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Supreme Court Ruling Prohibits “Lien Stripping” on Junior Liens in Chapter 7 Bankruptcy Cases

mortgage-295211_640.pngThe U.S. Supreme Court recently issued an opinion, Bank of America v. Caulkett, 575 U.S. ___ (2015), addressing a controversial bankruptcy procedure known as “lien stripping.” This procedure involves removing the portion of a lien on real property securing a debt, such as a mortgage loan, that exceeds the fair market value of the property. Lien stripping is generally permitted in Chapter 13 bankruptcy cases, but the Supreme Court prohibited it in Chapter 7 cases in Dewsnup v. Timm, 502 U.S. 402 (1992). The Dewsnup decision, however, left several loopholes, which Caulkett appears to have closed.

When the fair market value of the property securing a debt is less than the amount owed, that debt and the associated lien are described as “underwater.” The creditor in this situation essentially has two claims: a secured claim equal to the fair market value of the property, and an unsecured claim equal to the remaining debt amount. Lien stripping involves asking the court to find that the underwater portion of a lien on real property is unsecured. 11 U.S.C. § 506(a)(1). That portion then joins the other unsecured claims, which are subject to discharge at the conclusion of the case. The lien associated with the unsecured claim is void under 11 U.S.C. § 506(d).

The provision of the Bankruptcy Code that voids the unsecured portion of the lien only applies if the underlying claim “is not an allowed secured claim.” Id. In Dewsnup, the Supreme Court looked at the “allowed” requirement of § 506(d), rather than treating “allowed required claim” as a single requirement. It found that, since the claim at issue was “allowed” within the meaning of 11 U.S.C. § 502, it was not covered by § 506(d) whether or not it was “secured.” This led to a holding that lien stripping is not permitted in Chapter 7 cases.

Dewsnup only directly addressed first-lien mortgages that are partially underwater. It left a loophole open for second-lien mortgages, and other junior liens, whose senior lien is underwater. If a first-priority lien is underwater, no money will be available to pay any junior liens. Some courts held that Dewsnup did not apply to wholly-underwater junior liens in Chapter 7 cases, and that they could therefore be stripped. See, e.g., In re McNeal, 735 F.3d 1263 (11th Cir. 2012). Caulkett closed this loophole by applying the same reasoning applied in Dewsnup to underwater junior liens, finding no meaningful distinction between senior and junior liens in this context.

Many businesses elect to file bankruptcy under Chapter 11 instead of Chapter 7. The availability of lien stripping in Chapter 11 cases remains unresolved, with courts in the Ninth Circuit seeming to allow it in some circumstances. See In re Weinstein, 227 B.R. 284, 292 n. 8 (B.A.P. 9th Cir. 1998); In re Taffi, 144 B.R. 105 (Bankr. C.D. Cal. 1992) (prohibiting lien stripping in Chapter 11 cases); In re Dever, 164 B.R. 132 (Bankr. C.D. Cal. 1994) (allowing lien stripping in Chapter 11 cases); In re 1441 Veteran Street Co., 144 F.3d 1288, 1293 (9th Cir. 1998) (holding that Dewsnup does not apply when a Chapter 11 reorganization plan has been confirmed, but it might apply when the plan has been rejected.)

If you or your business is struggling with debts, creditors, or a related matter, you should consult with a knowledgeable and experienced business and personal bankruptcy attorney. James G. Schwartz has practiced business and commercial law in the Bay Area since 1976. To schedule a free and confidential consultation, contact us today online or at (925) 463-1073.

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