On June 1, 2015, the United States Supreme Court issued a ruling that is a victory for lenders dealing with borrowers who file Chapter 7 bankruptcy. In Bank of America v. Caulkett, the Supreme Court held that Chapter 7 debtors cannot "strip off" or void junior mortgages on real property. This is the case even if the real property is currently completely "underwater" (the current market value of the property is less than the amount of the senior mortgage, and thus the junior lienholder would receive nothing if the property were sold today). As a result of the decision in Caulkett, a junior lienholder's lien will be retained in a Chapter 7 bankruptcy proceeding, resulting in the junior lienholder having substantially more leverage in dealing with the debtor and the senior lienholder.
Background
In a Chapter 7 bankruptcy proceeding, a debtor asks the bankruptcy court to discharge most of the debtor's debts. In exchange for this discharge, the bankruptcy trustee can take any of the debtor's property that is not exempt from collection, sell it, and distribute the proceeds the debtor's creditors.
In a Chapter 13 proceeding, a debtor files a repayment plan with the bankruptcy court to pay back all or a portion of the debtor's debts over time. The amount to repay depends on how much the debtor earns, the amount and types of debt owed, and how much property the debtor owns.
In any bankruptcy proceeding creditors are generally classified as having either a "secured" or "unsecured" claim. A secured claim is supported by collateral securing the loan, while an unsecured claim is not supported by collateral. With personal property collateral, a creditor's secured claim is limited to the lesser of the value of the collateral or the amount of the debt. If the personal property collateral is worth less than the amount of a creditor's lien, then the Bankruptcy Code allows the debtor to strip off that portion of the lien that exceeds the value of the collateral.
The Real Property Collateral Issue
Debtors in bankruptcy have been trying to do the same thing with real property collateral, but in Caulkett the Supreme Court ruled that they may not do so in a Chapter 7 case. Consequently, Chapter 7 debtors will be forced to deal with the lien of a junior lienholder.
After Caulkett, more Chapter 13 filings may result because in Chapter 13 bankruptcy cases a debtor may strip off a junior lien even on real property. But, the lien strip does not take effect until the debtor's successful completion of the case and the court's entry of a discharge order. Chapter 13 plans can run for up to five years and have notoriously low success rates, so there is always the possibility that the lien strip will never come to fruition.
Conclusion
The ruling in Caulkett also means that junior lenders will not have to incur the expense of a valuation hearing in Chapter 7 cases. As long as the junior lender can establish that it has a valid debt and lien on the real property collateral, then, pursuant to the Supreme Court's ruling in Caulkett, the junior lender will continue to have an allowed secured claim for the full amount of the debt.
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