A recent Supreme Court case considered whether, in a Chapter 7 bankruptcy proceeding, a junior mortgage may be voided when the senior mortgage amount exceeds the value of the property. For lenders, this means that if you hold a mortgage that is second in line to the primary mortgage, and that primary mortgage is larger than the value of the property, your subordinate mortgage would be automatically voided. Consequently, collection would be impossible even if the value of the property increases in the future. While helpful for a debtor, a statutory interpretation in this manner would put lenders of junior mortgages in a very undesirable position.
In the consolidated case Bank of America v. Caulkett, the Supreme Court evaluated whether the junior mortgage is a “secured” or “unsecured” claim within the meaning of the Bankruptcy Code. Only secured claims allowed by the bankruptcy court may be considered in the Chapter 7 proceeding. In Caulkett, Bank of America held junior mortgages for two debtors on property for which the senior mortgage amount owed exceeded the value of the property. The bankruptcy court found that although Bank of America’s claims were allowed, they were not “secured” because the lender in this unique situation had no interest in the property due to its subordinate position to the senior mortgage. Prior cases led the Supreme Court to decide that a claim is “secured” when the claim is supported by a security interest in property, regardless of the relative value of the claim to the property securing it.
Before this case, lenders involved in a Chapter 7 bankruptcy proceeding could be sure that a mortgage partially underwater could not be reduced to match the value of the property. The Supreme Court has confirmed that even a junior mortgage wholly underwater may not be voided. This is good news for creditors who hold junior mortgages. Even if a debtor’s property value is less than that of the senior mortgage, junior mortgage holders can proceed through the Chapter 7 process in hopes of recouping some of the amount the debtor borrowed in the future as property values increase. For questions about this case or any other collection or bankruptcy matter, please contact one of the knowledgeable and experienced attorneys in our Bankruptcy and Creditors’ Rights group.