A creditor made two prepetition loans to a chapter 13 debtor for payment of delinquent real estate taxes. The loans were supposed to be secured by the debtor’s homestead, but no mortgages were executed. The creditor filed an adversary proceeding in bankruptcy court seeking a determination that she held a valid first mortgage on the property, or alternatively requesting specific performance of an agreement to execute a mortgage.
The debtor borrowed $9,400 from the creditor in 2011 and $6,300 in 2012 to pay delinquent real estate taxes in order to prevent sales of the property. Both loans were memorialized in promissory notes that included language referring to the fact that the loans were supposed to be secured:
Such amount owing shall be secured as a lien upon the property owned by Borrower located at [address]… This note is secured by a mortgage on real estate of even date herewith, and shall be construed and referenced accordingly.
However, the debtor never executed any mortgages. (The court noted that the creditor prepared the documentation “apparently based on her twenty years of experience as a paralegal.”) According to the debtor, notwithstanding the language in the notes, the creditor “never approached nor discussed with the Debtor anything about executing a mortgage on his homestead as security for payment of the notes.”
The court began its analysis by noting that the state homestead exemption was to be liberally construed, while any exceptions were to be strictly construed. The primary exceptions were obligations (1) arising from property taxes and assessments, (2) for purchase, improvement or repair, and (3) “house, field, or other labor performed on the property.”
In addition, case law provides for equitable liens in certain situations. The primary circumstance is where the homestead is used as “an instrument of fraud or imposition upon creditors.” The leading case in this area involved a husband who fraudulently obtained a loan to satisfy pre-existing mortgages. In that case the court imposed an equitable lien against the wife’s interest even though she did not participate in the fraud. This was justified in part based on equitable subrogation of the lender to the prior liens.
Another circumstance involves contracts that demonstrate an intent to charge a particular homestead with a debt. In one case a borrower delivered a letter promising to give a lender a second mortgage on specific property to secure a loan just before dying in an airplane accident. Although the borrower died before executing a mortgage, the court granted an equitable lien.
Given this precedent, the court determined that an equitable lien could be imposed even though the mortgages were never actually executed based on the intent to grant mortgages reflected in the notes. This result was also supported by equitable subrogation, since the loans were used to pay real estate taxes.
Although the court would not necessarily have agreed to allow an equitable lien based on the reference to a nonexistent mortgage in the second sentence of the quote above, it found the language in the first sentence that the loans “shall be secured as a lien upon the property” to be sufficient.
The debtor responded by citing rules of construction, including the rule that a court of equity “should be mindful of the maxim: ‘neither law nor equity favors the negligent, nor do they hold out a premium to the careless,…’” However, the court concluded that negligence was not a defense to the equitable lien. In essence, most equitable liens will involve some degree of negligence.
Accordingly, the court granted the creditor’s motion for an equitable lien.
Note that this is a dispute between the debtor and his creditor and does not involve the Chapter 13 trustee. Although a Chapter 13 trustee can exercise the strong arm powers of a bona fide purchaser of real estate as of the commencement of the case – and thus probably could have avoided the equitable lien since it was unrecorded – that is not an option available to a Chapter 13 debtor. This is in contrast to a Chapter 11 debtor-in-possession, which is given most of the rights of a trustee, including the strong arm powers under Section 1107 of the Bankruptcy Code.
Vicki R. Harding, Esq.