Two recent cases are good examples of “why” secured lenders, who hold liens on real property, correctly view bankruptcy court as a very, very, very bad place.  One case has received a lot of attention, including an appeal of the decision and state legislation; and the second bankruptcy ruling was overturned on appeal.

The lessons learned are expansive and expensive:

  • Constant change to form documents (expansive): at least in Illinois, unless a ruling in a recent bankruptcy case is overturned or state law changed, a new mortgage should describe the terms of the mortgage note.  Indeed, a lender should include these terms in every Illinois loan modification; and even consider modifying all of its existing (Illinois) mortgage loans to describe the terms of the mortgage loan.  “Expansive” here means the reach of a bankruptcy court can be very, very, very long.  If your fail to keep your mortgage documents current on events like this, then perhaps . .  . good-bye mortgage.
  • Bankruptcy busts your litigation budget (expensive): James Ruiz recently handled a case where after allowing the mortgage lender to foreclose (pursuant to state law and outside of the bankruptcy), the bankruptcy court ruled that it retained control over the proceeds from the state foreclosure sale.  Eventually, the ruling was over turned, but the time and expense to the mortgage lender made the process . . . expensive.  “Expensive” here means expensive.  If your mortgage loan goes into bankruptcy where results are difficult to predict, then . . . good-bye legal fee budget.

The first bullet point is based on a recent bankruptcy case in Illinois (known as In re Crane, Case No. 11-90592, U.S. Dist Ct. C.D. Ill)  In the case,  the court construed a state conveyancing statute, which takes a permissive approach on disclosing loan terms in a mortgage, to in fact require disclosure of the terms of the loan (including the interest rate).   Based upon this approach, the bankruptcy court ruled that the mortgage loan was avoidable in bankruptcy.  And so, the court struck down the  mortgage.  Good-bye mortgage.

If you find this upsetting, then join the crowd: the case is on appeal, it has received a lot of attention by key mortgage lending organizations, and the state legislature is considering passing a new state statute addressing this problem.

Bottom line: form work on mortgage loan documents will NEVER stop. Expansive.

The second bullet point is a lesson given to me by James Ruiz.  After the bankruptcy court issued a lift stay order permitting a nonjudicial foreclosure sale under state law,  the bankruptcy court held (i) that it had continuing jurisdiction over the proceeds of the nonjudicial foreclosure and (ii) that the bank’s entitlement to interest, fees and expenses under the Note would be governed by bankruptcy law – not the terms of the Note or state law. The bankruptcy court also held the substitute trustee commission would be governed by bankruptcy law – not state law. The bankruptcy court denied the bank’s recovery of its attorney’s fees and the substitute trustee’s five percent commission – notwithstanding the fact that surplus proceeds were generated from the foreclosure sale to pay the mortgage lender in full, the substitute trustee commission and 100% of the other creditor claims against the debtor.

In essence the bankruptcy court ruled that every creditor of the bankruptcy estate would be paid 100% of their claims (including general unsecured creditors), except the mortgage lender and the substitute trustee. Going one more step, the bankruptcy court’s ruling would return surplus proceeds to the debtor after all creditors – other than the mortgage lender and substitute trustee – were paid in full.

The US District Court reversed the bankruptcy court’s ruling and held state law and the loan documents governed the distribution of the foreclosure sale proceeds, not bankruptcy law.  Therefore the mortgage lender and substitute trustee are to be paid in full from the proceeds under the terms of the Note and Deed of Trust.

Bottom line: with good lawyering, good results can happen; but . . . at a price. Expensive.

If you have any comments, or your own story to tell, please comment below.