In Wright, a mortgage lender obtained relief from the automatic stay in a chapter 11 bankruptcy and proceeded with a state non-judicial foreclose sale on two properties. However, it did not take the next step and file an action as required under state law to preserve its deficiency claim. The lender then attempted to pursue a claim for the deficiency in the bankruptcy court. The court begins its opinion with the following: “Ultimately this is a cautionary tale woven from wealth and its loss, a proof of claim that was lost in the paperwork, and hazy memories of years past.” Translation: The lender lost.
A chapter 11 debtor owned 240 units of rental housing on 160 parcels of real property, which it listed in its schedules as having an aggregate value of ~$36.4 million subject to liens of ~$43.2 million. (The court concludes its rendition of these facts with the statement: “Thus, the Debtor could be described as a real estate investor, who utilized the income received from his numerous rental properties to subsidize a lifestyle of comfort until the value of his real estate assets dramatically declined in value.”)
One lender (MidFirst) provided loans on two properties. The debtor estimated that in one case the property had a value of $760,000, leaving an estimated deficiency claim of $686,600, and in the other case the property had a value of $975,000, with an estimated deficiency of ~$644,000.
Prior to bankruptcy MidFirst had commenced non-judicial sales that were stayed when the debtor filed bankruptcy. MidFirst sought relief from the automatic stay, arguing that the debtor had no equity and that MidFirst’s interests were not adequately protected. It also argued that the debtor had converted prepetition rents.
Ultimately the parties stipulated to an order granting relief from the stay in very broad terms:
All stays and injunctions in this case, including the automatic stay of Bankruptcy Code §362(a), with respect to the Properties shall be, and hereby are vacated, terminated, and annulled… MidFirst is immediately entitled to enforce all of its rights and remedies in connection with the Properties, including without limitation any acts which MidFirst may undertake or direct to obtain possession and control of the Properties pursuant to its loan and security documents entered into with the debtor, and applicable state and federal law.
MidFirst proceeded with the foreclosure sales, and as expected, was left with deficiency claims. Under applicable state law, a secured creditor that pursues a non-judicial foreclosure sale must bring an action to recover a deficiency judgment (that includes a determination of the fair maket value of the property) within 90 days after the date of the sale. In this case, MidFirst did not pursue the required action.
In response the debtor’s argument that this precluded MidFirst from asserting a deficiency claim in the bankruptcy, MidFirst made various arguments, including that (1) it could not have pursued the action since the relief from the automatic stay only allowed it to exercise its in rem rights with respect to the property, and did not authorize it to take any action against the debtor personally, and (2) the proof of claim it filed in the bankruptcy proceeding served as an “action” sufficient to preserve its deficiency claim.
The court disagreed on all counts. Given the very broad nature of the relief from stay, it was the court’s expectation that MidFirst could pursue all actions relating to the foreclosure proceedings, including any action required to establish the deficiency. With respect to the proof of claim, it was not sufficient to satisfy the statutory requirement for an action. Among other things, MidFirst waited for over a year after the foreclosure proceeding to amend its proof of claim to reflect the results of the sale.
In considering the proper treatment of the claim in a bankruptcy, the court noted that under Section 502(b)(1) of the Bankruptcy Code, a claim is disallowed to the extent it is unenforceable under non-bankruptcy law. Here the anti-deficiency statute was applicable non-bankruptcy law, and has been interpreted as a statute of repose (meaning that if the statutory requirements are not met, a valid cause of action no longer exists, as opposed to merely extinguishing the right to proceed). So, the claim was properly disallowed under the Bankruptcy Code.
The court also found that the issue of a deficiency claim was resolved as part of a settlement of the adversary proceeding regarding rents. So, MidFirst was also barred by res judicata.
As this case makes clear, although obtaining relief from the automatic stay does not mean that a lender is free from the requirements and limitations of bankruptcy (see Mortgagees Beware: Stay Relief Does Not Mean You Are Home Free), it also means that the lender must be cautious and consider the effect of state law that was previously not relevant due to the automatic stay.
Vicki R. Harding, Esq.