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High Court Win is No Cure-All for Subordinate-Lien Market


Moorari K. Shah

Lenders in both consumer and commercial real estate markets have reason to celebrate the U.S. Supreme Court’s unanimous ruling in Bank of America NA v. Caulkett, (U.S. June 1, 2015), reversing a contrary ruling of the Eleventh Circuit. The court backed a second-lien lender’s right to maintain its lien throughout the bankruptcy process regardless of any diminution in the value of the real property in question. Had the debtors prevailed in Caulkett and its companion case, as they had in lower courts, real estate markets would have been in turmoil as second-lien holders would have had little, if any, recourse on loans with severely diminished equity positions, even if property values later returned to normal levels. In addition, the potential ramifications of similar treatment in Chapter 11 cases involving corporate debtors would likely have led to substantial disruption and a potential credit freeze in the $40 billion subordinate-lien industry for commercial loans.

Despite the unanimous ruling, the outcome of this case was by no means a foregone conclusion, and Caulkett includes an implicit plea for congressional action. The issue in Caulkett was straightforward enough: In a Chapter 7 bankruptcy liquidation, may debtors void their second lien if their home is now worth less than their first lien? Under the express terms of Section 506 of the Bankruptcy Code, a debtor may do precisely that when the lien secures a claim against the debtor that is not an allowed secured claim. So, are second-lien claims “secured” if the bank’s property interest is reduced to nothing? Under the plain language of Section 506, the court concluded in the negative. Nonetheless, the court felt constrained to follow Dewsnup v. Timm, 502 U.S. 410 (1992), which (as noted below) the court may otherwise have been inclined to overrule.

Originally printed in Law360; reprinted with permission. 

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