Articles Posted in Bankruptcy

When Lien Strips Attack

As a Bankruptcy lawyer I can’t count how many times people have asked why Courts won’t reduce their mortgage debt to match the deflated value of their home, or why they should pay anything on that second mortgage, line of credit, or HELOC, when they’re underwater. I even discussed these questions and the state of the law concerning lien strips in this post. Now, the very cases referred to in that post have made it to the U.S. Supreme Court and the stage is set for the battle of the lien strip cases.

Of course this all started with the Supreme Court’s 1992 Opinion in Dewsnup v. Timm that the Bankruptcy Code does not permit the cramdown of a partially secured mortgage. Some Courts took this to mean that lien-strips are a no-no. Others interpreted it to mean that lien-strips were permissible under the right circumstances. So in some parts of the country a completely unsecured second mortgage can be stripped, but only in a Chapter 13 reorganization; while in other parts it can be stripped in a Chapter 7 liquidation, too.

So, with Courts in disagreement, what’s a home-owner to do? Remember, in Dewsnup the Court ruled the Bankruptcy Code doesn’t permit mortgages to be written down to the value of the home – even though that practice, known as the cram down,  is acceptable as to vehicles. Ironically, one of the Court’s primary concerns in Dewsnup was to prevent windfall gains to home-owners who strip away their loans, then enjoy the profits as their homes rise in value.

But that didn’t exactly happen, did it? These days, most people’s homes are more a burden than a boon. Luckily the Supreme Court has agreed to take another look at the question. And just in time: being underwater with your 1st mortgage while having an unsecured 2nd is the new normal. And nowhere is that more true than in Florida where both cases to be consolidated and heard by the Court, Bank of America v. Caulkett and Bank of America v. Toledo-Cardona, started off as Chapter 7 Bankruptcies.

In a nutshell, the issue to be decided is whether, in a Chapter 7, partially secured mortgages can be written down and unsecured ones written off, despite the Supreme Court’s Dewsnup decision. Here, Florida home-owners filed Chapter 7 and were allowed to strip their unsecured second mortgages. That decision by the Bankruptcy Court was affirmed by the Federal District Court as well as the 11th Circuit Court of Appeals. Bank of American now wants the Supreme Court to outlaw Chapter 7 lien strips once and for all.

Stay tuned to this station as the case goes up for argument and decision. We’ll bring you the opinion as soon as it’s available.

Your Turn

Want to share your thoughts on the largest municipal Bankruptcy in U.S. history? Need to discuss your own situation? Call us in confidence at 630-378-2200 or reach us via e-mail at mhedayat[at]mha-law.com.

Detroit SkylineThe Announcement

Recently Steven Rhodes, the Judge tasked with managing the largest municipal Bankruptcy in American history, cleared Detroit to emerge from reorganization and put to bed a series of hard-fought battles between creditors, citizens, employees, and pension recipients. Before approving the move though, Judge Rhodes issued a heart-felt plea to all involved: “move past your anger” and “fix the Motor City. What happened in Detroit must never happen again.” He also observed that “Detroit’s inability to provide adequate municipal services… is inhumane and intolerable, and must be fixed.”

Politicians and civic leaders, including Michigan’s Republican Governor Rick Snyder, hailed Friday’s decision as a milestone and a “fresh start” for the Motor City. Indeed, it was Snyder who originally agreed with State-appointed Emergency Manager Kevyn Orr to take the City into Chapter 9: a last-resort he had promoted during his re-election campaign.

Lightning Fast Recovery

By Bankruptcy standards Detroit’s case finished in a flash thanks to a series of deals between the City and major creditors, especially retirees who agreed to smaller pension checks (after the Judge reminded them that they had no protection under the Michigan Constitution) and bond insurers who relented on their push to sell the City’s art collection despite being owed more than $1 Billion. By contrast it took more than 2 years for Stockton, California to get out of Bankruptcy, while tiny San Bernardino is still operating under Chapter 9 more than 2 years after filing.

An Innovative Plan

Detroit’s Plan of Reorganization involves cutting pensions of non-public-safety retirees by 4.5%, completely discharging $7 Billion of debt, and spending over $1.7 Billion to demolish blighted buildings and improve basic services. In particular, Judge Rhodes praised the way contentious issues in the Plan were resolved: such as the deal to avoid selling artwork from the Detroit Institute of Arts, and to keep pension cuts from getting worse. In fact, while he said the pension deal bordered on “the miraculous,” he acknowledged that the necessary cuts would cause hardship for the many who would now have to get by on less than $20,000 a year.

Ultimately Judge Rhodes had to accept or reject Detroit’s Plan in full rather than cherry-picking sections. He relied on the advice of an expert, who deemed the Plan “feasible” and predicted that its success would depend on the fiscal skills of the Mayor and City Council, as well as a City Hall technology overhall. Maybe the most unusual feature of the Plan was its reliance on $816 Million put up by the State, foundations, philanthropists, and the Institute of Arts, in order to forestall even deeper pension cuts and avert the sale of art – a step the Judge warned “would forfeit Detroit’s future.”

What Went Wrong In The First Place

In retrospect, perhaps this was inevitable. After all, Detroit’s economy was clearly at the center of a “Perfect Financial Storm” consisting of municipal corruption, fiscal mismanagement, the long, slow decline in the auto industry, and widespread urban flight that strangled the population from 1.2 Million to 688,000 by 1980, turning whole neighborhoods into boarded-up wastelands. Adding insult to injury, despite encompassing more square mileage than Manhattan, Boston, and San Francisco combined, Detroit couldn’t even count on sufficent tax revenue to cover pensions, retiree benefits like health insurance, and debt service on funds borrowed to meet its budget burden. Still, the nail in Detroit’s coffin was the horrible debt deal made by former Mayor Kwame Kilpatrick, which locked it into paying high rates on its debt even as interest rates fell during the recession

Light At The End of The Tunnel

Detroit Regional Chamber President and CEO Sandy K. Baruah declared Detroit to be “on the cusp of a new era and primed to reinvent itself in a way many people did not think possible.” True. But what really matters is that the Motor City has a new direction and a long, hard, clean-up job ahead. Sure, Bankruptcy was the catalyst for change, but only the City and its residents – businesses, individuals, religious institutions, and government – can affect real change. Here’s hoping, Detroit. We’re all pulling for you.

Your Turn

Want to share your thoughts on the largest municipal Bankruptcy in U.S. history? Need to discuss your own situation? Call us in confidence at 630-378-2200 or reach us via e-mail at mhedayat[at]mha-law.com.

Gift CardIn the recent case of Beeman et. al. v. Borders Liquidating Trust et al. from the Circuit Court for the Southern District of New York decided on October 29, that Court examined what ought to happen when relief that could be granted, for practical reasons is not.

This controversial policy, referred to as “Equitable Mootness” means certain judgments will not be issued – even though they could – because doing so upsets the established order in a Bankruptcy case. It is obviously a touchy subject, but squarely within a court’s discretion.

Here, more than $17 Million had been distributed to creditors of Borders Bookstores in its Chapter 11 reorganization when 3 of its customers whose store gift cards became useless when it went bankrupt sought to be placed in a special “class” of claimants. The Plaintiffs started in the Bankruptcy Court but did not get traction there, so they proceeded in District Court.

In the Bankruptcy case below, the Court determined due to a variety of factors, including timing of the claims and the stage reached in the case, that Equitable Mootness should kick in.  The District Court agreed and clarified that the doctrine applied not only to ongoing reorganizations but to the ones, like this, that ended in liquidation – a s0-called “Liquidating 11.”

In its Opinion the District Court did point out the exceptions to the Equitable Mootness doctrine articulated in the 1993 case of Frito‐Lay v. LTV Steel(In re Chateaugay Corp.). But the Court also made it clear that this situation did not satisfy those conditions.

In the end, the decision in this case was complex, as were the legal principals, but the basic idea could be reduced to this: if you are a creditor in a Bankruptcy , act fast, be timely, and don’t let up. If you can’t do that, stay home and save yourself the Attorneys’ fees.

If you are a Creditor in a Bankruptcy case, call us in confidence at 630-378-2200 or via e-mail at mhedayat[at]mha-law.com.

Money Fight

So you’re doing business as usual and notice that payments from your customer are getting later and later. Turns out that customer is struggling to navigate in the sputtering economy. Waiting for your money is bad enough; but what if you receive a demand to refund what you’ve been paid? And not because of anything you’ve done but because your customer has filed for Bankruptcy?

Sound like a nightmare? Actually, it happens everyday. So what do you do if you’re next? That was the question addressed in the recent New York case of Davis vs. Clark-Lift, in which a reorganizing Chapter 11 Debtor paid vendors later and later as it listed towards Bankruptcy. But even those lucky creditors who got paid could not escape the demand of the Trustee (Davis) to fork over what they had received.

As the Court in Davis explained, to set aside a payment as a “Preferential Transfer” under Section 547(b) of the Bankruptcy Code the moving Creditor or Trustee must established that the Debtor made it:

(1) To an  existing creditor to satisfy an existing debt;
(2) While it was actually, or presumptively, insolvent;
(3) Within 90 days before filing its Bankruptcy case; and
(4) The payee therefore gets more than it otherwise would.

So if you got paid within 90 days before your customer filed Bankruptcy, it’s all over right?

Not exactly. Even if a payment qualifies as a Preferential Transfer the recipient can assert defenses. If successful, the payee retains the money. One of the most frequently-used strategies is the “Ordinary Course of Business” defense found in Section 547(c)(2) of the Code, which provides that a payment made in the ordinary course of business will not be avoided as a preference. The idea behind the defense is to permit a reorganizing Debtor to maintain a semi-normal relationship with some creditors: because rebuilding goodwill is key to a successful reorganization.

In the Davis case the Court’s analysis was primarily focused on what the “ordinary course of business” was; which in turn meant determining the most common and frequently-used payment terms for vendors during the relevant 90-day period. This means looking at all vendors at first; then vendors of a certain type; then payments of a certain type; and finally a comparison between terms bef0re the 90-day period began running and afterwards.

The decision in the Davis case, like many similar cases, was that the vendor had to disgorge what it was paid. What would it get in return? Perhaps a return of its goods so it could resell them and offset its losses? Nope. In return for disgorging the payment the vendor got a claim in the Debtor’s case. Most likely, it wouldn’t see the money. So now the vendor was out both its money and its property. Isn’t the law grand?

If you have seen situations like this or are yourself the subject of such a situation, call us in confidence at 630-378-2200 or reach us at mhedayat[at]mha-law.com.

seal_of_the_supreme_court

In June 2013 the US Supreme Court published an opinion arising from a dispute over the estate of Pierce Marshall – better known as the husband of Anna Nichole Smith. That case, Stern vs. Marshall, gave rise to a surprising decision; namely, that Bankruptcy Courts could not rule on the State-law aspects of a dispute even if they were before the Bankruptcy Court as part of the larger dispute. The operative distinction would henceforth come down to whether or not a dispute qualified as a “core proceeding” (i.e. whether it was the kind of question over which the Bankruptcy Court had jurisdiction).

Since the Stern decision was released in 2011, results across the country have often been inconsistent as Bankruptcy Lawyers and Judges attempt to apply this new set of distinctions and decide whether cases should be heard or referred back to the State Courts. In many cases, Bankruptcy Courts defaulted back to State Courts without much discussion.

In an update and clarification to its Stern vs. Marshall Opinion, the Supreme Court recently decided Executive Benefits vs. Ch. 7 Trustee for Bellingham Ins. Agency(Jun. 09). The opinion answered a number of questions that had arisen in the wake of Stern. In particular, the Supreme Court clarified how Bankruptcy Courts should proceed when faced with “core” claims that were now designated as “non-core” under the Stern standard. These claims fall into the so-called “statutory gap” in the Bankruptcy Code.

In its Opinion the Supreme Court observed that 28 U.S.C. §157(c) does in fact permit “Stern” type claims to proceed before the Bankruptcy Court as non-core claims. How? The Supreme Court explained it this way:

With the “core” category no longer available for the Stern claim at issue, we look to section 157(c)(1) to determine whether the claim may be adjudicated as a non-core claim – specifically, whether it is “not a core proceeding” but is “otherwise related to a case under title 11.

In short the Supreme Court determined that, when faced with a Stern claim, the Bankruptcy Court must now decide whether it satisfies the standards of 28 U.S.C. §157(c)(1). If it doesn’t, the Bankruptcy Court could not hear the claim and had to send it back to State Court. If it did however, the the Bankruptcy Court was to “hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.”

Discharging Taxes in Bankruptcy

In response to questions we get over and over, here is our totally unofficial Guide to Discharging Taxes in Bankruptcy. We’ve gathered many of the tried-and-true rules on the topic but beware! The rules and decisions are constantly evolving, so take this guide with a grain of salt and always consult a competent Bankruptcy Attorney before making any decisions. Okay, enough disclaimers. Here it is:

Chapter 7 Liquidation

In a Chapter 7 liquidation Bankruptcy – whether an individual or a business entity – taxes can be discharged as long as:

(1) They relate to a return due 3+ years before a filing;
(2) That tax return was filed 2+ years before the filing;
(3) They weren’t assessed within 240 days before filing;
(4) That return was not fraudulent or frivolous; and
(5) Taxpayer/debtor not found guilty of evading tax laws.

Note: Even if the tax debt in question does not qualify under these criteria, penalties may still be discharged in Chapter 7 if the events that gave rise to the penalties occurred 3+ years before the filing date.

In such a situation the whole claim, including penalties and interest, would be listed on Schedule E and bifurcated into the non-dischargeable and dischargable portions.  The non-dischargeable portion would be listed in the “Amount Entitled to Priority” column of Schedule E, while the dischargable balance would be identified as “non-priority” and listed in the “Amount Not Entitled to Priority” column. The non-priority penalties do not get listed again on Schedule F.

Chapter 13 Reorganization

Taxes that do not qualify for discharge in Chapter 7 can stll be paid over 3 to 5 years in Chapter 13

(1) Interest stops accruing the moment the Chapter 13 bankruptcy is filed so payments are interest-free.
(2) Most tax penalties are treated as non-priority, unsecured debt and typically discharged or 10-15 cents on the dollar or less.
(3) In such case, tax penalties area still bifurcated from the priority tax claim and listed as “non-priority, unsecured” claims.

Note: If a tax lien has been recorded against the debtor’s real or personal property prior to the bankruptcy filing date, then the tax claim should be listed on Schedule D as secured – not on Schedule E as unsecured priority. That lien will be eliminated if there is no equity in the underlying property, or reduced to the present equity value of the debtor’s interest in that property as of the filing date of the case.

Want to know more about tax discharge strategies in Bankruptcy? Contact M. Hedayat & Associates, P.C. for your confidential consultation.

In re MS Valley Livestock

As a rule, debtors ask the Bankruptcy Court to protect them. In return for its iron-clad protection the Bankruptcy Court demands that all rules be obeyed and debtors refrain from hiding or giving away assets that could be used to satisfy creditors.

To ensure that nothing slips through the cracks Bankruptcy law empowers the case Trustee to claw back anything paid or given away by a debtor within 90 days of filing. In essence, Bankruptcy law treats all such transfers as attempts to shed assets. So payments in that period automatically constitute preferential transfers (“preferences”). Preferences can be sucked back into the Bankruptcy Estate by the Trustee; so unsuspecting vendors can be ambushed and forced to give back money they actually earned!

Finally, to make things even more confusing there are exceptions to the preference rule such as payments in the ordinary course of business, a contemporaneous exchange for value, and receiving new value for the payment.

In re Mississippi Value Livestock

In re Mississippi Valley Livestock, decided recently by the 7th Circuit Court of Appeals, involved payments made by the debtor within 90 days of an involuntary bankruptcy filing. But since the debtor had not planned on filing, it would be hard to say that it was purposely trying to get rid of property or playing hide-and-seek with assets. So this was not exactly the kind of case the law was meant to prevent. No, this was one of those cases that pushed the Bankruptcy law to its limits.

The Facts

Mississippi Valley Livestock (“Debtor) was in the business of buying and selling cattle for slaughter. J&R Farms (“J&R”) hired the Debtor to sell its cattle and remit the proceeds – essentially a consignment arrangement. The two entities enjoyed a long, prosperous commercial relationship until the Debtor started to fall behind in payments: first to J&R, then to all its other creditors.

While J&R was prepared to wait for things to turn around, a group of creditors got together and petitioned the Debtor into involuntary bankruptcy; but not before it paid around $900,000 to J&R. The Trustee in the Debtor’s case objected that the constituted a “transfer” of “property of the estate” on account of an existing (i.e. “antecedent”) debt: the dictionary definition of a preference.

Finally, no exception applied because this was not an “ordinary” payment – it represented an extraordinary payment to a particular creditor while the other creditors were poised to get nothing at all. The upshot, said the Trustee, was that the Debtor had chosen to pay J&R with money that should have been used to pay all creditors pro rata.

The Issues

The first issue in the case was whether or not the money paid by the Debtor was really its property, and therefore property of the Bankruptcy Estate. If this was the Debtor’s money, then paying it all to J&R – even though it was owed – was a derogation of the pro rata payment obligation of the Trustee: a Bankruptcy no-no.

But J&R argued that the Debtor was really just giving it back its own property (or at least the proceeds from the sale of that property). So if the sold cattle had never belonged to the Debtor, the proceeds from the sale of those cattle didn’t belong to the Debtor either.  And when the Debtor paid J&R, it was just returning what it didn’t own: certainly, that did not constitute a preference, right?

As usual however, there was a fly in the ointment. The Debtor had placed the proceeds from the sale of J&R’s cattle into the same account it used for other monies. The result was comingling of funds, making them indistinguishable when paid out.

So the second issue in the case was whether the Debtor paying J&R back with the proceeds from the cattle sale (J&R’s own money) or with its operating funds and savings (which should have gone to the Trustee and been distributed to other creditors)?

Bankruptcy Court and District Court Agree: The Proceeds Were Not the Debtor’s Property

 The Bankruptcy Court and District Court agreed with J&R that the Debtor was merely holding the proceeds of the cattle sale as a bailee and did not have a legal or equitable interest in them.  This was especially true because property interests in Bankruptcy are created and defined by State law – not Bankruptcy law. In its evaluation of the case, the 7th circuit does a very thorough analysis of the law on this subject, focusing on the distinction between bailor/bailee relationships and conditional sales in Illinois.  The Court concludes that a bailor/bailee relationship existed here.

Time For A Constructive Trust

While that conclusion could have been the end of the story, in this case it was not. Had the Debtor returned the consigned cattle, there would be no dispute. But here the proceeds were returned to J&R, not the cattle.  The Court concluded that a link had to be found between those cattle and the money returned, or the Debtor would be back in preference territory.

The method used to create that link was the constructive trust – an equitable device in Illinois law that is used when one party has money to which it is not entitled. A constructive trust prevents unjust enrichment of that party. Here, if a constructive trust were construed then the funds in question would never have been part of the Debtor’s Bankruptcy Estate.

Of course a constructive trust actually circumvents the Bankruptcy Code since it prioritizes some creditors over others (which is why it is used so sparingly in Bankruptcy Court). Here however, it was the perfect vehicle because it permitted the Debtors payments to J&R to be characterized as a kind of restitution claim.  The Court noted that in order for a restitution claim to lie, the funds had to be traced to the creditor’s specific interest; which is just what happened here.

But since the funds in this case were comingled, there were insufficient findings at the Trial Court level to support the necessary tracing. As a result the case was remanded for further findings.

The Upshot

The moral of the story here is 2-fold:

First, comingling proceeds or fungible items of personal property is a danger to all parties – Debtors, Creditors, and everyone involved.

Second, even where the parties maintain solid practices, proceeds should be remitted in the ordinary course of business and not permitted to pile up.

Got a thorny issue yourself? Give us a call and find out how we can help you!

Chapter 13 Bankruptcy

[T]here are known knowns… known unknowns … and unknown unknowns… things we do not know we don’t know.—US Secretary of Defense Donald Rumsfeld

When it comes to Bankruptcy, many Debtors don’t know what they don’t know about real estate taxes. Confused? So were the District Courts until the 7th Circuit Court of Appeals addressed the issue in the case of In re LaMont, Opinion 13-1187 (January 7, 2014).

The 7th Circuit began its analysis in LaMont by acknowledging the 2 kinds of real estate taxes with which Debtors must deal:

(a) Sold; and (b) Unsold.

The 2 are treated differently under State law and receive distinct treatment in a Plan of Reorganization as well:

Unsold taxes can be paid through the Plan in the same way that a Debtor would pay arrears to a secured creditor like a mortgage company. The rationale for such treatment is that the taxing body – the County – is presumed to have a secured lien in the subject property for its taxes. Moreover, those axes cannot be sold once a Bankruptcy Petition is filed. Such taxes generally get paid directly to the County Treasurer via the Plan.

Sold taxes are trickier. They can be paid through the Plan like unsolid taxes, but only so long as the “redemption period” has not expired. Even if the redemption period expires during the Plan, sold taxes can still be paid over the rest of the Plan period. And while that is taking place, the Automatic Stay will remain in effect to prevent Tax Buyers from redeeming the sold taxes or forcing a sale of the underlying property (the typical State law remedy).

In LaMont the issue was sold taxes. The LaMont Debtors owed real property in Minooka, Illinois on which the Village had levied a special assessment that they hadn’t paid. The Court noted that in this context a special assessment was deemed a property tax. Thus, the unpaid assessments were disposed of at a tax sale. Shortly afterwards the Debtors filed Chapter 13 and their Plan provided for payment of the assessment directly to the Village. However, the Plan did not identify. nor did notice go out to, the tax buyer. Nonetheless, the Plan was confirmed and the Debtors made payments to the Trustee who distributed them to the creditors including the Village.

But was the tax buyer bound by the terms of the confirmed Plan even though he had not been notified? In answering the questions the Court conducted a thorough analysis of the Illinois property tax system including tax sales and redemption periods – treating the sold special assessments the way they would sold property taxes.

The upshot of the analysis was that for the entirety of the redemption period – usually 2 to 2 ½ years, – a property owner could redeem his or her sold taxes by paying the County Clerk the past due amount, plus penalties and interest. Between 3 and 6 months before the expiration of the redemption period, a tax buyer had to file a Petition for Tax Deed with the Circuit Court, then take the resulting Order to the County Clerk to secure a Tax Deed, which then had to be recorded within a year. If those steps were not followed the tax buyer would lose his interest in the subject property. That is time enough for the property owners to act, but here the time period was tolled because of the Bankruptcy. Still, the Debtors neither identified the proper party to pay nor made adjustments to their Plan of Reorganization.

The LaMont the tax buyer filed his Petition for Tax Deed with the Circuit Court 3 years after the Debtors filed Bankruptcy and the Circuit Court denied it. The tax buyer then filed a Lift Stay Motion in the Bankruptcy Court, which denied the Motion because he was ostensibly being taken care of in the Plan. The tax buyer appealed, arguing that the Stay should not apply since he was not given notice of the case. But the District Court affirmed the Bankruptcy Court.

The tax buyer had also argued that his interest was in the real property, so it was not an interest against the Debtors. In other words he argued that his interest automatically divested the Debtors of their interest in the property after the redemption period expired. In response the 7th Circuit first examined whether or not the tax buyer had a claim, concluding that he did even though there wasn’t a traditional creditor-debtor relationship present. Nonetheless, the Court found that the tax buyer did not have an executory interest in the property itself: he merely had a tax lien on the property.

In reaching its decision the LaMont Court reviewed Illinois case law in concluding that, while there were differences, precedent favored the treatment of sold taxes as a lien. Since the tax buyer’s claim was deemed to be a lien, it could be modified under Section 1322(b)(2) of the Bankruptcy Code and the Debtors could force him to take payments even past the redemption date as long as the Plan was in effect.

In short, sold taxes can be addressed in a Plan of Reorganization but notice should be given to the payee or the Debtors risk paying into their Plan for 5 years only to end up with no credit towards their sold property taxes – and in the end stand to lose their home. Sad but true.

Battle Royale

A Little Light Reading

Are you excited to read about a dispute between competing secured creditors for the priority of their liens in property of the Bankruptcy Estate? Of course not.

Lucky for you issues such as these are generally heard in State court rather than in Federal Bankruptcy courts. Why? Because real property is considered a unique feature of the state and county in which it is located. Local features get local treatment.

But priority disputes can, and do, get played out in Bankruptcy court. For example take the case of In re Jones, 2011 WL 6140686 (Bankr. SD IL 2011) in which Debtors in a Chapter 11 case owned several pieces of property encumbered with mortgages cross-collateralized with other property of the Estate.

1st mortgage on Property #1 was taken by Bank #1, cross-collateralized, and provided that the maximum secured liability under its terms was approximately $214,000.

2nd mortgage on Property #1 was taken by Bank #2.

Both mortgages were timely recorded and Bank #2 did not contest its priority status. But then something happened.

1st mortgage on Property #2 was taken by Bank #1 and cross-collateralized with its mortgage on Property #1.

Since the interest of Bank #2 was not yet recorded when the additional loan from Bank #1 was taken, Bank #2 found itself in a tentative position.

Got all that? Because here is where it gets interesting…

As part of their reorganization, the Debtors sought lave to sell, and the Court agreed to permit the sale of, Property #1.  But by that time the Great Recession was in effect. Property #1 was not worth nearly what it had been when the loan was taken. In fact, it looked as if a sale of the property would not even generate enough to pay off all the lenders.

That’s when the fighting started.

Eventually Property #1 sold for $388,000. At that time Bank #1 was owed $115,000 under the terms of its 1st mortgage, plus more than $300,000 under the loan against Property #2. Bank #2 looked to be owed more than $300,000. But it was Bank #1 that sought all sale proceeds; so when Bank #2 objected, the battle was on!

Come Out Swinging

At the core of In re Jones was the distinction between 2 equally accepted concepts found in Illinois law:

  • Actual Notice; and
  • Record (“Inquiry”) Notice

There was no denying that Bank #1 and Bank #2 had actual notice of  claims on Property #1. Nor could it be denied that Bank #2 did not know of Bank #1’s claim on the 2nd Property until it was too late.

Rather, the question was whether Bank #2 should have known of the cross-collateralization clause and investigated further. In its opinion the Court noted that the cross-collateralization clause was on the first page of the mortgage document so even a cursory review of the title records would have revealed it. The Court also went through an analysis of Illinois case law and the recording statute in reaching its decision.

The opinion in Jones explains record notice: if a mortgage is properly recorded, then actual knowledge is no longer important. The burden of due diligence shifts to subsequent lenders who can, and should, search public records. The Court explains inquiry notice in a similar way. Where a lender has been made aware of facts or circumstances that lead it to believe there could be other liens on a property, that lender has a duty to perform a diligent inquiry.

The Decision and Appeal

Here, the Court found Bank #2 knew about the senior mortgage and cross-collateralization – the language was on the front page of the mortgage document, which was sufficient to put Bank #2 on inquiry notice that its borrower might have additional loans that could trigger the cross-collateralization. Finally, since Property #2 was in the same county as Property #1, the loan could easily have been discovered.

On appeal, the 7th Circuit affirmed the Bankruptcy Court and found for Bank #1.

There are many instances where priority fights occur in bankruptcies. Cross-collateralization is a frequent case, but refinancing can also trigger such clauses. Generally, the lender who refinances will get a formal subrogation agreement to eliminate a potential priority fight, but even if it doesn’t, equitable subordination will allow it to keep its priority intact.  

Questions about your own situation? Contact us for a no-cost consultation.