Lien Stripping in Bankruptcy after Caulkett

Under the Bankruptcy Code, “lien stripping” allows a debtor to void a property lien “[t]o the extent that [the] lien secures a claim against the debtor that is not an allowed secured claim.” Lien stripping is based on the concept that a second claim must actually be secured by collateral of sufficient value to equal or exceed the amount of the secured claim. Section 506(a) of the Bankruptcy Code provides that claims which are only partially secured, or “underwater,” are to be split into two claims – one fully secured and one fully unsecured.

In 1992, the U.S. Supreme Court addressed an important question about lien stripping in Dewsnup v. Timm (1992). In Dewsnup, a Chapter 7 debtor sought to strip the unsecured portion of an underwater lien on her residence under Section 506(d). Specifically, the debtor wanted to reduce her debt of approximately $120,000 to $39,000, the value of the collateral securing her debt at that time. Relying on the statutory definition of “allowed secured claim” in Section 506(a), the debtor argued that her creditor’s claim was “secured only to the extent of the judicially determined value of the real property on which the lien [wa]s fixed.”

The Court rejected this argument, relying on policy considerations and pre-Code practice. The Court concluded that if a claim has been “allowed” under Section 502 and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of Section 506(d). As such, the Court held that the debtor could not strip down the creditor’s lien to the value of the property because the creditor’s claim was secured by a lien and had been fully allowed under Section 502.

The Dewsnup Court defined the term “secured claim” in Section 506(d) as a claim supported by a security interest in property, irrespective of whether the value of the property would be sufficient to cover the claim.  Under this definition, lien stripping is limited to “voiding a lien whenever a claim secured by the lien itself has not been allowed.” Dewsnup has been widely criticized as being contrary to the plain language of Section 506(a).

In 2015, the Court addressed a similar issue in Bank of America v. Caulkett (2015). Caulkett was a consolidated case with two Chapter 7 debtors, each owning a home with a senior mortgage and a fully unsecured second mortgage. Like Dewsnup, the debtors sought to strip their junior mortgages under Section 506(d). The debtors requested that the Court limit Dewsnup’s holding to the facts of that case, where the liens were only partially – as opposed to wholly – underwater liens. In a 9-0 decision written by Justice Thomas, the Court declined to adopt this limitation and in fact extended the holding of Dewsnup to fully unsecured junior liens in Chapter 7 cases.

The Court reasoned that embracing the partially/fully unsecured distinction would render an odd statutory framework. If the Court adopted this distinction and the collateral was valued at one dollar more than the amount of a senior lien, the debtor could not strip down a junior lien. On the other hand, if it valued the property at one dollar less, the debtor could strip off the entire junior lien. “Given the constantly shifting value of real property, this reading could lead to arbitrary results.”

Possibly the most interesting part of this opinion is its sole footnote:

From its inception, Dewsnup v. Timm, 502 U.S. 410, 112 S.Ct. 773, 116 L.Ed.2d 903 (1992), has been the target of criticism. See, e.g., id., at 420–436, 112 S.Ct. 773 (SCALIA, J., dissenting); In re Woolsey, 696 F.3d 1266, 1273–1274, 1278 (C.A.10 2012); In re Dever, 164 B.R. 132, 138, 145 (Bkrtcy.Ct.C.D.Cal.1994); Carlson, Bifurcation of Undersecured Claims in Bankruptcy, 70 Am. Bankr. L. J. 1, 12–20 (1996); Ponoroff & Knippenberg, The Immovable Object Versus the Irresistible Force: Rethinking the Relationship Between Secured Credit and Bankruptcy Policy, 95 Mich. L. Rev. 2234, 2305–2307 (1997); see also Bank of America Nat. Trust and Sav. Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 463, and n. 3, 119 S.Ct. 1411, 143 L.Ed.2d 607 (1999) (THOMAS, J., concurring in judgment) (collecting cases and observing that “[t]he methodological confusion created by Dewsnup has enshrouded both the Courts of Appeals and … Bankruptcy Courts”). Despite this criticism, the debtors have repeatedly insisted that they are not asking us to overrule Dewsnup.

This footnote recognizes the many criticisms of Dewsnup and seems to hint that the Court may have even overturned it had the debtors requested it. In addition, lower courts across the country have not been thrilled with the Caulkett Court’s extension of Dewsnup and have responded by limiting its holding to only Chapter 7 cases.

The U.S. Bankruptcy Court for the Eastern District of Kentucky addressed whether the Caulkett holding applies to Chapter 13 debtors in DiGiacomo v. Travers. In Travers, Chapter 13 debtors owned a home with a senior mortgage and a fully unsecured second mortgage. Under Sixth Circuit precedent Lane v. Western Interstate Bancorp, a Chapter 13 debtor may strip-off wholly unsecured junior liens. In Travers, however, United Bank, the holder of the wholly unsecured mortgage, argued that Caulkett changes this result.

United Bank admitted that Caulkett did not explicitly overrule Lane, but argued that it implicitly did so. The bankruptcy court noted that for circuit precedent to be implicitly overruled there must be “a clear directive from the Supreme Court.” It did not find such directive in Caulkett as that case merely applied Dewsnup to prohibit the strip-off of wholly unsecured liens in Chapter 7, a holding the Sixth Circuit had already reached in Talbert v. City Mortgage Services.

Lane, on the other hand, relied on the post-Dewsnup case Nobelman v. American Savings Bank (1993). Unlike Dewsnup which interpreted Sections 506 (a) and (d), the Nobelman court addressed lien stripping under Sections 506(a) and 1322(b)(2). The Caulkett Court itself specifically rejected applying the logic of Nobelman in the Section 506(d) context. The Travers court was therefore satisfied that Caulkett did not disrupt the line of cases relying on Nobelman to find that wholly unsecured liens could be stripped off in the Chapter 13 context.

Many courts have agreed with Travers and declined to extend Caulkett to Chapter 13 debtors. [See Green Tree Servicing, LLC v. Wilson (S.D.N.Y. 2015); Kresl v. Beneficial Neb., Inc. (Bankr. D.Neb. Sept. 24, 2015); Larson v. Nationstar Mortgage (Bankr. W.D. Wisc. Jan. 22, 2016).]

In the Chapter 11 context, it is generally accepted that Chapter 11 debtors may lien strip.  Some courts have relied on Section 506(d) to analyze lien stripping in the Chapter 11 context, especially in the tax lien context.  [See In re Johnson (Bankr. W.D. Pa. 2008) (holding that Dewsnup does not extend to Chapter 11 cases with the result that the debtor could strip off a federal tax lien on his residence); See also In re Dever (Bankr. C.D. Cal. 1994); In re Berkebile (Bankr. W.D. Pa. 2011).]

However, most of the courts that permit lien-stripping in the Chapter 11 context do not rely on Section 506(d), but instead point to different provisions – such as the cram down provisions for Chapter 11 plans and the right of a class of creditors to make an election under Sections 1111(b) and 1123(b)(5), which permit modification of the rights of holders of secured claims (except for those claims secured solely by a debtor’s principal residence).

All in all, the Dewsnup and Caulkett holdings have not been widely popular among lower courts, and thus, many of them have limited the bar against lien stripping to the Chapter 7 context.

To read Dewsnup, click here.

To read Caulkett, click here.

To read Travers, click here.

Posted by Attorney Katherine M. Flett. Flett is a member of the litigation team focusing on assisting clients with matters relating to business, civil and commercial litigation.