On June 1, 2015, the United States Supreme Court issued its opinion in Bank of America v. Caulkett. The opinion holds that in a Chapter 7 bankruptcy case a debtor could not void an underwater junior mortgage lien.
In Caulkett, Bank of America held a junior mortgage lien on a piece of residential property. The debtor owed more on their first mortgage than the current market value of the property, meaning the junior lien was underwater. In the Chapter 7 case, the debtor moved to “strip off” (void) Bank of America’s underwater junior lien. The bankruptcy court granted the debtor’s motions and voided the liens. That decision was upheld on appeal, but reversed by the Supreme Court.
The discussion in Caulkett centers heavily on Dewsnup v. Timm, a Supreme Court case decided in 1992. In Dewsnup, the Supreme Court held that a Chapter 7 debtor could not “strip down” (reduce) a partially underwater lien to the value of the collateral. Dewsnup has been the subject of criticism since it was decided. The Supreme Court acknowledged the criticism, but explained that the debtors in Caulkett had not asked that Dewsnup be overturned. Under Dewsnup, because the liens in Caulkett were secured by property, even though the value of the property was not sufficient to cover the claim, the liens could not be voided.
Caulkett applies only in Chapter 7. Lenders should note that a Chapter 13 debtor can strip off an underwater junior mortgage lien, even on their principal residence. However, the junior lien must be wholly unsecured. If the value of the property exceeds the amount owed on the first lien, even by a small amount, the junior lien cannot be stripped off. Judge Rebecca Connelly of the Bankruptcy Court for the Western District of Virginia covers these issues in Johnston v. SunTrust Bank, 2013 Bankr. LEXIS 1850 (Bankr. W.D. Va. 2013). In Johnston, the court refused to void a junior lien secured by property valued no more than $9.00 above the total owed on the first lien.
Caulkett is an important decision for lenders. Although lenders’ underwater junior liens are still at risk in Chapter 13, Caulkett will mean that lenders will recover more on junior liens as the real estate market continues to improve and borrowers pay down their first liens.