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Supreme Court Rules that Chapter 7 Debtor Cannot Strip Underwater Second Lien from Home

OpenClipartVectors [Public domain, CC0 1.0 (https://creativecommons.org/publicdomain/zero/1.0/deed.en)], via Pixabay“Lien stripping” is the process of eliminating some junior liens, such as a second mortgage, from real property during a bankruptcy case. Junior liens are, by definition, subordinate to senior liens securing a piece of real estate. The lien-stripping process essentially converts junior liens that are “underwater”—meaning that the fair market value of the collateral property is insufficient to cover the amount owed—from secured to unsecured debt, then voids the unsecured portion. 11 U.S.C. §§ 506(a)(1), (d). Lien stripping is generally available in Chapter 13 bankruptcy cases, but the U.S. Supreme Court ruled over twenty years ago in Dewsnup v. Timm, 502 U.S. 410 (1992), that it is not available in many Chapter 7 cases. Earlier this year, the court built on this ruling and disallowed lien stripping in all Chapter 7 cases. Bank of America v. Caulkett, 575 U.S. ___ (2015).

The priority of most liens is determined by the order in which the lien was recorded. A purchase-money lien is usually the first to be recorded, and is therefore known as the senior lien or the first mortgage. Additional liens secured by the property are known as junior liens, or the second mortgage, third mortgage, and so on. A junior lien is not entitled to repayment from the collateral property, such as in foreclosure, until all superior liens have been satisfied. If nothing is left, the lien becomes an unsecured debt.

If the amount of debt secured by a lien is greater than the fair market value of the collateral, that lien is said to be “partly unsecured” or “underwater.” A lien that is subordinate to an underwater senior lien is “wholly unsecured” or “wholly underwater.” The underwater portion of a lien is subject to lien stripping, meaning that portion of the lien becomes unsecured debt that can be voided. Lien stripping allows a debtor to convert a wholly-underwater junior lien into unsecured debt in its entirety under § 506(a)(1), then void it under § 506(d). This applies to “allowed” claims, defined as claims that are entitled to payment from the bankruptcy estate.

Lien stripping is often available in Chapter 13 cases, but its availability in Chapter 7 cases remained controversial for some time. The Supreme Court’s ruling in Dewsnup held that a Chapter 7 debtor may not use lien stripping on a partly-underwater lien. The court found that § 506(d) did not void the lien in a Chapter 7 case. The lien would therefore survive the bankruptcy case, although the court held that a Chapter 7 discharge would eliminate the creditor’s right to a deficiency judgment against the debtor.

While Dewsnup foreclosed the possibility of lien stripping on partly-underwater liens in Chapter 7 bankruptcy, it left a few possible loopholes. Some appellate court decisions allowed debtors to strip off wholly-underwater junior liens. See In re McNeal, 735 F.3d 1263 (11th Cir. 2012). In Caulkett, the Supreme Court appears to have closed those remaining loopholes. The court held that the same issues that determined the Dewsnup case, including Congressional intent with regard to voiding liens in liquidation cases, apply to wholly-underwater junior liens in Chapter 7 cases.

Since 1997, bankruptcy attorney Devin Sawdayi has represented individuals and families in Los Angeles in Chapter 7 and Chapter 13 bankruptcy cases. We have dedicated our law practice to helping our clients get a fresh start and rebuild their finances with dignity and respect. To schedule a free and confidential consultation with an experienced financial advocate, please contact us today online or at (310) 475-939.

More Blog Posts:

Court Allows Mortgage Lender to Enforce Lien Against Property Years After Chapter 7 Discharge, Los Angeles Bankruptcy Lawyer Blawg, June 6, 2014

Court Does Not Allow Chapter 13 Debtor to Strip Unsecured Amount of IRS Tax Lien, Los Angeles Bankruptcy Lawyer Blawg, May 19, 2014

Bankruptcy Courts Disagree on “Chapter 20″ Procedures Used to “Strip” Liens from Debtors’ Residences, Los Angeles Bankruptcy Lawyer Blawg, August 6, 2013

Photo credit: OpenClipartVectors [Public domain, CC0 1.0], via Pixabay.