U.S. Supreme Court Rules That Underwater Mortgages Cannot Be “Stripped Off”

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While the American economy has shown tentative signs of stabilization and recovery, the nation’s courts continue to grapple with legal questions that emanate from the Great Recession and the bursting of the so-called “housing bubble.” In one notable development, the United States Supreme Court has decided an important question regarding the treatment of home mortgages in Chapter 7 bankruptcy cases (i.e., cases in which the bankruptcy trustee gathers and sells the debtor’s non-exempt assets and uses the proceeds of such assets to pay creditors in accordance with the Bankruptcy Code.)

In two substantially similar cases, Bank of America, N.A. v. Caulkett and Bank of America, N.A. v. Toledo-Cardona, the Supreme Court was called upon to decide whether section 506(d) of the Bankruptcy Code permits a Chapter 7 debtor to void a junior mortgage lien in its entirety when the outstanding debt owed to a senior lien holder exceeds the current value of the home in question. In more colloquial terms, the Supreme Court was asked to determine whether a debtor may “strip off” a junior mortgage lien that is “under water.”

As a general matter, a Chapter 7 bankruptcy proceeding discharges only the debtor’s personal liability on his debts; it does not usually void a secured creditor’s right to foreclose on the property securing that creditor’s claim. This means that, in the case of a mortgage loan, the lender’s lien remains on the real estate until any foreclosure sale is conducted, even though the debtor’s obligation on the underlying promissory note has been discharged. In some cases, Chapter 7 debtors have no equity in their houses because the houses are worth less than the amounts outstanding on the mortgage loans they secure. In such cases, and because the house has little current value, the bankruptcy trustee may return the house to the debtor because sale of the property would not generate any proceeds to pay creditors besides the lender. The mortgage lender, in turn, may decide not to foreclose immediately, and instead wait to see whether the property increases in value in the future.

The question presented in the Caulkett and Toledo-Cardona cases was whether, when a first mortgage on a Chapter 7 debtor’s house exceeds the value of the property so that a second mortgage on the same house is completely “under water,” the debtor is permitted not only to discharge his personal liability for the second mortgage loan, but also to “strip off” the lien itself so that the second mortgage-holder has no right to foreclose on the property even if the property later increases in value.

In 1992, in a case captioned Dewsnup v. Timm, 502 U.S. 410 (1992), the Supreme Court ruled that Section 506(d) of the Bankruptcy Code does not permit a Chapter 7 debtor to reduce a secured creditor’s lien down to the value of the collateral securing that creditor’s claim. Dewsnup addressed what is commonly called a “strip down” in the situation where the creditor’s mortgage was only partially, and not totally, under water. Over the last two decades, most courts have ruled that the language and logic of Dewsnup also prohibit “strip offs” in situations in which a mortgage is completely under water (often because a senior lien exceeds the value of the subject property).

The United States Court of Appeals for the Eleventh Circuit (which covers the states of Alabama, Florida, and Georgia), however, had reached the opposite conclusion and held that Dewsnup‘s reasoning does not govern strip offs. The Caulkett and Toledo-Cardona cases arose from bankruptcy courts within the Eleventh Circuit. In each case, the Chapter 7 debtor had filed a motion to strip off Bank of America’s junior mortgage lien under Section 506(d). Those motions were allowed pursuant to binding Eleventh Circuit precedent.

Because the Eleventh Circuit’s refusal to apply Dewsnup in strip off cases was contrary to decisions rendered by several of its sister Circuit Courts of Appeals, Bank of America successfully petitioned the U.S. Supreme Court to resolve the “circuit split.”

The Supreme Court consolidated the Caulkett and Toledo-Cardona cases, and ruled on June 1, 2015 that “[t]he reasoning of Dewsnup dictates that a debtor in a Chapter 7 bankruptcy proceeding may not void a junior mortgage lien under [Section] 506(d) when the debt owed on a senior mortgage lien exceeds the current value of the collateral.” 575 U.S. ___ (2015). The high court’s decision is a significant “win” for mortgage lenders.

For more information concerning Fitch Law Partners LLP‘s banking law practice, please contact Stephen C. Reilly, Jennifer E. Greaney, or Ryan M. Cunningham.


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