A chapter 7 trustee objected to the unsecured deficiency claim of a mortgage lender that remained after the lender obtained relief from the automatic stay and proceeded with a foreclosure. The trustee contended that the claim should not be allowed because the lender did not comply with a state law requirement that an action must be commenced within 90 days after a non-judicial sale to preserve the deficiency claim. The bankruptcy court overruled the trustee’s objection, and on appeal the bankruptcy appellate panel affirmed.
The lender filed a proof of claim in the chapter 7 bankruptcy proceeding for ~$740,000, stating that the property was valued at $370,000 (as supported by an appraisal). As a result, the claim was treated as a secured claim for $370,000 and an unsecured claim for ~$370,000. After obtaining relief from the automatic stay, the lender purchased the property at a non-judicial foreclosure sale for $370,000. Under state law, the lender was required to commence an action to recover a deficiency judgment within 90 days after the sale in order to preserve its deficiency claim. The lender did not do so in this case.
As discussed in a prior blog post, under similar circumstances a bankruptcy court upheld an objection to the lender’s deficiency claim based on the effect of the same state law (see What Comes After Stay Relief: The Disappearing Deficiency Claim (Round 1)). That court (1) concluded that the stay relief would have allowed that lender to bring the state deficiency action, and (2) relied on Section 502(b)(1) of the Bankruptcy Code, which provides that a claim is not allowed if it is unenforceable under other applicable law, as support for its holding that the deficiency claim should be disallowed since it was no longer valid under state law.
The Rader courts took a diametrically opposite approach. To start with, the bankruptcy appellate panel found that it was impossible for the lender to comply with the state statute: (1) Proceeding against the debtors would have violated the automatic stay, and (2) shortly after the foreclosure sale the debtors were granted a discharge, so that filing a deficiency action would have violated the discharge injunction.
In contrast to the Round 1 case, the Rader BAP court found that the automatic stay order was ambiguous: The authorization to take “any and all steps” to recover on the indebtedness could be interpreted to authorize the deficiency action, while the reference to conducting a non-judicial foreclosure sale without mentioning a deficiency action could be read as limiting the authorization to foreclosure. Given that orders lifting the stay should be strictly construed, the court determined that the deficiency action was not authorized under the relief from stay.
However, on a broader note, the court concluded that the state statute was preempted by the Bankruptcy Code. As background, the court noted that preemption can be either express or implicit. Nothing in the Bankruptcy Code explicitly preempted the applicable state statute, so the issue was whether it was implicitly preempted.
The court outlined two types of implied preemption: field preemption and conflict preemption. Field preemption is when federal law “so thoroughly occupies a legislative field as to make reasonable the inference that Congress left no room for the States to supplement it.” Conflict preemption is applicable to the extent that federal law actually conflicts with any state law. The court found that field preemption was not applicable, since Section 502(b)(1) specifically acknowledges that a claim can be disallowed because it is unenforceable under state law.
This left conflict preemption. The court viewed this as determining whether (1) compliance with both federal and state requirements was impossible, or (2) “in light of the federal statute’s purpose and intended effects, state law poses an obstacle to the accomplishment of Congress’s objectives.”
The court concluded that both types of conflict preemption were present. As noted above, the automatic stay and the discharge injunction made it impossible for the lender to comply. In addition, requiring the lender to file an action in state court “poses an obstacle to Congress’ objectives in creating the Bankruptcy Code’s comprehensive, centralized claims resolution process in its framework for determining the validity and secured status of claims.”
In considering the bankruptcy claim process, the court noted that “claim” is broadly defined and includes unliquidated and contingent claims. The court characterized the status of the lender’s claim prior to the foreclosure sale as a secured claim for an amount equal to the value of the property, and an unsecured claim for the deficiency if any. Although the unsecured claim was unliquidated and contingent before the sale, it was still valid. After the sale, the unsecured became liquidated and non-contingent. However, this change did not affect the validity of the deficiency claim. Since the state statute mandated a different conclusion than the Bankruptcy Code, it was preempted.
Bankruptcy lawyers say that you can usually find a case to support either side of a proposition. This can be useful when you are looking for authorities to support a particular argument in court. It is less useful when you are trying to counsel a client on a course of action that will survive future court review. When advising clients on bankruptcy risks, it is helpful to keep this point in mind.
Vicki R. Harding, Esq.