mortgage where the debtor owed $120,000, but sought to reduce that secured debt in her Chapter 7 bankruptcy to $39,000, which was the current value of her residence. However, the Court ruled that the debtor could not do so because the creditors’ claim was an allowed claim (i.e., had no legal infirmities), and was secured by a mortgage lien and was therefore “secured” for purposes of Bankruptcy Code, § 506(d).
In this week’s Court decision, the debtor homeowners were “completely underwater.” In Caulkett, the debtor’s house was worth $98,000 when he filed for Chapter 7 bankruptcy, but he owed $183,000 on his first mortgage and $47,000 on his second. In Toledo-Cardona, the debtor’s residence was worth just under $78,000 when he filed for bankruptcy, yet he owed $135,000 on his first mortgage and $32,000 on his second.
The Court noted that § 506(d) of the Bankruptcy Code allows a debtor to void a lien on the debtor’s property when it “secures a claim against the debtor that is not an allowed secured claim.” All parties agreed in both cases that Bank of America’s claims were allowed. The only issue was whether the mortgagee’s claims were secured, given that at the time the Chapter 7 bankruptcies were filed, the value of the lender’s second mortgage interest on the properties was zero.
The debtors tried to distinguish between mortgages that are partially and fully underwater, but the Court ruled that this would create an “odd statutory framework,” because if a court determined that the value of the property was one dollar more than the amount of the first mortgage, then the second mortgage could not be voided, but the second mortgage could be voided if the property were valued at a dollar less than the first mortgage. “Given the constantly shifting value of real property,” the Court concluded, “this reading could lead to arbitrary results.” Therefore, the Court rejected the debtors’ attempts to “strip off” the second mortgages on their properties reaffirming the status of their bank loans as “secured” liens.
III. Practical Considerations
As a practical matter, what this week’s Supreme Court decision means to second mortgage consumer lenders on residential real estate is that more Chapter 13 bankruptcy filings may be expected, since a debtor can still “strip down” a second mortgage in a Chapter 13 proceeding under Bankruptcy Code, §1322(b)(2) if the second mortgage is wholly unsecured value wise. Also, there will likely be less Chapter 7 filings, since the second mortgage will remain intact after the debtor’s discharge. Moreover, if the debtor files a Chapter 7, the debtor may stop paying on all of the debtor’s mortgages, since the debtor cannot readily eliminate the second mortgage lien. On the other hand, the debtor may simply try to pay the first mortgagee and hope the second mortgagee will not foreclose, thinking it is unlikely that the second mortgagee will be tempted to pay off a first mortgage with a large balance simply to realize its smaller equity balance.
Finally, this decision also means that the second mortgage holder now has a say in any “short sale” or attempted refinance, and depending on the market trends, the second mortgage lender should take a closer look at the circumstances. If neighborhood market values are trending upwards, the first mortgage is current, and the taxes are being paid, then a second mortgage foreclosure might be worth considering or at least an objection to any Chapter 7 debtors’ “strip down” application. Obviously, this is an economic decision and a new option that should be weighed.
For further information regarding this matter, please contact attorneys Martin Ellis at (410) 825-5223 or Keith Clark at (717) 763-1121.