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THE LAW: The Supreme Court Talks about Stripping

BY BRAD R. BERGMOOSER

Strip offs and strip downs may be something you’d expect to hear in burlesque circles not credit union circles. The terms, however, are important ones for CUs that deal with bankruptcy issues. Learn the difference between the two and what the law has to say about them.

OK – the title of this article may be somewhat misleading, but the Supreme Court did, in fact, recently decide a case involving stripping…lien stripping, that is.

In Bank of America, N.A., v. Caulkett,the Court prohibited a debtor in a Chapter 7 bankruptcy from “stripping off” a completely underwater second mortgage.While the law is settled and does not allow a debtor to “strip down” a second mortgage in a Chapter 7, the Supreme Court’s recent ruling takes a unique approach to analyzing the Bankruptcy Code in order to extend the prohibition to strip offs.

This example will help clarify “strip offs” and “strip downs”:

Strip Off:The debtor files for relief under Chapter 7 of the Bankruptcy Code.At the time of filing, his home is worth $200,000.There are two mortgages on the property, a first mortgage with a balance of $225,000 and a second mortgage with a balance of $100,000. Based on these facts, the value of the property wouldn’t be enough to satisfy the first mortgage, so the debtor would attempt to strip off the entire second mortgage from the property and eliminate it from debt owed by the bankruptcy estate.These were the circumstances the Supreme Court ruled on in Caulkett.

Strip Down:Use the same facts as above but change the balance of the first mortgage to $150,000.The value of the property would pay off the first mortgage,with $50,000 remaining to apply to the balance of the second mortgage.This is an example of a strip down – the debtor would ask the bankruptcy court to reduce what’s owed on the second mortgage from $100,000 to the amount left over after satisfying the first mortgage ($50,000).The Supreme Court ruled in 1992 to prohibit strip downs (Dewsnup v. Timm).

What the Law Says

The fate of underwater second mortgage lenders in Chapter 7 bankruptcies hinges on the interpretation of only a few words in the Bankruptcy Code.Section 506(d) states, “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.”Translated from Bankruptcy Code language into normal English, this means that a loan (the “claim”) in place when the debtor filed bankruptcy will be part of the bankruptcy estate and will be paid from the proceeds, if it is an “allowed secured claim.”

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