Bank of America, NA v. Caulkett; Bank of America, NA v. Toledo-Cardona

Issues 

Does 11 U.S.C. § 506(d) permit a bankruptcy court to “strip off” a junior lien on a home that is completely underwater?

Oral argument: 
March 24, 2015

The Supreme Court will determine whether 11 U.S.C. § 506(d) permits bankruptcy courts to “strip off” junior liens on property if the value of the property used as collateral is less than the amount the debtor owes to the senior lienholder—in other words, the junior mortgage lien is “completely underwater.” Bank of America asserts that junior liens should not be “stripped off,” or treated as unsecured loans, because § 506 only “strips off” claims from property that are disallowed and because the Supreme Court’s ruling in Dewsnup v. Timm, disallowing “stripping down” of primary liens to the value of the underlying property, should extend to this case. Caulkett and Toledo-Cardona argue that second liens should be treated as unsecured, and hence disallowed, loans when the value of the collateral exceeds the amount owed on the first mortgage and that the Supreme Court’s ruling in Dewsnup is limited to “stripping down” and should not extend to these circumstances. The Court’s ruling impacts the right of junior lienholders to collect on loans in the event of a debtor’s declaration of bankruptcy and the treatment of previously secured, but subordinate, debt in bankruptcy proceedings.

Questions as Framed for the Court by the Parties 

Section 506(d) of the Bankruptcy Code provides in relevant part that "[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void." In Dewsnup v. Timm, 502 U.S. 410 (1992), this Court held that section 506(d) does not permit a chapter 7 debtor to "strip down" a mortgage lien to the current value of the collateral. The question presented in this case, on which the courts of appeals are divided, is does section 506(d) permits a chapter 7 debtor to “strip off” a junior mortgage lien in its entirety when the outstanding debt owed to a senior lienholder exceeds the current value of the collateral?

Facts 

In 2013, Respondents David Caulkett and Edelmiro Toledo-Cardona (collectively, “the borrowers” or “Caulkett and Toledo-Cardona”) each filed a petition for chapter 7 bankruptcy in the United States Bankruptcy Court for the Middle District of Florida (“bankruptcy court”). At the time, their respective homes had a second mortgage, a “junior lien,” that was “completely underwater.” Specifically, the value of their homes, the collateral, was lower than the amount owed on the first mortgage, a “senior lien,” which would recover first in the event of a foreclosure. In each case, Petitioner Bank of America possessed the rights of the junior lien.

Before the bankruptcy court, Caulkett and Toledo-Cardona each requested that the court void, or “strip off,” Bank of America’s junior liens under 11 U.S.C. § 506(d) (“§ 506(d)”). Section 506(d) voids liens that secure claims that are not an “allowed secured claim.” The bankruptcy court granted Caulkett and Toledo-Cardona’s motions in each of their cases, thereby “stripping off” the junior liens on their houses.

After the bankruptcy court’s decision, Bank of America appealed to the United States District Court for the Middle District of Florida (“district court”). The district court upheld the bankruptcy court’s rulings in both Caulkett and Toledo-Cardona’s respective cases. Bank of America then appealed the decisions to the United States Court of Appeals for the Eleventh Circuit (“Eleventh Circuit”). The Eleventh Circuit, based on the circuit’s precedent, affirmed the rulings from the lower courts voiding the junior liens. That precedent held that the Supreme Court’s decision in Dewsnup v. Timm, holding “that a chapter 7 debtor could not ‘strip down’ a creditor’s lien” that was partially underwater, did not apply to completely underwater mortgage liens.

Afterwards, Bank of America submitted petitions for writs of certiorari, which the Supreme Court granted, consolidating the Caulkett and Toledo-Cardona cases. The Supreme Court will now consider whether § 506 allows debtors to invalidate, or “strip off,” second liens on property if the value of the property that secures the lien is less than the amount owed to the senior debtor, who holds the first lien.

Analysis 

In this case, the Supreme Court is confronted with two provisions in § 506 of the Bankruptcy Code. Section 506(a) states 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.” Section 506(d) states that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” The parties in this case disagree over whether the language “allowed secure claim” in 506(d) refers to the language “allowed . . . secured claim” in 506(a) and thus, whether a chapter 7 debtor can strip off—or, in other words, remove—a junior mortgage lien from the property when the loan is completely underwater.

Bank of America contends that § 506(a) is not applicable in this case because as held in Dewsnup v. Timm, § 506(d) only eliminates liens from the property of invalid claims, and Bank of America's underwater junior mortgage loans are valid claims and are secured by liens supported by collateral. On the other hand, Caulkett and Toledo-Cardona (“the borrowers”) argue that § 506(d) does apply in this scenario and Bank of America's junior mortgage loans are not valid claims as § 506(d) voids completely underwater liens (such as the one in this case). Additionally, the borrowers argue that Dewsnup does not control this case as Dewsnup's scope is limited only to partially underwater liens, and here, a wholly underwater mortgage lien is at issue.

DOES DEWSNUP APPLY TO COMPLETELY UNDERWATER LOANS?

Bank of America asserts that this case is analogous to Dewsnup, even though Dewsnup involved a partially underwater lien rather than a completely underwater lien. According to Bank of America, nothing in the reasoning of Dewsnup prevents its holding from applying with equal force to completely underwater loans. For instance, Bank of America argues that “Dewsnup’s construction of § 506(d) admits no distinction between partially and wholly underwater liens.” Moreover, Bank of America contends that the value of the collateral was unnecessary in Dewsnup’s reasoning; rather it matters only in the treatment of the creditor’s claim for purposes of distribution. Thus, Bank of America asserts, it is immaterial that a junior lienholder would not recover anything should a completely underwater home be foreclosed upon—the lien still remains a “real and valuable property interest.” Finally, Bank of America submits that “every court of appeals to address the question other than the Eleventh Circuit has concluded, that [Dewsnup’s] reasoning also applies to wholly underwater liens.”

In contrast, the borrowers contend that Dewsnup is unlike this case because the mortgage in Dewsnup was partially underwater and thus the mortgaged property had some value as well as a mixed secured and unsecured claim. The borrowers assert that, in contrast to the facts in Dewsnup, here the mortgage is wholly underwater and so no component of the mortgage is secured in bankruptcy. Moreover, the borrowers contend that the Court's holding in Dewsnup was difficult to reconcile with a natural reading of the text in §506, which on its face voids underscored parts of partially underwater liens; however, the Court did so with the limitation that Dewsnup's holding would not be extended to the issue of whether completely underwater second mortgages are secured claims. Additionally, the borrowers assert that the Court later decision in Nobelman v. American Savings Bank “confirms” that Dewsnup's scope only pertained to partially underwater liens; thus bankruptcy courts, while not allowed to eliminate partially underwater mortgage liens, can eliminate completely underwater liens. The borrowers also contend that all of the courts of appeals that had cases before them implicating this issue have held that Nobelman and § 506(a) authorize eliminating completely underwater second mortgage liens.

STATUTORY ANALYSIS OF § 506

Bank of America asserts that any ambiguity in § 506 is resolved in favor of not permitting the stripping off of liens that secure allowed claims. First, Bank of America argues that the phrase "secured claim" embedded in § 506(d) is referring to the standard English understanding of a claim secured by a guaranty, rather than the language in § 506(a). Second, Bank of America stresses that this interpretation is supported by pre-Bankruptcy Code history; before the enactment of the Bankruptcy Code, liens, no matter the value of the collateral backing them up, survived liquidation proceedings. Bank of America adds that the Court has stated that Bankruptcy Code should not be read to deviate from pre-Bankruptcy Code practice without Congress’s clear intent, and here Congress has provided no intent to do so. Third, Bank of America asserts that Congress has largely given states the authority to govern bankruptcy because bankruptcy involves state-law property rights, and thus, bankruptcy should not change state-law property rights unless it is necessary to meet a bankruptcy goal. Fourth, Bank of America contends that the drafting history of § 506(d) showed that a lien was not voided unless an individual in interest had objected to the claim at issue and the court had disallowed it; thus, a lien securing an allowed claim, as is the case here, cannot be voided based on the value of the collateral. Fifth, Bank of America argues that the structure of the Bankruptcy Code includes sections that “do permit debtors to strip down liens to the current value of the collateral” but those provisions only apply in rare circumstances and § 506(d) is not one of those provisions that apply. Lastly, Bank of America asserts that Congress has continually revised the Bankruptcy Code and § 506 and has never changed § 506(d) in regards to Dewsnup's holding; therefore, Congress has acquiesced to Dewsnup's interpretation of § 506(d).

In contrast, the borrowers argue that the Bankruptcy Code clearly eliminates fully underwater mortgage liens as § 506(a)(1) states that a completely underwater claim “is an unsecured claim,” and § 506(d) states that thus the claim's associated lien is void. The borrowers argue that “secured claim” means the part of a claim that is treated as "secured" for purposes of distribution under § 506(a). Borrowers stress that based on English grammar, a claim such as an underwater claim is not secured and is thus is void under § 506(d). Additionally, the borrowers assert that § 506(d) incorporates two phrases, “lien secures a claim” and “secured claim” that Bank of America considers analogous. However, the borrowers argue that these analogies are not accurate. The borrowers argues that the phrase, “lien secures a claim” refers to non-bankruptcy law rights, while “secured claim” is a “term of art” defined by bankruptcy law. Moreover, the borrowers claim that how the non-bankruptcy lien securing a claim is treated under § 506(d) varies on whether the claim is or is not an allowed secured claim in bankruptcy. The borrowers argue that Bank of America's interpretation that § 506(d)'s definition of secured claim requires only that the claim be secured by a lien in connection to the collateral regardless of whether the collateral's value is erroneous; they maintain that this is because Bank of America’s interpretation cuts against the terms of § 506(a), which states that secured status requires a determination of the value of the creditor's interest in their property. The borrowers also contend that if Bank of America was correct and every lien that secures a claim is a secured claim, then § 506(d)'s multiple “secured” words in the provision would be redundant and would have been eliminated as the Court must take into account every clause and word of the Bankruptcy Code. Additionally, the borrowers counter that Congressional legislative history does not support a Congressional intent to omit § 506(a) from operating on secured claims because if Congress had intended to remove § 506(a) from § 506(d), Congress would have specifically said so—as Congress did previously with other provisions. Finally, the borrowers also assert that Bank of America’s asserted pre-Bankruptcy Code history cannot overcome the clear statutory language and that past courts have, in fact, voided completely underwater junior liens.

Discussion 

In this case, the Supreme Court will determine whether § 506(d) permits bankruptcy courts to “strip off” junior liens on property if the value of the property used as collateral is less than the amount the debtor owes to the senior lienholder. Bank of America asserts that completely underwater junior liens should not necessarily be “stripped off,” because such liens secure claims that are “allowed secured claim[s]” for purposes of § 506(d) as reasoned in Dewsnup—which should extend to this case. Caulkett and Toledo-Cardona argue that completely underwater second liens should be treated as unsecured, and hence voided under § 506(d), and that the Supreme Court’s reasoning in Dewsnup does not extend to completely underwater liens. The Court’s decision will likely have important impacts on the rights of junior lienholders to collect on loans in the event of a debtor’s declaration of bankruptcy and, consequently, how much a lienholder can recover which will, in turn, affect the mortgage markets.

SECOND MORTGAGE MARKETS AND LOAN AVAILABILITY

According to Loan Syndications and Trading Association (“LSTA”) and other organizations, in support of Bank of America, if the Court allows the stripping off of junior liens, lenders will hesitate to extend loans to borrowers when those loans will be secured with a second lien on property. Moreover, LSTA and other organizations assert, lenders will be less likely to accept property as collateral if the property’s value consistently fluctuates because the lenders may lose their rights to the property in the event of bankruptcy during a downturn in value. Additionally, Community Bankers Association of Illinois and other organizations (“CBAI”), amici for Bank of America, contend that junior lienholders who relied on the understanding that liens survive bankruptcy when they made the loans will be harmed.

On the other hand, Adam J. Levitin, amicus for Caulkett and Toledo-Cardona, argues that allowing judges to “strip off” junior liens on property will have only a negligible effect on the secondary mortgage market. According to Levitin, empirical research suggests that invalidating liens that are secured with valueless property would only slightly increase interest rates and would marginally decrease the number of borrowers approved for loans. In addition, Levitin asserts that lenders will not change their behavior significantly for second mortgages because lenders enter into junior liens knowing that they risk losing their investment in certain circumstances, such as when a borrower liquidates his or her property.

EFFECTS ON BANKRUPTCY PROCEEDINGS

CBAI and other organizations contend that judges’ determinations of real property values are not reliable appraisals of property—as apprising properties is not an exact science. If the Court were to allow bankruptcy courts to strip off underwater junior liens, CBAI and other organizations fear that a judge’s inaccurate valuation of property could lead to a junior lienholder losing his or her entire stake in a property. Moreover, CBAI and other amici stress that a decrease or increase in valuation of even a few cents could be the difference between a junior lienholder losing his or her entire stake, if the value of the property is more than the first lien, or a junior lienholder being able to recover on the loan after the bankruptcy proceeding. According to CBAI and other organizations, because property values fluctuate so frequently and are difficult to determine, a judge’s determination should be disfavored regarding whether a junior lender might recover.

On the other hand, because the junior lienholder does not have any stake in the value of the property when the value of the property is less than the amount owed on the primary mortgage, according to the National Association of Consumer Bankruptcy Attorneys (“NACBA") and the AARP, amici for Caulkett and Toledo-Cardona, a foreclosure on the underlying property would be worthless for the junior lender. Additionally, several law professors, in support of Caulkett and Toledo-Cardona, assert that allowing junior lienholders to keep their stake in the property will prevent the senior lender and the borrower from resolving their dispute outside of a foreclosure proceedings, a process that would be much more efficient and less costly than foreclosure. Moreover, these law professors believe that “stripoffs” might allow the borrower to stay in his or her home, such as after negotiations with the primary lender, and thus might offer the borrower a fresher start. This interest to stay in one’s home, the law professor assert, is more important than any interest the lien holder may have in completely underwater mortgages.

Conclusion 

In this case the Court will decide whether Dewsnup's holding allows under § 506(d) for a debtor to remove a junior mortgage lien when the lien is completely underwater and whether an allowed secured claim in § 506(d) is analogous to an allowed secured claim in § 506(a) if the claim in § 506(a) is completely underwater. Bank of America maintains that § 506(d) does not apply in this case and that Dewsnup’s reasoning controls. The borrowers counter that § 506(d) does apply in this scenario and that Dewsnup's holding is constrained to partially underwater junior liens. The Court's ruling implicates the right of junior lienholders to collect on loans in the event of a debtor's declaration of bankruptcy and the treatment of previously secured, but subordinate, debt in bankruptcy proceedings.

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