Naked Liens – Stripping Prohibited

In June, the US Supreme Court decided the case of debtors in bankruptcy desirous of stripping off a lender’s real estate lien that was fully in excess of the fair market value of the real estate. The Supreme Court unanimously held that a debt secured by a lien, although completely underwater, could not be stripped from the debtor’s real estate under Bankruptcy Code § 506(d). Accordingly, the naked lien passes through bankruptcy unaffected.

Because lien stripping is now prohibited, secured lenders need to carefully evaluate their lien positions in bankruptcy cases where the debtor(s) retains the property after abandonment by a chapter 7 trustee.

To understand the Supreme Court’s decision in Bank of America v. Caulkett, 575 US ___ (2015), we must rewind twenty-three years to the Supreme Court decision in Dewsnup v. Timm, 502 US 410 (1992). In Dewsnup, a chapter 7 debtor argued that a debt secured by real estate that greatly exceeded the value of the real estate should be reduced to the fair market value of the real estate. Although finding that the value of the real estate was less than the full amount of the debt owed, the court refused to invalidate the lien amount in excess of the fair market value – the bankruptcy concept referred to as § 506(d) lien stripping.

In Dewsnup (six justices in the majority to two justices dissenting) was based upon the bankruptcy statutes and bankruptcy issues, including historical bankruptcy law. The Dewsnup Court noted the difficulty of interpreting the bankruptcy provisions to fit all situations and therefore limited its decision to the specific facts of a debt secured by a lien on real estate that greatly exceeded the fair market value of the collateral (partially secured but primarily underwater).

The Supreme Court stated that an ambiguity exists within the bankruptcy statutes and that prior bankruptcy law provided that a lien passes through bankruptcy unaffected. Thus, the Supreme Court would not permit a lien partially secured by real estate at the time of bankruptcy from being stripped down to the current value of the real estate.

Based on the Dewsnup definitional interpretations that were not challenged by Caulkett, the Caulkett Court applied the same definitions and rationale to fully underwater secured loans. Thus, secured lenders need to carefully evaluate their lien positions in bankruptcy cases, if the debtor(s) retains the property after abandonment by a chapter 7 trustee, as lien stripping is now prohibited. Constantly shifting real estate values may provide hope of some recovery from the naked lien that passes through bankruptcy.