Under section 1111(b) of the U.S. Bankruptcy Code, a non-recourse secured creditor that holds “a claim secured by a lien on property of the estate” is granted recourse against the bankruptcy estate upon the filing of a chapter 11 bankruptcy petition. But what happens when there has been a post-petition foreclosure on such property, so that it is no longer part of the estate and the liens have been extinguished? Can the creditor still use section 1111(b) to assert a claim against the bankruptcy estate? The Ninth Circuit answered no in Matsan v. Salamon (In re Salamon).

The facts in Salamon are straightforward. Salamon (“Buyer”) purchased real property from Behrend (“Seller”) that was already subject to two liens (the “Preexisting Debt”). Instead of paying cash at closing, the Buyer executed two notes (the “Two Notes”) in favor of the Seller that required the Buyer to make monthly payments to an entity designated by the Seller, who would then make monthly payments to the lienholders on the Preexisting Debt. The Seller filed for bankruptcy in 2010, and in 2012, the Buyer filed for bankruptcy. The trustee of the Seller’s bankruptcy estate (the “Trustee”) filed a proof of claim in the Buyer’s case for the Two Notes.

Subsequently, in the Buyer’s bankruptcy case, the court approved a stipulation between the Buyer and the senior lienholder under the Preexisting Debt lifting the stay so that the senior lienholder could foreclose on the property. The property was later sold at a foreclosure sale, and the Trustee received a check for the balance of the foreclosure proceeds. The amount received did not satisfy all of the obligations under the Two Notes, leaving the Seller with a deficiency claim for which the Trustee then filed an amended proof of claim. The Buyer filed a motion for an order disallowing the amended claim, arguing that because the property was no longer part of the estate, a recourse lien could not exist and the Trustee was not entitled to any deficiency. The bankruptcy court agreed as did the Bankruptcy Appellate Panel and the Ninth Circuit, holding that since the Trustee no longer had liens on property of the estate, his non-recourse claim could not be transformed into a recourse claim under section 1111(b).

The Ninth Circuit analyzed the plain language of section 1111(b), and found that the “property of the estate” reference in section 1111(b) does not refer to property that existed at the time of the bankruptcy filing. Because the property was sold during the Buyer’s bankruptcy case, the result of which extinguished all liens on the property, section 1111(b) has no applicability and the Trustee has no basis for its deficiency claim.

The court found that it would make little sense to grant the Trustee the protections of section 1111(b), as the Trustee, standing in the shoes of the debtor, is left with exactly what was bargained for in non-bankruptcy: a senior creditor foreclosed on the property, extinguishing the junior liens and leaving the Trustee without recourse. Indeed, the court found that allowing the Trustee to assert the deficiency claim would afford him more rights in bankruptcy than the debtor would have had under California law outside of bankruptcy.

The court, however, did provide non-recourse secured creditors with guidance on how to protect themselves from such result -- by objecting to relief from the automatic stay to permit the foreclosure sale if concerned that the sale will not adequately protect the creditor’s rights. In light of the Salamon decision, holders of non-recourse claims should be aware that they cannot rely on section 1111(b) if the collateral securing the indebtedness is sold during the borrower’s bankruptcy case and should take protective steps prior to the stay if lifted.