Breathing underwater: the survival of second mortgages in bankruptcy proceedings.

• Author: Savino, Joseph C.
• Position: Cover story

In conjunction with the Wall Street collapse of 2008, the foreclosure crisis hit hard in Florida, and its impact was devastating. Not only were businesses losing revenue and consumers facing furloughs, pay cuts, and unemployment, but their properties' values were plummeting. For example, median household income in Florida dropped from $53,707 to $46,036 between 2007 and 2013, (1) while median home values decreased from $247,000 to $136,000 during the same period. (2) The quick decline in property values placed Florida cities among the United States metropolitan areas with the highest percentage of "underwater" homes, i.e., homes in which the mortgage debt exceeded the property value. (3)

The torrent of foreclosure filings that followed reached its peak in the 2008-09 fiscal year, when 403,473 new foreclosure cases were filed in Florida. (4) Amid the hysteria, banks failed, (5) law firms shut down due to, among other things, corruption, (6) and borrowers were left searching for answers. For multiple reasons, one of the most effective strategic tools that borrowers could use during this foreclosure wave was petitioning for bankruptcy relief under Chs. 7, 11, and 13 of the Bankruptcy Code. (7)

Since the filing of a bankruptcy proceeding automatically stays all collection efforts, including a state court foreclosure case, borrowers can obtain time to secure additional income from their property or wait for its value to increase by filing for bankruptcy. (8) In addition, under Ch. 11 and Ch. 13, debtors can propose a repayment plan that modifies the amount of debt secured by a lien on property. (9) In bankruptcy jargon, reducing a lien to the value of the underlying collateral is called a "strip-down," and reducing the value of the lien to zero when the underlying collateral is valueless is called a "strip-off." The availability of such relief provided additional protection to debtors in Florida after the market crash.

While lien strip-offs were previously permitted in Florida through precedent laid down by the 11th Circuit, a recent Supreme Court decision and subsequent 11th Circuit rulings have abolished lien strip-offs in Ch. 7 bankruptcy proceedings. The issue came before the Supreme Court on appeal from the 11th Circuit in the consolidated cases of Bank of America v. Caulkett and Bank of America v. Toledo-Cardona, 2015 U.S. LEXIS 3579 (June 1, 2015) (Caulkett), and the Supreme Court struck down Ch. 7 lien strip-offs as being contradictory to the text of the code. The 11th Circuit subsequently acknowledged the precedent of the Caulkett decision, which confirmed that Ch. 7 lien strip-offs are no longer permitted in Florida. (10) This article examines the history of lien-stripping in bankruptcy, the unique position of second mortgagees on underwater properties, and the changing legal landscape pertaining to the treatment of junior liens in light of Caulkett and Bank of America, N.A. v. Waits, 793 F.3d 1267 (11th Cir. 2015).

The History of Claims Allowance, Lien-Voiding, and Lien-Survival

Florida debtors had, for decades, been able to use the Bankruptcy Code to strip-off a wholly under-secured second mortgage through an adversary proceeding in Ch. 7 bankruptcy. (11) Under the Bankruptcy Reform Act of 1978, which established the modern Bankruptcy Code, (12) when a debtor files for bankruptcy, an estate is created that consists of all of the debtor's nonexempt property. The modern code introduced the concept of bifurcation of claims. As it pertains to mortgages, for example, if the creditor is under-secured, the code bifurcates the secured creditor's claim against the estate into a secured and unsecured portion. (13)

For example, assume a piece of real property within a debtor's bankruptcy estate is worth $100,000 and is encumbered by a first mortgage in the amount of $120,000 and a second mortgage in the amount of $30,000. The first mortgagee's claim is bifurcated into a $100,000 "secured claim" and a $20,000 "unsecured claim." (14) The second mortgagee's claim is strictly an "unsecured claim" since the value of the underlying collateral is zero. (15) The bifurcation of claims also opened the door for modifying the value of liens through [section]506(d). Under [section]506(d) of the code, "To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such a lien is void ...." (16) When read in conjunction with [section]506(a)(1), this would suggest that a lien on property can be voided or "stripped" down to the value of the underlying collateral through a Ch. 7 bankruptcy. (17)

As a result of the claim bifurcation and lien-voiding provisions introduced by the 1978 Act, Ch. 7 debtors began utilizing adversary proceedings as a way to strip-down liens under [section]506(d), or strip-off liens completely when the underlying collateral carried no value. (18) This had the practical effect of modifying the lien by reducing the lien to the property's value at the time of bankruptcy, thereby allowing any subsequent increase in property value to inure to the benefit of the debtor. Since a claim in bankruptcy was only "secured" to the extent of the underlying collateral's value pursuant to [section]506(a)(1), debtors contended that a lien securing an amount beyond the value of the property was "void" because it was a lien on a claim that was not an "allowed secured claim" under the meaning of [section]506(a)(1). (19) Proponents of this contention deemed this the logical approach since both uses of "allowed secured claim" fell within the same section of the code. (20) Under In re Folendore, 862 F.2d 1537 (11th Cir. 1989), strip-offs of wholly undersecured second liens were permitted in Florida for the past 26 years until the Supreme Court's recent Caulkett decision struck down this practice. (21)

Treatment of Liens in Florida Under the Modern Code

Due to the lien-voiding language of [section]506(d), lien-stripping was common immediately following the 1978 Act, but whether lien-stripping was permissible under the code was a question for future adjudication in the courts. Under previous bankruptcy acts, liens passed through bankruptcy unaffected. (22) The creation of [section]506 under the modern code, however, led practitioners to challenge whether the modern code provided a new mechanism for voiding liens. While the Supreme Court recently struck down Ch. 7 lien strip-offs, the opposite was the prevailing practice in the 11th Circuit for the past two decades. (23)

In the late 1980s, the majority of courts held that strip-offs were permissible under [section]506(d) in Ch. 7 cases, and the 11th Circuit followed the majority view. (24) For example, in 1989, the 11th Circuit in Folendore held that liens could be voided when they did not secure an "allowed secured claim" within the meaning of [section]506(a)(1). (25) The Folendore court held that an "allowed secured claim" should be construed as a term of art under [section]506(d) (as it was defined through [section]506(a)(1)) because this was the "plain language of the statute." (26)

Despite its agreement with the majority view, the Folendore precedent was at odds with centuriesold practice and Supreme Court precedent supporting bankruptcy lien survival. The Supreme Court in Dewsnup v. Timm, 502 U.S. 410, 418-19 (1992), emphasized the importance of lien survival:

Apart from reorganization proceedings, no provision of the pre-Code statute permitted involuntary reduction of the amount of a creditor's lien for any reason other than payment on the debt.... [T]he [c]ourt [has] held that a discharge in bankruptcy does not release real estate of the debtor from the lien of a mortgage created by him before the bankruptcy. And in ... consider[ing] additions to the Bankruptcy Act effected by the Frazier-Lemke Act ... the [c]ourt noted that the latter act's avowed object is to take from the mortgagee rights in the specific property held as security; and to that end to scale down the indebtedness to the present value of the property. The [c]ourt invalidated that statute under the Takings Clause. It further observed [that] [n]o instance has been found, except under the Frazier-Lemke Act, of either a statute or decision compelling the mortgagee to relinquish the property to the mortgagor free of the lien unless the debt was paid in full. (27)

Thus...