On June 1, 2015, with a decision that is sure to please junior mortgage lien holders, the United States Supreme Court held in a Chapter 7 bankruptcy case known as Bank of America, N.A. v. Caulkett that a junior mortgage lien holder's mortgage would not be invalidated simply because the entire value of its mortgage is underwater. In Caulkett, the Supreme Court specifically examined whether 11 U.S.C. Section 506 of the United States Bankruptcy Code (the "Code") voids the lien of a second mortgage lien holder on a residential property because the value of the property was less than the amount of the first mortgage lien holder's lien and thus not a "secured claim."
Underwater Junior Mortgages
David Caulkett and Edelmiro Toledo-Cardono, the debtors in Caulkett, each had two mortgage liens encumbering their respective homes when they separately filed for Chapter 7 relief under the Code. The amount owed on each debtor's first lien mortgages exceeded the value of each debtor's home, therefore rendering the second lien mortgages completely underwater—essentially, the second lien mortgage holders would receive no money if the properties were sold today. Each debtor argued under their Chapter 7 bankruptcy cases that the second mortgage liens should be "stripped off"/voided because they were not allowed "secured claims" under Section 506(d) of the Code due to the fact that Section 506(a)(1) provides that an allowed claim secured by a lien on property is unsecured "to the extent that the value of such creditor's interest...is less than the amount of such allowed claim." The Bankruptcy Court agreed and the Eleventh Circuit affirmed the decisions to "strip off"/void the second lien mortgages in their entirety.
The Eleventh Circuit's decision to uphold the Bankruptcy Court's decisions was obviously not a welcome decision to many junior residential lenders across the country and the cases were appealed to the Supreme Court.
The Dewsnup Application
The Supreme Court had previously decided in Dewsnup v. Timm, 502 U.S. 410 (1992), that a mortgage lien that is only partially underwater would not be written down to the value of the property as long as any value remained— in other words, so long as just one dollar of the remaining value of the real property is just one dollar greater than the amount of the mortgage lien in question, then the lien would remain as a valid secured claim. The decision, however, left open the interpretation that a completely underwater mortgage would be void. The Supreme Court's decision in Dewsnup has been embraced by debtors and their attorneys because it prevents an underwater junior mortgage holder from holding a potentially blocking position as a debtor attempts to negotiate a settlement in bankruptcy with a first lien mortgage holder.
The debtors in Caulkett, therefore, asserted that the holding in Dewsnup required the Supreme Court to uphold the decision of the Eleventh Circuit and void the second mortgage lien holders' mortgages.
The Caulkett Decision
In Caulkett, however, the Supreme Court decided that the artificial distinction between a partially underwater mortgage lien (as in Dewsnup) and a completely underwater mortgage lien (as in Caulkett) does not hold water. In particular, the Supreme Court noted that "[g]iven the constantly shifting value of real property, this reading could lead to arbitrary results" and potentially deprive a second lien mortgage from the benefit of any potential appreciation of the real property in the future. The Supreme Court elaborated that the Dewsnup decision provided that a "secured claim" under Section 506(d) of the Code "is a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim." The Supreme Court, therefore, reversed the decision of the Eleventh Circuit and held that the junior mortgage lien would not be "stripped off"/voided under Section 506(d) of the Code.
The Caulkett decision certainly provides greater clarity for junior residential mortgage lenders in the bankruptcy context. Although the Caulkett case centers on residential home mortgages, there are potential implications for commercial mortgage lenders as well. While it remains to be seen whether the Caulkett decision will be extended to the commercial context, junior lenders in both the residential and commercial context should take note.
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