Bank of America, N. A. v. Caulkett from U.S. Supreme Court (2015) currently is the defining case regarding avoiding junior mortgages in a bankruptcy filed under Chapter 7. It may not be the last word on this issue, but it does set forth the current law.
Caulkett held that a debtor in a Chapter 7 bankruptcy proceeding may not permit avoiding junior mortgages under 11 U.S. Code §506(d) if the debt owed on a senior mortgage lien exceeds the current value of the collateral while the creditor’s junior claim is secured by a lien and allowed under §502 of the Bankruptcy Code (found in Title 11 of the U.S. Code).
CLOSER LOOK AT “SECURED” AND “UNSECURED” CLAIMS IN BANKRUPTCIES
Defining the term “secured claim” is not easy as context plays a large role in this. 11 U.S. Code §506 is the provision in the Bankruptcy Code that defines “[d]etermination of secured status.” However, case law interprets the meaning of statutes. Dewsnup v. Timm from U.S. Supreme Court (1992) defined a “secured claim” in §506(d) to mean a claim supported by a security interest in property, without any consideration of whether the value of that property would be sufficient to cover the claim.
The Supreme Court in Dewsnup concluded that an allowed claim (under §502) that is “secured by a lien with recourse to the underlying collateral . . . does not come within the scope of §506(d),” which could permit the debtor to avoid the lien on the collateral. However, there is a “secured claim” under Dewsnup because the claim is supported by a security interest in property, even though the value of that property is not sufficient to cover the claim. Furthermore, Caulkett states that a claim secured by a lien that also qualifies as an allowed claim under §502 cannot be voided under the Bankruptcy Code.
IMPACT OF NOT REQUIRING FILING OF A PROOF OF CLAIM IN A NO-ASSET CHAPTER 7
According to 11 U.S. Code § 502 (“Allowance of claims or interests”), a claim or interest – upon the filing of a proof pursuant to §501 of this Code – is deemed “allowed” unless a party in interest objects. As noted in In re Smoot from the U.S. Bankruptcy Court in the Eastern District of New York (2011), one can argue that, in a no-asset chapter 7 case, the adjudicative process for claims is not even invoked because claims need not be filed; therefore, a junior mortgage claim is going to be deemed allowed under 11 U.S.C. § 502(a).
Here, a filed proof of claim to determine if a claim or interest against the Debtor’s property should be allowed is not required. Whether or not any assets are available for distribution to general unsecured creditors is not an issue in such situations. Instead, the determination of whether a lien or interest against property is unsecured, leaving it disallowed as a secured claim, is made independent of the existence of assets to be distributed to the general unsecured creditors.
“ANTIMODIFICATION” PROVISION IN CHAPTER 13 & ITS NONEXISTENCE IN CHAPTER 7
The “antimodification” provision in (b)(2) of 11 U.S.C. §1322 does not apply regarding avoiding junior mortgages that are wholly unsecured on a Chapter 13 debtor’s home. The Third Circuit decided that, because the U.S. Supreme Court in Nobelman stated that § 506(a) still applies and determines the “status” of a creditor’s claim, a wholly unsecured junior mortgage ceases to be a secured claim under the Bankruptcy Code and hence is not subject to the “antimodification” clause. However, because there is no similar provision in Chapter 7 of the Bankruptcy Code, this reasoning from the Third Circuit’s In re McDonald cannot be directly applied to the issue of avoiding junior mortgages in bankruptcies under Chapter 7.
LOOKING AT DIFFERENCES BETWEEN JUDICIAL LIENS & MORTGAGE LIENS
When entered of record, the judgment also operates as a lien upon all real property of the debtor in that county — in Pennsylvania, see 42 Pa.C.S. Sections 4303(a)(b), 1722(b), and 2737(3). Due to this, a judgment lien is called a general lien. Meanwhile, a mortgage lien is a specific lien that encumbers a particular piece of real property. Additionally, the Bankruptcy Code and related case law have defined these two liens quite differently, which can explain why they receive different treatment when the issue of avoiding junior mortgages comes into play.
The Bankruptcy Code defines the judicial lien in Section 101(36) as those obtained by judgment, levy, or other legal or equitable processes. Under Section 522(f) of the Code, judicial liens that impair exemptions provided in bankruptcy law can be avoided so liens that fit this definition must be involved. On the other hand, mortgage liens are said to be “bargained for” and consensual, as opposed to judicial liens which are viewed as imposed by the legal system.
Mortgage liens are part of an agreement between lenders and borrowers. People are free to make deals that they later regret, and the government generally does not feel obligated to save them from themselves. This helps to explain why the opportunities of avoiding junior mortgages are more limited. Section 506, in conjunction with Section 502, sets forth the only mechanism in the Bankruptcy Code for seeking to avoid these liens while both methods of avoidance could be explored for avoiding judicial liens.
AVOIDANCE WHEN OBLIGATION IS SECURED BY MULTIPLE AGREEMENTS
When an obligation is secured by more than one agreement, the extinguishment of a debtor’s obligation under one agreement does not necessarily end all of the obligations. However, in In re Stendardo from Pennsylvania, the bankruptcy court concluded that any right the creditor had to attorney’s fees and costs under the note was extinguished once it entered judgment on the note.
The analysis did not end at this point, though. The court went on to hold that the rights created by the continuing lien of the secured creditor’s mortgage and its asset purchase agreement that also secured the debtor’s obligation were not extinguished until the creditor received payment. In addition, the court cited In re Clark Grind & Polish, Inc., 137 B.R. 172 (Bankr.W.D. Pa. 1992), which stated that a confessed judgment on the promissory note did not extinguish the independent provisions of the mortgage and the asset purchase agreement. Since the various debt instruments were not seen as relying on each other for their continued existence, when one ceased to exist, the others still remained in place.
DIFFERENT INTEPRETATIONS OF SECTION 506 IN CHAPTER 13 & CHAPTER 7
U.S. Bankruptcy Court for the Eastern District of Pennsylvania noted in In re Cusato that “a discharge extinguishes only the personal liability of the debtor [while] a creditor’s right to foreclose on the mortgage survives or passes through the bankruptcy.” While the debt that was owed by the mortgagor cannot be obtained from the mortgagor after a discharge, the mortgagee retains the ability to pursue a judgment against the property to obtain a foreclosure sale to satisfy the mortgage lien on the property. This highlights the importance of Section 506’s applicability, as it can result in a mortgage debt being treated as an unsecured debt that would be discharged at the completion of the bankruptcy case, which could be permitted in Chapter 13 bankruptcies. When this occurs, a mortgage lender has no recourse for seeking repayment.
Courts, in the belief that Chapter 7 debtors would reap a windfall if in personam and in rem liabilities were eliminated through the bankruptcy action, have read and applied laws such as 11 U.S. Code §506 more strictly in Chapter 7 cases. The idea that the impact is different for debtors in Chapter 7 versus those in Chapter 13 could be viewed as unfair, but it seems to stem from the belief that a Chapter 7 debtor can walk away from a discharge without paying any money to creditors while the debtor in Chapter 13 will repay some amount on debts under a Chapter13 Plan. However, the justification for differing treatment of debtors regarding avoiding junior mortgages that are wholly underwater and are not subjects to payments under either bankruptcy chapter could be questioned. However, at this point in time, while potentially questionable, it also is unquestionably the applicable law under these circumstances.