After a mortgagee obtained relief from the automatic stay so that it could foreclose its mortgage in state court, it returned to the bankruptcy court to assert a deficiency claim. The debtor objected on the basis that claim splitting was prohibited. The bankruptcy court ruled against the debtor, the district court reversed, and the mortgagee appealed to the Seventh Circuit.
The debtor and a non-debtor party were jointly and severally liable on a bank loan secured by a mortgage. After they defaulted, the bank commenced a foreclosure action in state court.
The debtor filed bankruptcy, temporarily halting the foreclosure action. However, the bank requested relief from the automatic stay and the bankruptcy court entered an order granting “full and complete relief from the Automatic Stay of Section 362 to permit [the bank] to proceed with the pending State Court foreclosure litigation with respect to the property … as more particularly described in the Motion for Relief.”
The property was sold and the sale confirmed in the state foreclosure action. The sale proceeds are insufficient to satisfy the loan. Although originally the bank asked for a deficiency judgment against both borrowers, after the sale it obtained a deficiency judgment against the co-borrower but not the debtor (i.e. the judgment against the debtor was only in rem, not in personam).
The bank did not object to the omission of a state court deficiency judgment against the debtor. Instead, it filed a claim for the deficiency in the bankruptcy court. The debtor objected, arguing that the state court judgment extinguished the bank’s claim based on the doctrine of claim preclusion: the judgment against the debtor could have included the deficiency, and state law does not allow single claims to be split into multiple actions.
After the bankruptcy court denied the debtor’s motion, the debtor took an interlocutory appeal to the district court. The district court reversed, and the bank appealed to the Circuit Court.
Unlike the district court, the Circuit Court’s jurisdiction is limited to final decisions. So, a threshold question was whether it had jurisdiction to hear the appeal. Ultimately the court concluded that the district court’s order was final even though the bankruptcy court’s order was not, and under these circumstances the appeal was proper.
Turning to the merits, the court concluded that the primary consideration was whether the bank could have sought further relief in the state court under state law, as opposed to the scope of the automatic stay. And under state law, a party is required to present all of its theories arising from one transaction in a single proceeding – i.e. claim splitting is not allowed.
Specifically, the court reviewed state cases holding that if a creditor does not seek a deficiency judgment in a foreclosure action it cannot later seek a deficiency in a different proceeding. In response, the bank argued that there were state decisions characterizing the mortgage and note as separate transactions, which meant that a creditor could sue on them separately.
However, the court noted that if a creditor presents both the mortgage and note in a single case and fails to seek a deficiency judgment on the note, it is precluded from doing so in a separate action. In this case the bank filed a two count complaint: count one related to the mortgage and count two related to the note. Thus, the Seventh Circuit concluded that the bank would no longer be able to obtain a deficiency judgment in state court (since it failed to obtain a judgment in the foreclosure action). In the court’s view this position should be given full faith and credit in the federal courts.
The bank’s next response was that the state court judgment was not final (since “after all, it leaves dangling the complaint’s request for deficiency judgment” against the debtor). If the judgment was not final then it was not preclusive.
However, the Seventh Circuit noted that state cases treat a foreclosure action as finally decided as soon as the court enters an order approving the sale and directing distribution. It had been almost 4 years since the state court judgment was entered with no hint that the state court considered its job unfinished.
With respect to the effect of the automatic stay, the Seventh Circuit emphasized that the stay does not concern jurisdiction. If the bank had asked the state court for an in personam deficiency judgment against the debtor, the state court might have granted it. Regardless it would not have declared that it lacked jurisdiction. Besides, the court pointed out that even federal statutes that provide for exclusive jurisdiction do not override giving state court judgments full faith and credit.
Bankruptcy courts have the option of relinquishing authority in favor state courts. Allowing the state court to find the debtor liable would not have interfered with the bankruptcy case, although the claim would still need to go to the bankruptcy court for resolution of any disputes about priority and discharge.
Here the bank “had its chance in state court and did not use it.” Accordingly, the bank was precluded from pursuing a deficiency claim in bankruptcy court.
Bankruptcy courts can be very touchy about violations of the automatic stay. It would not be unreasonable for the bankruptcy court to allow the creditor to pursue its collateral while retaining control of all actions relating to the debtor itself. However, it behooves the creditor to be absolutely clear on the scope of any relief from the stay. Otherwise it may find that it lost an opportunity to pursue the debtor as happened in this case.
Vicki R Harding Esq.