Nagle & Zaller, P.C. | Attorneys At Law

Supreme Court Prohibits “Stripping” Junior Liens in Chapter 7 Bankruptcy

On Behalf of | Aug 1, 2015 | Uncategorized

A recent US Supreme Court decision will strengthen the position of condominiums and homeowners associations when their delinquent owners file Chapter 7 bankruptcy. Whereas, in a Chapter 13 bankruptcy, where the subject property has no equity (i.e. is “underwater”), the debtor may seek to “strip” the association’s lien by filing a motion to that effect in the bankruptcy court (this varies by jurisdiction and by judge), it was not entirely clear whether the same action could be taken to strip a lien in a Chapter 7 bankruptcy.

Prior to the Supreme Court’s recent decision in the consolidated cases of Bank of America v. Caulkett and Bank of America v. Toledo-Cardona, 575 U.S. _____ (2015), the question of whether a junior lien could be stripped had been addressed by the Supreme Court in the case of Dewsnup v. Timm, 502 U.S. 410 (1992), where the Court heard arguments from a debtor who attempted to strip off a second lien in a Chapter 7, where the home had enough value to satisfy the first mortgage lien, but not the entire amount of the second lien. Section 506(d) of the Bankruptcy Code allows a debtor to void a lien on his property to the extent that the lien secures “a claim against the debtor that is not an allowed secured claim.” In Dewsnup, the Court interpreted Section 506(d) to mean that, even if the lien was secured against a property whose value could not pay it in full, it was still a secured claim and could not be stripped. This was settled and unquestioned law for a significant period of time.

Despite the precedent established in Dewsnup, debtors and their attorneys began making the argument that the Court’s decision in Dewsnup applied only in circumstances where the subject property was only partially underwater. They further argued that in cases where the junior lien was completely underwater, the lien did not create a secured debt under the Bankruptcy Code, and it should be stripped. Judges in some jurisdictions were persuaded by this argument, while others were not, leading to inconsistent and unpredictable results.

In order to restore uniformity to the interpretation of Section 506(d) of the Bankruptcy Code in the context of Chapter 7 cases, the Supreme Court took up the aforementioned consolidated Bank of America cases; and, on June 1, 2015, it held that a Chapter 7 Debtor may not void, or “strip,” a junior lien from his property, even when the debt owed to the senior lienholder exceeds the value of the property. In these cases, the only question before the Court was: “Is a lien that is completely underwater still a secured claim for purposes of a Chapter 7 bankruptcy?” Because of the changing values of real property, and because the Court in Dewsnup held that a partially underwater lien was still a secured claim, the Court in these consolidated cases answered with a straightforward and unanimous “yes.”

This decision is significant because it settles a question that did not previously have one uniform answer across all jurisdictions. Further, it affords community associations some security; a Chapter 7 bankruptcy can discharge the debtor’s personal obligation only. The association’s lien survives, entitling the association to: (1) be paid on the lien upon the sale/transfer/refinance of the property; or, (2) foreclose the lien (within the time frame permitted under applicable state law, subject to certain exceptions).

What this means for community associations is that when an owner files a Chapter 7 bankruptcy, a lien filed against the owner’s property prior to the bankruptcy cannot be stripped, regardless of the current value of the property. So, while a Chapter 7 could result in a discharge relieving the debtor of his in personam obligation (avoiding judgment, garnishment, levy, etc.) for delinquent assessments and related charges, the in rem security of the lien against the property will survive. That being said, the association should still keep in mind that it holds a lien against a property that presently does not have sufficient value to pay it off, so a foreclosure is unlikely to yield proceeds sufficient to satisfy the lien. Nevertheless, this decision by the Supreme Court protects the leverage, the options, and the rights of the association.

If you have questions regarding lien-stripping, lien-priority, or how bankruptcy affects your Association, please feel free to contact us.