The United States Court of Appeals for the Ninth Circuit recently held in Mastan v. Salamon (In re Salamon) that an undersecured creditor with a nonrecourse claim lost the right to assert a deficiency claim under section 1111(b) of the Bankruptcy Code when a senior secured creditor foreclosed on and sold its collateral during the bankruptcy case.

In Salamon, a bankruptcy court approved a stipulation between a debtor and a senior lienholder to modify the automatic stay to allow the senior lienholder to foreclose on and sell certain of its collateral. The proceeds from the foreclosure sale were sufficient to pay the senior lienholder in-full, but the junior lienholder’s claim was only partially satisfied from the proceeds. The junior lienholder filed an unsecured deficiency claim against the debtor’s estate, but the debtor objected to the claim because the loan documents provided that the claim was nonrecourse.

Ultimately, the Ninth Circuit concluded that the junior creditor lost its right to convert its nonrecourse claim to a recourse claim under section 1111(b) of the Bankruptcy Code as a result of the senior creditor’s sale of the collateral. Section 1111(b) requires a nonrecourse claim “secured by a lien on property of the estate” to be treated as recourse “whether or not [the creditor] had recourse against the debtor on account of such claim.”

Under this section, the undersecured creditor will lose its right to a deficiency claim if the collateral “is sold under section 363 [of the Bankruptcy Code] or is to be sold under the plan.” Because the collateral was sold by the senior lender in the exercise of its state law remedies, the junior creditor asserted that neither of these exceptions applied. The Ninth Circuit agreed, but found another reason why the junior creditor lost its right to assert a deficiency claim.

The Ninth Circuit found that, under the plain language of the statute, the junior lienholder was entitled to a deficiency claim only if it holds a claim secured by a “lien on property of the estate.” Under California law, the lien securing the nonrecourse claim was extinguished as a consequence of the foreclosure sale. Accordingly, the court stated that the right to a deficiency claim was extinguished at the same time the lien was extinguished in the senior lienholder’s foreclosure sale. The court stated its ruling is consistent with the Fifth Circuit’s ruling on this precise issue in In re Tampa Bay Assocs., Ltd. The Ninth Circuit noted that, while no other circuit has addressed this issue, other circuits have also generally emphasized that a lien on property of the estate is necessary to invoke section 1111(b).

The Ninth Circuit disagreed with the junior lienholder’s argument that section 1111(b) should be interpreted to fix a lienholder’s rights as of the bankruptcy filing. The Ninth Circuit reasoned that courts are to apply the Bankruptcy Code as written without extra statutory exceptions, so long as the statutory language does not lead to an absurd result. Not only did the Ninth Circuit conclude that its application of the plain language of the statute was far from absurd, but it found the result to be “sensible.” Because the debtor was not retaining the collateral under the Bankruptcy Code, the junior lienholder would be left with exactly what it bargained for in the non-bankruptcy context: the inability to seek recourse following foreclosure of the collateral by the senior lienholder. The court noted that allowing the junior lienholder to assert a deficiency claim would afford the lienholder more rights than it otherwise has under state law, which is contrary to the principle that bankruptcy law largely respects substantive state law rights.

In summary, the Ninth Circuit stated, “We hold that § 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.” This interpretation seemingly would render the 363 sale exception in section 1111(b) superfluous, but at least in the Ninth Circuit, that result apparently is not considered absurd.