Bank of America v. Caulkett

The Supreme Court ruled 9-0 in favor of Bank of America in this case regarding treatment of second liens in Chapter 7 bankruptcy, which is surprising.  There are some links at the bottom for background info, in case you haven’t been following the case :p  Here’s how I see it…

– Chapter 7 liquidation involves selling off all assets and satisfying creditors in order of seniority.  To avoid the unnecessary disruption of foreclosure (evicting bankrupt people out of their homes as part of liquidation), trustees allow the home mortgage arrangements to remain intact through the bankruptcy proceedings.

– Section 506(d) says that a lien is void if it’s not a secured claim, which 506(a) says is a claim secured by the value of an underlying asset.  It appears to say that any part of the claim above the value of the asset is essentially unsecured.

– Dewsnup v. Timm in 1992 was a case where a bankrupt person attempted to keep a house and use Chapter 7 to reduce the bank’s claim on it to the lower current market value.  The idea was to split the claim into a secured and unsecured portion, and void the unsecured part by applying 506(d).  The Supreme Court ruled 6-2 in favor of the banks by applying case law and common sense, but essentially noted that’s not what Section 506 says.

– Bank of America v. Caulkett considers what happens when there’s a second mortgage on a home and it’s completely underwater.  That is, if the house were liquidated, the holder of the first mortgage would receive a partial recovery and the second one would be wiped out.  The question is whether the second mortgage should remain or be voided in the Chapter 7 proceedings.

At first, I agreed that the second liens should stand.  It seems illogical to base whether or not they’re voided on some court-decided value of the house.  Also, just because loans are underwater doesn’t mean they have no value, since they have potential to rise in the future.  It’s why stocks for companies that continually lose money still trade for more than $0 (they may earn profit in the future).  Another important consideration was that for over 20 years, banks have relied on Dewsnup in pricing second mortgages, with an understanding that they wouldn’t be voided in Chapter 7.

Those arguments are weak.  Note that the option value argument is completely flawed because 506 doesn’t refer to the value of the loan, rather the value of the underlying asset.  The reliance argument is hardly a good reason to continue a bad decision.  And the problem of court-decided house valuation can be solved by overturning Dewsnup or by applying market-based pricing.

Think about what actually happens in a single-mortgage Chapter 7 situation.  The debtor has the choice of walking away from the house, leaving the bank holding the house.  The bank also has the choice to foreclose, evict the debtor and take the house.  Instead, they often reach a mutually beneficial agreement to continue the mortgage and home ownership arrangement.  Dewsnup is essentially irrelevant if Chapter 7 were handled properly because the bank would buy the house at auction for the full value of the mortgage and then renegotiate a new zero-down mortgage with the debtor.  Dewsnup cannot guarantee the bank keeps the entire original value of the mortgage because the debtor has the power to walk away if the house is deeply underwater.  The mortgage size will get renegotiated to an agreeable value, Dewsnup or not.  All Dewsnup did was apply an ugly fix to the problem of courts deciding the value of the house in Chapter 7 rather than auctioning the house.

In the dual-mortgage situation, something similar happens.  Let’s consider the case of the $5 million senior loan, $2 million junior loan that Justice Breyer brings up.  If the property is worth $1 million, as in his example, the owner would walk away instead of keeping it along with the $1 million dollar secured and entire $4 million unsecured lien on it.  It’s illogical to keep making payments on a house if all the appreciation goes to someone else.  Therefore, in a realistic situation, the first lien holder would negotiate to drop the lien to something like $1 million secured plus $1 million unsecured as incentive for the debtor to not walk away.  Unfortunately, the new ruling makes such an arrangement impossible because the $2 million second lien would remain on the house as well.

Consider what happens if the second lien is ‘close to the water’ as Chief Justice Roberts considers, “Isn’t the question complicated by the fact that whether it’s $1 above or $1 below is a matter of a fairly subjective valuation by the court?”.  I suspect a big motivation for the new ruling was to avoid the problem of the court could deciding that the house is worth a little less than the first lien, voiding the second lien.  In a market-based approach, the second lien holder could contest the court’s valuation by bidding for the house, paying off the first lien in entirety, and taking possession of the house to either sell it or arrange new terms with the former debtor.  If they believed the house to be worth $5.1 million, they could bid $7 million for it, paying off both the first mortgage and their own.  Then, they could renegotiate agreeable terms with the debtor, for example for $6 million in total.  The spirit of Chapter 7 liquidation would be upheld and all parties involved (debtor, first, second, and any other lienholders) would have fair choices to make regarding the true value of the property and who should live in it.

The new ruling gives secondary lien holders excessive and unfair economic power to block re-negotiation of the first lien.  Stephanos Bibas did a terrible job of articulating how that happens.  Specifically in this section:

Justice Antonin Scalia: — I’ve — I’ve lost in Dewsnup.

What I am concerned about is the — what should I say — the ridiculousness of saying if under Dewsnup — and you haven’t asked us to overrule Dewsnup — under Dewsnup, if — if there’s $1 worth of value, okay, you don’t lose your lien.

But if there is zero value, $1 less and it’s stripped entirely, it seems to me a — a very strange — strange outcome.

Why would any intelligent system want to produce an outcome like that?

Stephanos Bibas: I’ll talk about that doctrinally and then as a policy matter.

“Doctrinally and then as a policy matter”?!  He should have said, in slow and assertive words as Spinelli used, “To be clear, quite the contrary is true.”  “Keeping a lien that has $0 backing it leads to a strange and ridiculous outcome, an illogical system.” “Let me explain how…” and then he could have gone on to describe how negative $100,000 of value would end up being stripped while negative $100 in value would be bid up by the second lien holder until it’s $1 or more, eliminating the apparent strange system.

It will be interesting to see whether the effect is that more people walk away from their homes in Chapter 7 to discharge those entirely underwater mortgages.  Or if the secondary lien holders exercise their power to extract a ransom payment that’s a portion of the economic benefits to the first lien holder and debtor when they renegotiate the first mortgage.  There was talk about Dewsnup being revisited, so maybe there’s a chance that they’ll sort it all out and get it right in another few decades.


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