A deed of trust creditor filed a claim in a Chapter 11 case contending that its nonrecourse loan was entitled to treatment as a recourse loan under section 1111(b) of the Bankruptcy Code. The bankruptcy court ruled against the creditor, agreeing with the debtors that the claim was barred by a state anti-deficiency statute. The bankruptcy court decision was affirmed by the 9th Circuit Bankruptcy Appellate Panel (BAP), and the creditor appealed to the 9th Circuit.
The underlying facts are outlined in a prior post discussing the BAP decision (Non-Recourse Loans: Turning into Recourse and Back Again). Suffice it to say that property was sold to the debtors subject to a senior mortgage loan. The purchase was financed by a wraparound mortgage note and a new purchase money note secured by deeds of trust on the property, which were held by a junior deed of trust creditor at the time the debtor-buyers filed bankruptcy.
Shortly after the junior creditor filed timely proofs of claim for its deed of trust loans, the bankruptcy court approved a stipulation between the debtors and the senior lienholder lifting the automatic stay so that the senior lienholder could foreclose on the property. After the foreclosure sale the balance of the sale proceeds were turned over to the junior creditor.
The proceeds were sufficient to pay the wraparound note in full, but only part of the purchase money note. The junior creditor filed an amended claim in the amount of the deficiency, continuing to assert that it was entitled to full recourse status based on section 1111. This section provides:
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:
(i) the class of which such claim is a part elects [alternate treatment under another subsection]; or
(ii) such holder does not have such recourse and such property is sold under section 363 of this title or is to be sold under the plan.
The only condition for potential treatment as a recourse claim is that the claim be “secured by a lien on property of the estate.” The debtors argued that since the property had been sold at the foreclosure sale the junior creditor no longer had liens on property of the bankruptcy estate. Thus, it was not entitled to convert its nonrecourse loan into a recourse loan. The junior creditor responded that claims must be determined as of the date a bankruptcy is filed, and on the filing date it held the required liens.
The 9th Circuit noted that the Supreme Court has made it clear that courts should apply the Bankruptcy Code as written unless the result would be absurd. In this case the plain language provides that section 1111(b) cannot apply if there is no lien on estate property. Further, this result is sensible given the context.
Although the debtor is not electing to sell the property when there is a foreclosure sale (as would be the case if the property was sold in a section 363 sale or under a plan of reorganization, as provided in the exception to section 1111(b)), the purpose of this section is to “‘put the chapter 11 debtor who wishes to retain collateral property in the same position as the person who purchased property ‘subject to’ a mortgage lien would face in the non-bankruptcy context.'”
In this case since the debtors were not retaining the property the court concluded that there was no reason to give the junior creditor protection under section 1111. The junior creditor got exactly what it bargained for: a senior creditor foreclosed, extinguishing the junior liens, leaving the junior creditor without recourse to pursue a deficiency claim.
Consequently, the court held that if a claim ceases to be secured by a lien for any reason a creditor can no longer transform a non-recourse claim into a recourse claim under section 1111. The court also noted that the junior creditor could have objected to the automatic stay relief if it was concerned that its rights would not be adequately protected in the foreclosure sale – and the junior creditor made no such objection.
Although not a foregone conclusion, the court’s decision is not terribly surprising. However, the court’s admonition that the junior creditor could have objected to the automatic stay relief leaves one wondering what arguments it could have made that could have changed the result.
Vicki R Harding, Esq.