Supreme Court Takes Second Look at Second Liens

The corporate loan market is paying close attention to two high-profile lawsuits involving residential mortgages.

At issue is whether a loan with a secondary lien on a debtor's asset can be stripped down to the value of the collateral securing it — even if that value is zero.

The cases both involve Florida homeowners who had their second mortgages voided in Chapter 7 bankruptcies because the loans were completely underwater. In each case, Bank of America holds the second mortgages and is seeking to have the ruling reversed. The cases, which have been combined, have made it all the way to the U.S. Supreme Court, which heard arguments last week.

The first case, Bank of America vs. Caulkett, is based on two mortgages that David Caulkett obtained in 2006 for the purchase of his $249,500 home — a $199,600 first mortgage and a $49,000 second mortgage. At the time of his Chapter 7 filing, Caulkett's house was valued at $98,000, while he owed $183,000 on his first mortgage and $47,000 on his second mortgage.

The second case, against Edelmiro Toledo-Cardona, involves two mortgages taken out to refinance his home, a $135,000 first mortgage and a $32,000 second mortgage. Toledo-Cardona's property was worth nearly $77,700 when he filed for bankruptcy; he still owed $135,000 and $32,000.

The arguments on both sides would seem to rely heavily on a ruling by the high court in a 1992 case, Dewsnup vs. Timm, which barred debtors in Chapter 7 bankruptcy from "stripping off" a partially underwater second mortgage down to its market value, thus voiding the junior lien holder's claim against the debtor.

The Dewsnup ruling has been inconsistently applied to second liens that are wholly underwater, which is likely one of the reasons that the justices agreed to hear this case.

In her opening statement, Bank of America's lawyer, Danielle Spinelli of Wilmer Cutler Pickering Hale and Dorr, cited the high court's ruling in Dewsnup, arguing that this reasoning "applies with equal force to completely underwater mortgages."

Several of the justices seem to have expected the respondents' lawyer, Stephanos Bibas of the University of Pennsylvania Law School, to argue that Dewsnup should be reversed. Some went so far as to prod, or even goad, him to make arguments for reversing Dewsnup.

Instead, Bibas argued that a claim unsupported by any value is a completely unsecured claim and so can be discharged in bankruptcy like any other unsecured claim.

At one point Justice Samuel Alito asked, "Well, why haven't you argued that we should overrule Dewsnup? Is it because of reliance, because you think that there has been a great deal of reliance on Dewsnup as applied to a partially underwater mortgage, but not reliance as applied to totally under?"

Bibas responded: "Its reasoning was limited to a case with some value."

Justice Ruth Bader Ginsburg spoke next. "But the law would be much more coherent if either Dewsnup applies to the totally underwater as well as partially underwater, or Dewsnup is overruled," she said.

"I don't believe that's the case," Bibas replied. "While the court could consider overruling Dewsnup, we haven't advocated for that."

The justices then debated with Bibas for a few minutes about the distinction between partially underwater and fully underwater mortgages before Justice Elena Kagan interjected: "Mr. Bibas, can I take you back to Justice Alito's question, which was about stare decisis, and why you haven't argued it? Because I tell you that my sort of reaction to this case is that these distinctions that you are drawing between partially underwater and fully underwater are not terribly persuasive. But the only thing that may be less persuasive is Dewsnup itself."

Her comment prompted laugher in the courtroom.

Kagan continued, "So the question, to me, is — or at least one question is — whether we should bite the bullet and overturn Dewsnup. ... If you do have something relevant to say about that matter, here's your chance to say it."

Bibas did not take the bait.

In its weekly email, the Loan Syndications and Trading Association speculated that his reticence stems from the fact that "the Supreme Court almost never reverses itself in a case of textual interpretation."

The LSTA, along with two other trade groups, the American Bankers Association and the Securities Industry and Financial Markets Association, filed briefs in support of Bank of America.

The LSTA's brief notes that loans secured by second liens are "an integral part of the nation's consumer and commercial lending markets. Borrowers have had access to this funding because lenders felt secure that these liens could pass through a bankruptcy proceeding unaffected, and that these liens could not be stripped from borrowing even if the value of the underlying collateral is less than the value of the debt obligation.

"A ruling that validated 'lien-stripping' would cause an unanticipated disruption to this important sector of our nation's consumer and commercial lending market, and we urge the court to follow more the 100 years of jurisprudence and its own previous ruling by reversing" decisions by the 11th U.S. Circuit Court of Appeals and lower courts, the LSTA said.

The high court is expected to rule by June.