US Supreme Court Holds that Out of the Money Mortgages Cannot be Stripped Off in Chapter 7 Bankruptcy Cases

The U.S. Supreme Court held that a secured creditor in a chapter 7 bankruptcy case is protected from having its lien “stripped off” even if the collateral securing its claim is worth less than the claims asserted by a senior secured creditor; i.e. the junior creditor’s secured claim is completely "out of the money.” The June 1, 2015 decision, Bank of America, N.A. v. Caulkett, reaffirmed the Court’s prior holding in Dewsnup v. Timm that chapter 7 debtors cannot reduce the value of a creditor’s secured claim to the market value of the collateral supporting it. 

Statutory Background and Precedent 

The plain language of Section 506 of the Bankruptcy Code bifurcates a secured claim to secured and unsecured portions based on the value of the collateral supporting it. Section 506(a) provides that “[a]n allowed claim of a creditor secured by a lien on property in which the estate has an interest… is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property… and is an unsecured claim to the extent that the value of such creditor’s interest… is less than the amount of such allowed claim.” Thus, a secured creditor’s claim is bifurcated into a secured claim for the value of the collateral and an unsecured deficiency claim for the remainder. Section 506(d) provides that a lien that secures a claim against a debtor that is not an “allowed secured claim” is void. 

The Supreme Court’s Dewsnup decision previously addressed this issue in the context of a partially underwater mortgage and held that the term “allowed secured claim” in Section 506(d) means an allowed claim that is a secured claim under applicable state law. Therefore, as long as the claim is allowed (i.e. there are no grounds to object to its validity) and is otherwise properly secured, it is an allowed secured claim for the entire amount of the claim, even if it is partially underwater.¹ 

The Caulkett Decision 

Caulkett arose from two chapter 7 bankruptcy cases filed by individual debtors. Each debtor owned real property that was encumbered by a senior mortgage and a junior mortgage. Bank of America was the junior creditor with respect to each property and in each case the amount owed to the senior creditor exceeded the judicially determined value of the collateral. The debtors sought to avoid Bank of America’s mortgages under Section 506(d) by arguing that because Bank of America was underwater and thus, its interest had no value, it did not have an allowed secured claim. The bankruptcy court in the respective proceedings granted the debtors’ motions to strip down Bank of America’s lien under Section 506(d), the Eleventh Circuit affirmed the bankruptcy courts, and Bank of America appealed. Before the Supreme Court, the debtors did not ask the Court to overrule Dewsnup but instead attempted to distinguish Dewsnup by arguing that a creditor with a lien on collateral should not have an allowed secured claim if the creditor was entirely, as opposed to partially, undersecured. 

By unanimous decision, the Supreme Court, finding Dewsnup controlling, overruled the Eleventh Circuit and held that the debtors could not avoid Bank of America’s mortgages. The Court rejected the debtors’ textual argument that an allowed secured claim under Section 506(d) must have some value as a secured claim under Section 506(a) in order to be allowed and relied upon the Dewsnup holding that “allowed” in Section 506(d) refers to whether the claim would be allowed, i.e. valid and enforceable, rather than what portion of the claim is supported by value in the collateral. The Court also rejected the debtors’ various policy arguments as to why fully underwater liens should be void and found the arguments to be insufficient to overcome the precedent established by Dewsnup. 

In addition, the Court noted the impracticality of the debtors’ arguments, as allowing a lien to be stripped off under Section 506(d) depending solely on whether a secured creditor had any interest in the collateral could permit a the creditor’s lien to be stripped off based on slight fluctuations in the dollar value of the collateral; this result that made little sense in light of “the constantly shifting value of real property.” As in Dewsnup, the Court recognized that whether a claim is allowed does not depend on whether the creditor is fully secured and thus reversed the lower courts’ decisions allowing the debtors to strip off Bank of America’s liens. 

Implications 

Notwithstanding the Court’s affirmance of Dewsnup, it is not at all clear that Dewsnup and Caulkett will remain good law. The Caulkett decision notes that the parties did not request the Court to overrule Dewsnup and in a footnote, the majority of the Court noted that Dewsnup was criticized from its inception. The Court also hinted as to its current attitude towards Dewsnup by noting that Dewsnup appears to be in conflict with the “straightforward reading of the statute.” 

In the context of chapter 11 and 13 bankruptcies, it is unlikely that Caulkett will have much effect, except with respect of mortgages secured solely by a chapter 13 debtor’s principal residence. 

In chapter 11 cases, the Dewsnup/Caulkett result will apply should the partially secured (or completely undersecured) secured creditor elect to be treated as a fully secured creditor under Section 1111(b) of the Bankruptcy Code. Section 1111(b)(2) permits a secured creditor in a chapter 11 case to elect to have its claim treated as fully secured without regard to the value of the collateral. In making the 1111(b) election, the creditor is entitled to be paid the value of its interest in the collateral and gives up its unsecured deficiency claim. The tradeoff may be worth it if the creditor believes that the debtor has undervalued the collateral, but the creditor should also take into account the percentage distribution to be made on a count of general unsecured claims (since distribution will not be made on account of the waived deficiency claim). Even absent a Section 1111(b) election, a chapter 11 debtor can cramdown a plan on a rejecting secured creditor provided that the treatment offered is consistent with the options provided by Section 1129(b), one of which is essentially the same as required by Section 1111(b). 

In chapter 13 cases, Caulkett will have an effect when the mortgage is secured by the debtor’s primary residence. Bankruptcy Code Section 1322(b)(2) prohibits chapter 13 debtors from modifying the rights of a secured creditor holding a mortgage on the debtor’s primary residence. In line with Dewsnup, the Supreme Court in Nobelman v. American Savings Bank held that this provision prevented the bifurcation of a mortgage secured by the primary residence into secured and unsecured deficiency portions, even though the residence’s value was below the mortgaged amount. The majority of courts addressing this issue in chapter 13 cases held that Nobelman was inapplicable where the mortgage was completely, rather than partially, underwater. It would appear that this line of cases is no longer good law in light of Caulkett which dismissed the same distinction in chapter 7 cases. 

Footnotes 

_{1) In the Dewsnup case, the asserted secured claim was US$120,000 and the value of the real property secured by the mortgage was only US$39,000.}