In Salyersville Nat’l Bank v. Bailey (In re Bailey), 664 F.3d 1026 (6th Cir. 2011), Chapter 7 bankruptcy debtors, prior to filing for bankruptcy, obtained a loan from Salyersville National Bank, pledging their home and 40 acres of land as security.  Several years later, the debtors took out a second loan from the bank, this time pledging their truck as security.  After encountering financial difficulties, the debtors eventually filed for bankruptcy in 2005.  Less than a month later, the debtors and the bank entered into a reaffirmation agreement, which committed the debtors to pay the two debts that would have otherwise been dischargeable in bankruptcy.  In particular, the debtors reaffirmed their secured indebtedness in the two loans, and in return, maintained possession of their home and truck.

Shortly after signing the reaffirmation agreement, the debtors stopped paying back the loans.  The bank initially tried to repossess the truck, but it eventually gave up on the quest when it learned that the truck was in poor condition and had been stolen, thus making it unattractive as collateral.  As a result, the bank filed a wholly unsecured claim against the bankruptcy estate with respect to the truck loan.  As for the real property, the bankruptcy trustee sued the bank, seeking to avoid the lien on the property—thus preserving the property for the benefit of the bankruptcy estate—on grounds that the bank had not properly perfected the mortgage.  The trustee’s suit was ultimately settled by an agreed judgment, pursuant to which the bank relinquished its collateral and became an unsecured creditor.

Following the conclusion of the bankruptcy case, the bank sued the debtors in Kentucky state court for the unpaid balance on the two loans.  In response, the debtors moved the bankruptcy court to reopen their case and to declare the reaffirmation agreement void.  The bankruptcy court granted the debtors’ request and voided the agreement on the basis of mutual mistake.  Specifically, the court found that the parties signed the agreement based on the false assumption that the bank held secured interests in the real property and the truck, which would have allowed the debtors—as opposed to the bankruptcy estate—to maintain ownership of those items.  The district court affirmed.

On appeal, the bank argued that (1) there was no mutual mistake because it was, in fact, a secured creditor, and (2) even if it was an unsecured creditor, the reaffirmation agreement is nevertheless valid under Kentucky contract law.  The Sixth Circuit rejected both of these arguments.  

First, the court determined that, rather than filing a claim as a secured creditor or attempting to recover insurance proceeds for the stolen truck, the bank opted to file its claim on the truck debt as a wholly unsecured creditor and received approximately $2,400 on this claim from the estate.  In doing so, the bank waived its security interest in the truck.  Similarly, with respect to the real property, the court found that by virtue of the agreed judgment with the trustee, the bank effectively ceded the property to the bankruptcy estate and became an unsecured creditor.  The bank then filed an unsecured claim for the full amount of the debt on the real property loan and received approximately $35,000 on this claim from the estate.  As a result, the Sixth Circuit held that the bank remained an unsecured creditor with respect to both loans.  

Second, the court held that the reaffirmation agreement was properly voided under Kentucky contract law.  The court noted that although the Bankruptcy Code permits reaffirmations of unsecured as well as secured debts, the agreement must be enforceable under state contract law.  To that end, under Kentucky law, contracts are voidable where both parties are mistaken as to a material fact at the time of contracting.  Here, the court found that a reaffirmation agreement involving unsecured debt is not the bargain the debtors and the bank made.  At the time of the agreement, not only did the bank believe that it had a valid security interest in the property, but the court noted that it would defy logic to believe that the debtors would reaffirm these debts had they known they were unsecured, since the property and the truck would be lost to the bankruptcy estate either way.

As for materiality, the court explained that “[b]ankruptcy courts have uniformly concluded that reaffirmation agreements involving unsecured debt that the parties mistakenly believed was secured are unenforceable under state law.”  Therefore, the court affirmed the lower courts’ finding that the reaffirmation agreement was unenforceable under Kentucky law.