Bank of America scored a legal victory this week for all holders of second liens.

The Supreme Court ruled that bankruptcy courts cannot void a second mortgage because it exceeds the value of the home.

BofA was looking to reverse decisions by bankruptcy courts that had effectively released two homeowners, David Caulkett and Edelmiro Toledo-Cardona, from paying back second mortgages that were completely underwater.Now it appears that the homeowners are on the hook again.

BofA’s case relied heavily on a 1992 ruling by the Supreme Court in Dewsnup versus Timm. This decision barred debtors in Chapter 7 bankruptcy from stripping a partially underwater second mortgage down to its current market value.

This ruling has not always been applied to second liens that are completely underwater.

Interestingly, the lawyer for the homeowners, Stephanos Bibas, did not ask the Court to reverse that earlier ruling. Instead, he argued that an underwater loan is simply not an allowed claim under the bankruptcy code.

Apparently this tack didn’t work.

In the opinion, which was written by Justice Clarence Thomas, the Court said that the homeowners’ were making a distinction between partially and fully underwater mortgages that was “artificial.” 

He added, “The debtors do not ask us to overrule Dewsnup, but instead request that we limit that decision to partially—as opposed to wholly—underwater liens. The debtors offer several reasons why we should cabin Dewsnup, but none of them is compelling.”

The decision was unanimous, with the exception of a footnote observing that Dewsnup has often been criticized; Justices Kenney, Breyer and Sotomayer did not join in this footnote.

It has implications for mortgage bond holders as well as investors in corporate loans and collateralized loan obligations.

The Loan Syndications and Trading Association, along with two other trade groups, had filed amicus briefs in support of Bank of America.

Don Hawthorne, a partner at New York law firm Axinn, Veltrop & Harkrider LLP who often represents creditors, said that the ruling gives second-lien holders more leverage to influence the outcome of bankruptcies and restructurings.

“It’s more about the leverage between holders of first- and second liens,” he said. "The more widespread result is that second-lien holders of underwater mortgages can continue to exact a price from first-lien holders for releasing their liens.”

Christopher Hawkins, a partner at Bradley Arant Boult Cummings in Birmingham, Ala., who represents the interests of both debtors and creditors, said the Court’s ruling could result in more debtors filing for bankruptcy under Chapter 13 when looking to strip off junior mortgages.

“The ruling also may have a chilling effect on loss mitigation negotiations in Chapter 7 cases, given the potential ‘veto’ power that junior lienholders may have in discussions between the debtor and senior lienholder,” Hawkins stated in a post on the law firm’s website. “…This ruling eliminates a potential means for Chapter 7 debtors to maximize the relief associated with their discharge and provides junior lienholders with leverage in loss mitigation discussions between the debtor and the senior lienholder.”

The justices’ own criticism of Dewsnup could point the way for eventual changes in the law, however.

“It looked like there were a substantial number of judges who were willing to reconsider Dewsnup had they been directly invited to,” Hawthorne said. “You could read this decision by the Supreme Court as inviting someone to ask that question.”

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