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Supreme Court Hears Bank of America Case on Bankruptcy and Second Mortgages

Forbes - A case to decide whether homeowners can erase underwater second mortgages through bankruptcy quickly turned into a debate over whether the U.S. Supreme Court should overturn the precedent that raised the issue in the first place.

Oral arguments in Bank of America vs. Caulkett ostensibly focused on whether the 11th Circuit Court of Appeals should have allowed David Caulkett and a second plaintiff to dispose of their second mortgages in bankruptcy. Bankruptcy courts let them off the hook after determining there was no way the lenders could collect because the properties were worth less than even the first mortgage standing in front of them in them. Coulkett, for example, borrowed $183,000 through a first mortgage and another $47,855 with a second but his house at the time of foreclosure was only worth $98,000.

The financial crisis left thousands of homeowners in similar straits, and advocates for financial relief argue that second-lien holders can hold a blocking position preventing borrowers from using bankruptcy to negotiate a reduction in principal balances to stay in their homes instead of losing them to foreclosure. In a business bankruptcy, for example, creditors are ranked by priority and holdouts who refuse to negotiate can be forced to accept a loss under a judicial order known as a cramdown.

The Supreme Court ordered different treatment for mortgage lenders in a 1992 decision with the improbable title of Dewsnup v. Timm. That case held that Section 506 of the Bankruptcy Code did not authorize a court to “strip down” a mortgage lien to the current value of the property, eliminating the portion of the debt the lender wouldn’t get even if it seized the land and sold it at foreclosure. The question in Bank of America v. Caulkett was whether that same reasoning applied to a second lien that was completely underwater, with no hope of collecting anything in a foreclosure sale.

Justice Antonin Scalia dissented in Dewsnup and came out swinging in today’s arguments. Since Dewsnup was a “terrible decision,” he asked Bank of America’s attorney, Danielle Spinelli of WilmerHale, why shouldn’t the court use a familiar trick and narrow that precedent down to the exact facts in that case? Spinelli said that would leave an illogical distinction between semi-underwater and fully underwater liens and it was better to expand Dewsnup to include lenders in the position of her client.

Justices Sonia Sotomayor and Anthony Kennedy both expressed concern that second-mortgage holders with no hope of collecting anything in a foreclosure could nevertheless unfairly block a negotiated settlement in bankruptcy that would benefit borrowers and first-mortgage lenders.

Bankruptcy is supposed to give debtors a fresh start, Sotomayor said, and “if you’re able to hold up that fresh start, that is the concern.”

Bankruptcy does give borrowers a fresh start, Spinelli responded, but that doesn’t mean they get to erase a debt secured by their home and keep all the potential appreciation in the property if markets recover. A key question in this case and others like it is what a lien is really worth: Is it the current value of the property, or the value of a claim against the property if it recovers value closer to what was lent against it?

Several of the justices seemed to agree with Scalia that the strict holding in Dewsnup, protecting partially underwater mortgages but not loans that are totally underwater, seemed arbitrary. A second lien on a property worth one dollar more than the amount lent against it would survive bankruptcy, under the plaintiff’s argument, while a lien on a property worth a dollar less wouldn’t. If you don’t extend Dewsnup to totally underwater mortgages, Kennedy said, it has “absolutely draconian arbitrary results.”

That valuation itself is the subjective opinion of a judge, Chief Justice John Roberts added, before making an inadvertent joke. The difference between underwater and partially underwater is “completely fluid” Roberts said, before adding “I didn’t think of that one.” To laughter in the courtroom, he added, “that was totally unintended.”

Stephanos Bibas of the University of Pennsylvania Law School, arguing for the borrowers, came under tough questioning as the justices asked why he didn’t urge them to overturn Dewsnup and allow lien-stripping for all underwater loans in bankruptcy. “We win under Dewsnup,” anyway, he said, so there was no need to argue against stare decisis, the doctrine in favor of disturbing existing law as little as possible.

Kennedy asked whether ruling for the borrowers wouldn’t hurt future borrowers, however, by restricting access to credit. Bibas cited studies showing credit and interest rates were no different in states that adopted the reasoning of the 11th Circuit and those that didn’t.

Then the justices returned to Dewsnup, which gave a different meaning to the words “secured claim” in two different parts of the law. Does it mean a claim that is secured by actual value in the property, or secured by the fact that there is a lien against the property, no matter what it’s worth right now?

“You’re giving exactly the same phrase in the statute two different meanings, depending on whether one’s underwater or not, completely or partially,” Sotomayor said.

Later, Justice Elena Kagan asked why nobody was arguing to overturn Dewsnup. The distinctions between partially and fully underwater mortgages “are not very persuasive,” Kagan said, and “the only thing that may be less persuasive is Dewsnup itself.”

The question, she concluded, is “whether we should bite the bullet and overturn Dewsnup.”