Supreme Court to Decide if “lien strips” are Valid in Chapter 7 Cases

us supreme courtIt is about time the honest but unfortunate homeowner gets a break in Washington, D.C.

The Supreme Court has a bumper crop of bankruptcy cases this year.  For example, it has already decided that the denial of a Chapter 13 confirmation order is not a “final appealable order” for purposes of seeking relief in a higher court.  (Bullard v. Hyde Park Savings Bank  __  U.S. ___ (2015).  One very interesting case pending right now is Bank of America, N.A. v. Caulkett, which addresses the question of whether, under §506(d) of the Bankruptcy Code, a debtor can “strip off” a second mortgage on the debtor’s principal residence if the amount of debt owed for the first mortgage holder exceeds the current market value of the home.

Current law has mostly allowed the “strip off” of the second mortgage only under bankruptcy petitions filed under Chapter 13.  Chapter 13 is a plan of debt re-organization where the consumer makes monthly payments out of their income to re-structure their debt over time. I have used lien strip offs in many Chapter 13 cases to help consumers whose homes have fallen in value during the real estate crash which began sometime around 2005.

The facts are all too familiar for homeowners who lived through it.  The Chapter 7 debtor in Caulkett owned a home which was valued at around $141,000.  (Actually, there are two cases in Caulkett, consolidated for convenience, but the facts both involve a second mortgage which was not secured by equity in the home.)  It was subject to two (2) mortgage liens, one running to HSBC for about $176,000 and a second to a subsidiary of GMAC for around $44,000.  The debtor argued that that since the second mortgage was wholly unsecured (there was no equity to which the second mortgage could attach,) it could be stripped off, leaving the consumer in a much better position.  The debtor would still be “upside down,” owing $176,000 on a house worth $141,000.  But that is better than owing $220,000 on the same house, and the debtor would only have one mortgage payment.  The Eleventh Circuit has been the only circuit which has allowed a strip off for completely unsecured mortgages in Chapter 7, the Fourth, Sixth and Seventh Circuits have held the opposite view.  It was due to this split of authority that the Supreme Court agreed to hear this case and resolve the differing treatments for second mortgages.

The mortgage companies and banks are, of course, against such a notion.  Legally, they argue strip offs in Chapter 7 are prohibited by a prior Supreme Court case, Dewsnip v. Timm (502 U.S. 410) (1992).  Essentially, that case held that Chapter 7 does not modify the rights of secured creditors, whether or not there is equity in the collateral.    Practically, they argue, allowing strip offs of second mortgage would expose them to a tidal wave of financial harm, as practically every second mortgage nowadays has no equity to which it could attach, leaving them holding millions of dollars of worthless and unenforceable promissory notes.

Consumers, bankruptcy attorneys and several law professors argue that Dewsnip does not apply here because that case dealt with an underwater first mortgage, not an underwater second mortgage.  More generally, they argue, getting rid of these worthless second mortgages would be a benefit, as fewer foreclosures would arise.  The second mortgage companies, knowing a strip off is possible, would be eager to work with homeowners to avoid this result.   The second position mortgage holders, consumers argue, are large and sophisticated lenders who bargained for their position, knowing full well that their mortgages could sink completely under the water and be wiped out in a foreclosure.  Therefore the Court should have no sympathy for their plight.

I will update the blog when the Supreme Court issues a ruling.

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