The United States Supreme Court recently reversed a ruling from the Eleventh Circuit in the case of Bank of America, N.A. v. Caulkett, which had permitted individual chapter 7 debtors to “strip” junior liens off their homes when the first mortgage lien was underwater. The Supreme Court held that a debtor in a chapter 7 proceeding may not void a junior mortgage lien under section 506(d) of the Bankruptcy Code when the debt owed on a senior mortgage lien exceeds the current value of the collateral, if the creditor’s claim is both secured by a lien and allowed under section 502 of the Bankruptcy Code. The debtor may be discharged from the debt, but the mortgage lien remains against the property. This decision finally resolves the issue of whether a fully underwater mortgage lien may be stripped down to the market value of the collateral in a chapter 7 case.

This ruling is grounded upon a 1992 decision by the Supreme Court entitled Dewsnup v. Timm, in which the court disallowed the chapter 7 trustee’s attempt to strip a partially underwater lien to the value of the collateral.

However the Court, in a significant footnote, indicated that the Petitioners in Caulkett did not ask the Court to overrule the 23-year old decision, which has received criticism over the years. The issue was whether the Dewsnup holding in the context of a partially underwater mortgage applies to cases with totally underwater second mortgages in chapter 7 cases. The Supreme Court declined to allow a distinction between wholly or partially underwater liens. If this approach were followed, if the collateral was valued at one dollar more than the senior mortgage, the debtor could not strip down the lien, but if the value of the collateral was one dollar less than the senior mortgage, the entire junior lien could be stripped off. Given that property values are a constantly moving target, this approach could yield arbitrary results.

This ruling is not applicable in chapter 13 filings because a debtor may strip off a second mortgage pursuant to section 1322(b)(2) of the Bankruptcy Code provided the second mortgage is fully unsecured.

There is much talk within the bankruptcy bar about what might result from the suggestion contained in the hotly discussed footnote. Justice Thomas states three times in the decision that the debtors did not ask the Court to overrule Dewsnup. In one passage, Justice Thomas writes, “Despite this criticism, the debtors have repeatedly insisted that they are not asking us to overrule Dewsnup.” The door has been opened. It remains to be seen whether it remains closed or if the Court will be asked to revisit and overrule Dewsnup.

About Weltman & Moskowitz, LLP, a New York and New Jersey Business, Bankruptcy, and Creditors’ Rights Law Firm:

Founded in 1987, Weltman & Moskowitz, LLP is a highly regarded business law firm concentrating on creditors’ rights, bankruptcy, foreclosure, and business litigation. Michael L. Moskowitz, a partner with the firm, focuses his practice on business and bankruptcy litigation, as well as creditor’s rights, foreclosure, adversary proceeding litigation, corporate counseling, M&A, and transactional matters. Michael can be reached at (212) 684-7800, (201)794-7500 or mlm@weltmosk.com. Michele K. Jaspan is a senior associate.