The bankruptcy court disallowed the claim of a deed of trust creditor on the grounds that it was barred by the applicable state anti‑deficiency statute. The creditor contended that it was entitled to treat its non-recourse loans as recourse loans under the Bankruptcy Code, which trumped the anti‑deficiency statute.
The debtor acquired an apartment building subject to two pre-existing loans secured by the property. The acquisition was financed by the seller through a “wraparound” note and mortgage, which covered the first two loans, and an additional new loan.
The seller was actually a trust controlled by another individual (Behrend). Behrend filed a chapter 11 bankruptcy, which was converted to a chapter 7 bankruptcy. Subsequently the buyer and her spouse filed their own chapter 11 bankruptcy. Behrend’s chapter 7 trustee filed a secured proof of claim in the buyer’s bankruptcy for the total amount due under the wraparound loan and the additional loan.
Postpetition the successor bank that held the first loan obtained relief from the automatic stay so that it could foreclose under its first priority deed of trust. The proceeds from the foreclosure sale were sufficient to pay off the first and second loans, with surplus funds left over that were available to make a partial payment on the seller’s loan.
The seller’s chapter 7 trustee then filed an amended proof of claim for the unpaid balance as an unsecured claim. The debtors filed a motion to disallow this claim on the basis that the trustee could not file an unsecured claim for any deficiency remaining after the foreclosure since it was barred by applicable state law.
In response the trustee argued that Section 1111(b)(1) of the Bankruptcy Code overrides state anti-deficiency laws. Under that section, “a claim secured by a lien on property of the estate shall be allowed or disallowed under section 502 of this title the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse” unless (1) there is a class election for different treatment or (2) if the property is sold under a Section 363 sale or a plan of reorganization.
The key issue was whether the seller held a claim secured by property of the estate that would support application of Section 1111. The debtors argued that subsequent to the foreclosure sale the property was no longer part of the bankruptcy estate. Thus, the seller’s claim was no longer secured. The seller countered that the reference to determining a claim under Section 502 invoked the requirement in Subsection (b)(1) that the claim be determined as of the date of the bankruptcy filing.
Admittedly, as of the petition date the property was still part of the bankruptcy estate and thus the claim was secured by property of the estate. However, that was no longer the case. The court noted that the few cases that addressed this issue rejected the seller’s position. Instead, they held that once stay relief was obtained and the property was sold at a foreclosure sale, the claim secured by a lien on bankruptcy estate property was extinguished so that Section 1111(b) was no longer available. The 5th Circuit issued an opinion to this effect, and the court noted decisions of the 7th and 2nd Circuits that were consistent with this analysis.
In the court’s view: Under state law, the liens were extinguished as a necessary result of the foreclosure sale. While the original proof of claim might properly reflect a secured claim, once the sale occurred the liens were eliminated as a matter of law. And the unsecured deficiency was unenforceable under the state anti‑deficiency laws. Consequently, the court upheld disallowance of the claim.
Sometimes it can be difficult to keep track of the status of secured claims in a bankruptcy given the number of ways in which the Bankruptcy Code modifies or regulates those claims.
Vicki R. Harding, Esq.