Deficiency Claims: State Law Procedures Can Safely Be Ignored … Or Not

Melikian Enterprises, LLLP v. McCormick, 863 F.3d 802 (8th Circuit 2017)

Individual chapter 11 debtors objected to a proof of claim filed by a deed of trust creditor for the deficiency remaining after a trustee’s sale of their property. The debtors contended that the creditor was not entitled to a deficiency claim because it did not comply with state law, while the creditor argued that the state requirements were not applicable. The bankruptcy court sustained the debtors’ objection; the district court affirmed; and the creditor appealed to the Eighth Circuit.

A company (Centennial) owned by the debtors bought several parcels of property from the creditor with seller financing. Centennial signed a note for $6,475,000, which was guaranteed by the debtors and secured by a deed of trust on the purchased property. After Centennial defaulted, the creditor sued Centennial and the debtors to recover the balance owed, or alternatively, to recover any deficiency remaining after a trustee’s sale.

The debtors filed bankruptcy and listed an unsecured debt owing to the creditor. Subsequently the creditor purchased the property at a trustee’s sale with credit bids totaling $444,000. In the meantime, the creditor never effected service on Centennial and the debtors, so the state court action was dismissed.

The creditor filed a proof of claim for ~$6.4 million pursuant to the guarantee. The debtors objected that the claim did not reflect the market value of the property securing the debt, so the court scheduled a hearing. While the hearing was still pending the court confirmed the debtors’ plan and the case was closed as fully administered – although it was reopened the next day on motion from another creditor.

A state statute provided that if there was no action for a deficiency judgment within the applicable time, the proceeds of a trustee sale were deemed to be full satisfaction of the debt secured by the property and there would be no right to recover a deficiency. Eventually the debtors moved for summary judgment on the grounds that the creditor’s deficiency claim was barred by state law since the creditor failed to maintain a deficiency action within 90 days of the trustee’s sale.

In ruling in favor of the debtors, the bankruptcy court noted that the creditor’s entitlement to a deficiency was determined under state law. Although the state statute referenced commencing an action within 90 days of the sale, the court concluded the original case filed prior to the sale would have been sufficient if it had been pursued. However, it was dismissed for failure to obtain service.

The bankruptcy court rejected the creditor’s argument that state law was preempted by the Bankruptcy Code. Allowance of a claim is determined under the Bankruptcy Code, but state law determines whether a right is created in the first place. The Code did have an impact because the deadline for bringing a deficiency action was modified by section 108(c) of the Code.

Under section 108 the deadline was extended to the later of (1) 90 days after the trustee’s sale (the nonbankruptcy deadline) and (2) 30 days after expiration of the automatic stay with respect to the property. The bankruptcy court held that under section 362(c) the stay expired on the date the bankruptcy case was closed. The fact that it was reopened the next day was irrelevant. So, the deadline was 30 days after the initial closing of the case. The only action the creditor took by that date was filing the original complaint, was not sufficient since it was dismissed. Accordingly, the bankruptcy court disallowed the creditor’s deficiency claim.

On appeal, the creditor argued (1) the Bankruptcy Code preempted state law, so it did not have to comply with state law to preserve its claim; (2) in any event its state court action was sufficient; (3) the bankruptcy court’s exclusive jurisdiction precluded the need for separate state court deficiency action; and (4) the limitations period in the state statute never lapsed.

The Eighth Circuit reviewed the requirements for preemption (direct conflict or federal law so pervasive it shows an intent to occupy the field), noting the reluctance to find implied preemption, and found there was no preemption. Among other things, “the basic federal rule in bankruptcy is state law governs the substance of claims.”

In response to the argument that the creditor was prevented from filing a deficiency case in state court, the court noted the effect of section 108(c), which extended the state law deadline until after the automatic stay terminated. The creditor next argued that reopening the case the day after it was closed meant that the stay was reinstituted. However, the court noted that once the stay expires in connection with closing the case, it is not automatically reinstated if the case is reopened.

In response to the argument that the state court case was sufficient, the Eighth Circuit concluded that it was not necessary that the deficiency case be instituted after the trustee’s sale, nor was it mandatory that the creditor did not amend the complaint to allege a deficiency after the sale. However, it was fatal that the lawsuit was not “maintained.”

Finally, the court rejected the argument that the bankruptcy court had exclusive jurisdiction, so it was not necessary to file a case in state court, because bankruptcy courts are directed to determine whether a claim was allowed in accordance with “applicable law,” which includes state law.

Thus, the Eighth Circuit affirmed the decision below disallowing the creditor’s deficiency claim because it failed to meet state law requirements.

Bankruptcy courts take the automatic stay very seriously, so there is good reason to take a conservative approach. However, it is important to be knowledgeable about the interaction between the automatic stay and nonbankruptcy deadlines. This case provides a good illustration of the possible consequences of failing to understand the nuances.

Continuation of UCC financing statements is another example. Originally an argument could be made that filing a continuation statement was a violation of the automatic stay. But in 1994 section 362(b)(3) was amended to add an exception from the stay for actions “to maintain or continue the perfection” that qualified under section 546(b) – the net effect being that it became clear that filing a UCC continuation statement did not violate the stay. Lenders who were not cognizant of this change and failed to file timely continuation statements were left with unperfected security interests.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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