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​Supreme Court: Chapter 7 Debtors May Not Extinguish Underwater Liens

Financial Institutions Law Alert Christopher Combest

In a victory for secured lenders, the U.S. Supreme Court has ruled that a bankruptcy court may not extinguish a junior lien on a Chapter 7 debtor's property, even though the collateral has no value above the senior debt. Although the bankruptcy court had allowed the borrower to "strip off" the bank's junior lien on his home, the Supreme Court reversed, holding that junior lenders are entitled to retain their liens in Chapter 7, allowing them to share in any upside should the property be sold for more than the value determined in the bankruptcy case. Bank of America, N.A. v. Caulkett, No. 13-1421, 2015 WL 2464049 (June 1, 2015).

Under federal bankruptcy law, a secured creditor has two claims: a secured claim in an amount equal to the value of the collateral and an unsecured claim for the remainder. Because unsecured claims are discharged in Chapter 7, a homeowner with a $1 million mortgage debt might obtain from the bankruptcy court a low value for the mortgaged property—say, $400,000—discharge the remaining debt, and exit bankruptcy with a "stripped-down" mortgage of only $400,000. Borrowers often obtained just such a result until the Supreme Court stopped that practice in Dewsnup v. Timm, 502 U.S. 410 (1992). In Dewsnup,the Court held that in Chapter 7 cases, a lender with a lien supported by some collateral value may retain that lien for the full amount of the mortgage debt. A Chapter 7 trustee would not sell collateral valued below the debt secured by it, but would rather abandon it back to the borrower-debtor, subject to the lien. If the property had been undervalued, or later appreciated, then, upon a subsequent sale by the borrower, the lender, not the borrower, would benefit from the upside.

Recently, however, some federal courts have held that, if a lien has no current value—in lending parlance, if it is entirely "underwater"—the borrower in Chapter 7 may completely extinguish, or "strip off," the lien, thereby depriving the junior lender of any later appreciation in value and from any leverage in a post-bankruptcy foreclosure proceeding. It is this practice that the Supreme Court has now forbidden, holding in Caulkett that the rule established years ago in Dewsnup for partially underwater liens applies to wholly underwater liens as well.

While home mortgage lenders may be the principal beneficiaries of the Supreme Court's holding in Caulkett, the rules against impairing the value of liens apply for the benefit of all secured lenders. The Supreme Court's ruling honors the bargain between the borrower and the lender—that liens will stay with collateral until foreclosure or other sale—and ensures that increases in property value will benefit the lender, rather than providing a windfall for borrowers in bankruptcy.

For more information, please contact Christopher Combest at (312) 715-5091/christopher.combest@quarles.com or your local Quarles & Brady attorney.