On June 1, 2015, the US Supreme Court in Bank of America, N.A. v. Caulkett held that wholly underwater junior mortgage liens may not be "stripped off" or voided in Chapter 7 bankruptcy proceedings even if the amount of the senior mortgages is greater than the current value of the collateral (No. 13-1421, (S. Ct. June 1, 2015)).

The debtors owned homes that secured senior and junior mortgage liens held by Bank of America. The amounts of the senior liens were greater than each home's current market value. Because there was no equity in the collateral to satisfy any portion of the junior mortgage liens, these claims were considered to be underwater.

In 2013, the debtors filed for Chapter 7 bankruptcy and motioned to void the junior liens under Section 506(d) of the Bankruptcy Code. The Bankruptcy Court granted the motions and both the District Court and US Court of Appeals for the Eleventh Circuit affirmed.

Bank of America appealed the decision to the US Supreme Court.

Under Section 506(d) of the Bankruptcy Code, a lien that secures a claim against a debtor that is not an "allowed secured claim" is void. The parties agreed that the claims were "allowed" under Section 502 of the Bankruptcy Code. However, the parties disagreed over whether the lien was "secured" because the senior mortgages exceeded the equity in the collateral.

The U.S. Supreme Court noted that under Section 506 of the Bankruptcy Code, an allowed claim is bifurcated as:

The Court relied on the precedent set in Dewsnup v. Timm, which dealt with a similar issue involving a partially underwater junior lienholder (see 112 S. Ct. 773 (1992)). In Dewsnup, the Court held that a claim does not come within the scope of Section 506(d) if it is "allowed" under Section 502 and is secured by a lien with recourse to the underlying collateral.

The Court applied the reasoning from Dewsnup to wholly underwater junior mortgage liens in the current case. Bank of America's claims were both secured by liens and allowed under Section 502, so they could not be avoided under Section 506(d).

The Court also declined the debtors' requests to limit the application of Dewsnup to partially underwater liens. The Court did not want to have a different meaning based on the value of the collateral, which could lead to arbitrary results.

In reversing the judgments of the Eleventh Circuit, the Court ultimately held that a debtor in a Chapter 7 bankruptcy proceeding may not void a junior mortgage lien under Section 506(d) when the debt owed on a senior mortgage lien exceeds the current value of the collateral.

The threat of bankruptcy is now less potent to counsel for junior lenders, whether their loans are completely or partially underwater. This ruling allows junior or subordinate lenders to survive bankruptcy proceedings, which may allow recovery on claims that previously would have been voided.

Further, while this ruling was issued in the context of a Chapter 7 consumer bankruptcy, it applies equally to corporate bankruptcies. An adverse ruling allowing the stripping of completely underwater junior liens could have undermined the second lien corporate loan market and significantly impacted the basic rights of secured creditors in bankruptcy. Courts are likely to apply this ruling in the Chapter 11 context, given that they have applied Dewsnup, another Chapter 7 case, to prohibit lien stripping in Chapter 11.