The second priority lien held by a junior lien holder is a property interest sufficient to trigger the protection of the automatic stay. In re Three Strokes L.P., 379 B.R. 804 (Bankr. N.D. Tex. 2008). Inasmuch as a senior lien holder’s foreclosure proceedings would have the effect of extinguishing the debtor’s second lien interest, a court may only lift the stay and permit the foreclosure to proceed upon such senior lien holder’s showing of adequate protection. In other words: the bankruptcy of a junior lien holder can frustrate or prevent a senior lien holder’s attempts to foreclose its interest even when the record owner of the property is in default of its loan obligations.

In Three Strokes, the real property owner took a development loan from the senior lender in the amount of $28,600,000, evidenced by a note and secured by a first priority mortgage on the property. The senior lien holder entered into a commercially standard intercreditor subordination agreement with a junior lien holder, which held a note from the property owner in the amount of $1,992,643, secured by a second priority mortgage on the property. Subsequently, an appraisal confirmed the as-stabilized value of the property to be only $27,700,000. The property owner thereafter defaulted on its first priority mortgage obligations, which gave rise to the subject foreclosure; the junior lien holder (an entity related to the property owner) declared bankruptcy on the eve of foreclosure.

The senior lien holder argued that the Section 362 automatic stay did not apply to non-judicial foreclosure proceedings commenced pre-petition, or, to the extent that it did, that there was cause to lift the stay pursuant to Section 362(d) and permit the foreclosure to proceed. The court stated that even though the real property was not the property of the debtor/junior lien holder’s bankruptcy estate, the second lien interest was in fact a property interest that triggered the automatic stay. The court reasoned that if the foreclosure extinguished the second lien interest, the senior lien holder would have gained “control” over a portion of the debtor/junior lien holder’s estate, and, pursuant to Section 362, all entities—not merely creditors—are prohibited from exercising “control” over a debtor’s bankruptcy estate. In this case, the court stated, the senior lien holder must petition the court to lift the stay, whereupon the court would evaluate whether the second lien interest has any value (i.e., whether, based on the factual evidence, such as the appraisal, any equity remained to debtor) and whether the second lien interest was necessary to an effective and realistic reorganization of the debtor’s estate.  

The holding of Three Strokes followed earlier holdingsin several other jurisdictions and confirmed the prevailing interpretation of Section 362 with respect to the applicability of the automatic stay to senior lien holder foreclosure actions in the context of a junior lien holder bankruptcy, an interpretation ultimately distilled from the broad scope of “property of the estate” under the Bankruptcy Code. For instance, in a case under the prior Bankruptcy Act, the court held that first and second lien mortgage interests constituted “property” of the estate and that a water district tax lien foreclosure could not wipe out either the first priority mortgage or second priority mortgage without permission of the court. See Florida Institute of Tech. v. Carpenter (In re Westec Corp.), 460 F.2d 1139 (5th Cir. 1972). Another court held that the automatic stay in the debtor/junior lien holder’s bankruptcy was violated when a senior lien holder accepted a deed in lieu of foreclosure from the trustees under the senior deed of trust, which, according to the court, interfered with the debtor’s right of redemption—also property of the estate. In re Capital Mortgage & Loan, Inc., 35 B.R. 967 (Bankr. E.D. Ca. 1983) (citing cases therein). In fact, in a case in which a creditor improperly foreclosed on real property thought to be owned solely by the debtor’s non-debtor spouse but was actually community property of both debtor and his non-debtor spouse, the court held that the automatic stay provisions even reached property of uncertain ownership or status (i.e., “arguable” property). In re Chestnut, 422 F.3d 298 (5th Cir. 2005).

Three Stokes confirms the prevailing approach that the “property” of the debtor’s estate is broad in scope, encompassing even security interests in real property not owned by the debtor. In the context of the bankruptcy of a junior lien holder, a senior lien holder’s attempts to foreclosure its interest in the underlying real property may be frustrated or prevented—even when the record owner of the encumbered property is in default but has not sought the protection of the bankruptcy court.