On March 24, in a case that has captured the attention of commercial lenders, the United States Supreme Court heard oral arguments on the issue of whether a Chapter 7 debtor can “strip off” junior liens on residences that are already underwater.

Most courts agree that debtors filing under Chapter 13 of the Bankruptcy Code may strip off liens from their assets to the extent that the encumbrances (e.g., mortgages, liens, and lines of credit) against the property exceed its value.  In the typical case, the debtor’s residence will be encumbered by a first mortgage, the remaining balance of which exceeds the value of the property as of the bankruptcy filing date.  As to any junior mortgages, which are then essentially valueless as security interests, the homeowner can move the bankruptcy court for an order treating the junior lien holder as a general unsecured creditor and removing the junior lien from the property.

Until quite recently, courts had similarly agreed that such remedies should not be available to debtors filing under Chapter 7 of the Bankruptcy Code based on the 1991 Supreme Court case Dewsnup v. Timm.  The Eleventh Circuit Court of Appeals turned conventional wisdom on its head when it ruled that Chapter 7 debtors could, in fact, strip off second-mortgage liens where the primary mortgage was underwater on the date of bankruptcy.  In doing so, the Eleventh Circuit departed from holdings in the Fourth, Sixth, and Seventh Circuit Courts of Appeals, which had all previously held that Chapter 7 debtors could not strip off junior liens.

While the Supreme Court may not issue its decision for some time, the stakes are high for commercial lenders, who argue that a ruling in the debtors’ favor will have a chilling effect on the use and availability of junior liens and lines of credit to provide additional credit to individual borrowers, a proposition with which at least Justice Anthony Kennedy appeared to agree.  Such lienholders, who watched property values plummet during the recent economic recession, also argue that the ensuing recovery may soon leave them “in the money” again on their mortgages, making a strip off now all the more inequitable.  For their parts, the debtors pointed to the disruptive effects of allowing wholly unsecured lien holders to continue to encumber real property during the bankruptcy process, described more succinctly as “hostage value.”