In a decision which probably caused mortgage bankers everywhere to pop champagne corks and party like it’s 1999, the High Court ruled that Chapter 7 debtors are not entitled to strip-off a second lien on residential property.
Lien Removal and Reduction
Before Bank of America v. Caulkett, all bankruptcy debtors could remove junior liens, if the property’s value was insufficient to secure both notes. Assume Harry Homeowner used 80/20 financing to purchase a $200,000 residence, and the property’s value dropped to $160,000. The second lien would be unsecured, and dischargeable like any other unsecured debt.
The Supreme Court had already limited cram-downs, wherein the loan balance is reduced to the fair market value of the property, to Chapter 13 debtors. More on that in a minute.
As a rule of thumb, any case that contains the phrase “Unfortunately for the debtor” is probably not going to end well.
Caulkett was a consolidation of several actions from Alabama. The debtors had all filed Chapter 7 Bankruptcy in 2013, and sought to remove junior liens from their primary residences. Both the District Court and the Eleventh Circuit Court of Appeals voided the subsequent mortgages, holding that the declining property value had rendered these notes unsecured.
Writing for the majority, Justice Clarence Thomas drew heavily from 1992’s Dewsnup v. Timm, the aforementioned case on cram-downs. In that opinion, the Justices essentially redefined a secured claim as “a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim.” In other words, the loan instrument created a security interest, and the words on the paper are all that matter.
The homeowners attempted to distinguish Dewsnup, but the Justices were unpersuaded. Justice Thomas noted that the “constantly shifting value of real property” could lead to “arbitrary results” unless the Court drew a bright-line rule.
Caulkett is probably not the last word on the subject. Justice Thomas hinted that the Court may be willing to reconsider Dewsnup, because that decision has been so heavily criticized. Tellingly, only three Justices refused to join in the chorus of boos directed at Dewsnup.
At any rate, if eliminating a junior lien is a major concern, Chapter 13 is still an option. Both types of consumer bankruptcy ultimately give debtors a fresh start; they just work a bit differently.
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