The U.S. Court of Appeals for the Ninth Circuit recently affirmed the Bankruptcy Appellate Panel’s determination that a creditor’s pre-bankruptcy, non-recourse lien on two debtors’ real property is extinguished following a non-judicial foreclosure sale.

A copy of the opinion in In re: Salamon is available at: Link to Opinion.

In April 2009, two debtors purchased real property. Rather than fund the purchase price and pay off the two existing liens on the real property, the debtors executed a wrap-around mortgage in favor of the property seller. The debtors then funded the balance of the purchase price with a note secured by a deed of trust.

In March 2010, the real property seller filed a Chapter 11 bankruptcy petition, which was later converted into a Chapter 7 bankruptcy proceeding.

In June 2012, the debtors also filed a Chapter 11 bankruptcy petition. The trustee of the seller’s bankruptcy estate timely filed a proof of claim for the two liens secured by the real property.

In October 2012, the bankruptcy court lifted the debtor’s bankruptcy stay to allow the most senior lienholder to foreclose on the real property. The real property was sold at a foreclosure sale. The foreclosure trustee sent the surplus proceeds from the sale to the trustee. The trustee then filed an amended proof of claim for the unsecured balance of the note.

The debtors moved to disallow the amended claim on the ground that there was no longer any property in the estate on which there could be a recourse lien. The bankruptcy court agreed.

On appeal, the Bankruptcy Appellate Panel affirmed and held that the seller’s non-recourse claim could not be transformed into a recourse claim under 11 U.S.C. § 1111(b). The Bankruptcy Appellate Panel reasoned, “[a]lthough [the trustee’s] original proof of claim may have asserted a claim secured by liens on property of the estate, as recognized in the amended proof of claim [the trustee] filed, those liens were eliminated as a matter of law as a result of the foreclosure.”

As you may recall, 11 U.S.C. § 1111(b)(1)(A) provides in pertinent part:

A claim secured by a lien on property of the estate shall be allowed or disallowed under section 502 of this title the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse unless:

(i) the class of which such claim is a part elects … application of paragraph (2) of this subsection; or

(ii) such holder does not have such recourse and such property is sold under section 363 of this title or is to be sold under the plan.

On appeal to the Ninth Circuit, the trustee of the seller’s bankruptcy estate argued that the phrase “property of the estate” in Section 1111(b)(1)(A) refers to the property that existed at the time of filing the petition and that the bankruptcy court was required to fix his rights as of that date.

The Ninth Circuit rejected the trustee’s argument. The Ninth Circuit found that what must be determined as of the date of the filing of the petition is solely the amount of the claim. The Ninth Circuit reasoned that the plain language of Section 1111(b) mandates that it cannot apply if the lien does not exist.

The Court observed that under California law, the liens securing the trustee’s claim were extinguished following the judicial foreclosure sale. As a result, extending the protections of Section 1111(b) to the trustee would allow the trustee to assert a deficiency claim against the debtors following the foreclosure sale, which would afford him more rights in bankruptcy than he would otherwise have under state law.

The Ninth Circuit then noted that the purpose of section 1111(b) is to put the Chapter 11 debtor who wishes to retain collateral property in the same position that a person who purchased property subject to a mortgage lien would face in the non-bankruptcy context. The Court explained that these purposes were not at issue in the debtors’ proceeding because the debtors were not seeking to retain the collateral property.

The Court held that section 1111(b)’s requirement that a creditor hold a “claim secured by a lien on the property of the estate” means that if a creditor’s claim, for any reason, ceases to be secured by a lien on property of the estate, the creditor can no longer transform a non-recourse claim into a recourse claim.

As a result, the Ninth Circuit held that section 1111(b) had no applicability to the trustee’s claim.