Wraparound Mortgages: Sorting Things Out

In re Tejeda, 586 B.R. 831 (Bankr. W.D. Tex. 2018) –

In connection with acquisition of real property a debtor executed a wraparound mortgage in favor of the sellers. The original note and deed of trust executed by the sellers remained outstanding at the time the debtor filed a chapter 13 bankruptcy. The trustee objected to the proof of claim filed by the holder of the sellers’ mortgage loan.

The court described a wraparound mortgage as follows:

[A] subsequent and subordinate mortgage secured by real property upon which there exists a first mortgage that is outstanding and unsatisfied. The purchase money wraparound mortgage differs from a conventional second mortgage in that the wraparound seller in the transaction remains personally liable under any prior obligation, but the purchaser never becomes personally obligated for such.

The sellers had executed a note and deed of trust in favor of a lender that was subsequently assigned to a bank. In connection with their sale of the property to the debtor, the debtor executed a note and a Deed of Trust to Secure Assumption in favor of the sellers with a five year balloon payment. The debtor was required to make payments to the sellers that were to be used to satisfy the sellers’ obligations under the original mortgage loan. However, the debtor did not have any contractual obligation to the bank, nor did she have privity to the contract between the sellers and their lender.

Although the original mortgage loan had a due on sale clause, there was no evidence that the bank contested the sale, and it did not object to the debtor’s treatment of its claim under the debtor’s chapter 13 plan.

The trustee’s sole grounds for objecting to the bank’s claim was that since the debtor was a stranger to the contract between the sellers and their lender, the bank could not be forced to participate in the debtor’s bankruptcy. In other words, according to the trustee the lack of privity between the debtor and the bank made the bank’s claim invalid.

In response, the debtor argued that her interest in the property became part of the bankruptcy estate, and privity to the bank was not required for the transaction between the sellers and the debtor. In particular, the debtor argued that the due on sale clause in the sellers’ original loan documents could not prevent alienability under state law, and consequently the sale to the debtor was valid. The bank also responded and generally denied everything in the trustee’s objection. It further emphasized that it consented to the proposed treatment of its claim in the debtor’s plan and wished to participate in the bankruptcy.

The court rejected the argument that privity was required as a condition for the bank’s participation in the bankruptcy. As a starting point, the trustee argued that the bank was not a “creditor” because it did not have a “claim against the debtor.” However, the court pointed out that section 102(2) of the Bankruptcy Code states “‘claim against the debtor’ includes claim against property of the debtor.” In this case the bank held a lien against the debtor’s property that secured a right to payment.

The court also agreed with the debtor’s argument that Supreme Court precedent establishes that Congress intended “claim” to be as broadly defined as possible. In the case cited by the debtor (Johnson v. Home State Bank) the Supreme Court held that the discharge of a debtor’s personal liability for a mortgage loan in one bankruptcy case did not prevent the mortgagee from having a claim in a subsequent bankruptcy case based on its surviving in rem rights.

The trustee cited two cases in support of its position. The first case involved a mortgagee seeking to enforce its right to foreclose based on violation of a due on sale clause. Since the debtor obtained the property in violation of the due on sale clause, it was not permitted to cure the mortgage defaults in a chapter 13 plan over the objection of the mortgagee.

The second case also involved a mortgagee’s objection based on its contention that the transfer of property to the debtor in violation of a due on sale clause was improper. The court in that case held that permitting the debtor to include the mortgage in its plan was an improper modification of the mortgagee’s right to enforce the due on sale clause.

The court distinguished these two cases as focusing on the impediment of a creditor’s rights. In this case the mortgagee not only did not object, but affirmatively expressed its desire to be included in the case.

The court further noted that section 502(b)(1) provides that a claim should be allowed unless “such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured.” In other words, even if a claim is unenforceable against the debtor, it should be allowed if it is enforceable against property of the debtor – as was the case here.

Accordingly, the court denied the trustee’s objection.

Circumstances involving a distinction between personal and in rem rights and liabilities – such as wraparound mortgages and “nonrecourse” loans – can be confusing. It is important to remember that under the Bankruptcy Code “claim against the debtor” is a term of art that includes a claim against the debtor’s property even if the debtor has no personal liability.

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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