Recently, in a year heavy on United States Supreme Court decisions involving Title 11 bankruptcy, the Supreme Court decided a case important to the residential lending and servicing industries. In Bank of American, N.A. v. Caulkett, ___ U.S. ___, 135 S. Ct. 1995 (2015), a Chapter 7 debtor sought to entirely void a junior lien on the ground that there was no equity to back the lien. In an unsurprising decision, the Supreme Court ruled that its clear precedent prevented the debtor from doing so. More interestingly, the Court may have set the stage for deciding whether a debtor may do the same in a Chapter 11 or 13 bankruptcy.
In exchange for complying with the Bankruptcy Code’s strictures, a debtor in Chapter 7, 11 or 13 will generally receive a discharge from all personal debts owed. However, liens against a debtor’s property pass through the bankruptcy discharge unaffected. Johnson v. Home State Bank, 501 U.S. 78, 84 (1991). Accordingly, unless the debtor can find a way to void the lien in bankruptcy, a creditor can enforce the lien after discharge.
Of the many ways a debtor can seek to void a lien in bankruptcy, two are important to this discussion. If the debtor can show that a lien is wholly underwater (where there is no value in the collateral to support the lien), a debtor may void the lien entirely. This is known as “lien stripping.” However, if the lien is only partially underwater, the debtor may instead seek to reduce the lien to the extent it is not supported by value in the collateral. This is known as a “cramdown.” This right to strip or cramdown a lien is created by statutory authority that is exclusive to Chapter 11 or 13 debtors. 11 U.S.C. § 1123(b)(5); 11 U.S.C. § 1322(b)(2).
In the seminal Supreme Court case of Dewsnup v. Timm, 502 U.S. 410, 415 (1992), a debtor sought to expand the right to cramdown a lien to Chapter 7. There, the debtor filed for Chapter 7 bankruptcy and then sought to cramdown the lien against his residence to the extent that the lien was underwater. Id. at 413. The debtor argued that this was allowed under Section 506 of the Bankruptcy Code. Id.
Section 506(a) provides that a lien “is a secured claim to the extent of the value of such creditor’s interest in . . . such property.” 11 U.S.C. § 506(a). Section 506(d) states, “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” 11 U.S.C. § 506(d). The debtor argued that the natural reading of these two subparts led to the inescapable conclusion that any lien was void under Section 506(d) to the extent that the lien was not supported by value in the collateral. Dewsnup, 502 U.S. at 413.
The Court ruled against the debtor and stated that cramdowns were not allowed in Chapter 7. The Court found that a lien is only void under Section 506(d) if the claim is not allowed or the lien is void under state law. Id. at 417. The equity in the collateral was irrelevant. The Court noted that this may not be the most natural reading of Section 506(d), but that before the Bankruptcy Code was enacted, a party could not modify a lien in liquidation. The Court found that Congress did not intend to change this in enacting the modern Bankruptcy Code. Id. at 419-20. Further, the Court stated that the result sought by the debtor was unfair, as “[a]ny increase over the judicially determined valuation during bankruptcy rightly accrues to the benefit of the creditor, not to the benefit of the debtor.” Id. at 417.
Twenty-three years later, this issue was revisited in Caulkett. There, the facts were the same as Dewsnup, but with one distinction. In Dewsnup, the debtor sought to cramdown the sole lien against his residence to the extent that the lien was not supported by value in the collateral. In Caulkett, the debtor did not seek to cramdown a partially underwater lien, but to lien strip a wholly underwater one. Caulkett, 135 S. Ct. at 1997. The debtor argued that this was a meaningful distinction. The Eleventh Circuit agreed, creating a circuit split, and the Supreme Court granted certiorari.
The Supreme Court did not find the distinction as meaningful. Citing Dewsnup, the Court concluded that “[u]nfortunately for the debtors, this Court has already adopted a construction of the term ‘secured claim’ in § 506(d) that forecloses this textual analysis.” Caulkett, 135 S. Ct. at 1999. The Court found that nothing in the language or history of Section 506(d) indicated any difference between a partially or wholly unsecured lien, and thus found that under Dewsnup, the debtor could not strip the lien. Id.
And in dicta, the Court may have opened the door to dispute a debtor’s ability to strip off wholly underwater liens on their residence in Chapter 11 and 13 cases. The right to modify a lien secured by a debtor’s principal residence is prohibited in Chapter 11 and 13 cases. 11 U.S.C. § 1123(b)(5); 11 U.S.C. § 1322(b)(2). Under the Supreme Court case of Nobelman v. American Sav. Bank, 508 U.S. 324 (1993), this exclusion prevents the cramdown of a lien that is secured by the debtor’s residence. Id. at 332.
While the Supreme Court has never addressed the issue, most circuits have determined that the Nobelman case, while prohibiting cramdowns of partially underwater liens secured by the debtor’s residence, does not prevent lien stripping of wholly underwater liens. The argument is that the Bankruptcy Code only prohibits the modification of liens secured by a debtor’s residence. The circuit courts have reasoned that a claim is not secured under Section 506(a) if the lien on the collateral is wholly underwater. See, e.g., In re Zimmer, 313 F.3d 1220, 1225 (9th Cir. 2002).
This distinction between partially and wholly underwater liens was the exact same distinction raised by the debtor in Caulkett. The Court found this distinction to be unsupported by the Bankruptcy Code, stating that “[u]nder the debtors’ approach, if a court valued the collateral at one dollar more than the amount of a senior lien, the debtor could not strip down a junior lien under Dewsnup, but if it valued the property at one dollar less, the debtor could strip off the entire junior lien. Given the constantly shifting value of real property, this reading could lead to arbitrary results . . . There is scant support for the view that § 506(d) applies differently depending on whether a lien was partially or wholly underwater.” Caulkett, 135 S. Ct. at 2001.
This paragraph opens the door to a future challenge to the ability of debtors to strip liens on their residence in Chapter 11 and 13 cases. Cualkett is not squarely on point, as lien stripping in Chapter 11 or 13 is predicated on a determination under Section 506(a) that a claim is completely unsecured. Caulkett instead focuses on whether a secured claim may be voided under Section 506(d). But, as the Caulkett Court stated, “[t]he debtors next contend that the term ‘secured claim’ in § 506(d) could be redefined as any claim that is backed by collateral with some value. Embracing this reading of § 506(d), however, would give the term ‘allowed secured claim’ in § 506(d) a different meaning than its statutory definition in § 506(a). We refuse to adopt this artificial definition.” Id. at 2000.
It appears that Caulkett may have, ever so slightly, shifted the legal landscape regarding the ability of a debtor to strip off a lien against a residence and then keep the benefit of any appreciation. Whether this shift results in a change on the issue or is simply viewed as dicta in a case that merely affirmed the validity of a twenty-three year-old decision remains to be seen.
For more information on the Caulkett decision, please contact Donald H. Cram, III at firstname.lastname@example.org.