Debtors 1, Bank 0

Giving chapter 13 debtors the ability to modify mortgages has been a hot topic in recent years. Although mortgage liens continue to have special protection in chapter 13 cases, a common occurrence in bankruptcy courts is the avoidance of completely underwater second mortgages. Courts that have allowed this have done so on the rationale that such mortgages are not entitled to the protection given to secured mortgage claims in bankruptcy, because they are not secured at all.

Given the lack of equity in real estate in many areas, banks often do not have much of a defense to an action to strip-off a second lien. In a recent case from the Southern District of Illinois, however, a bank holding such a second mortgage (“Bank”) made an interesting argument to try to avoid this consequence. [FN1]

In Stephens, chapter 13 debtors proposed and confirmed such a plan. The debtors’ property was valued at $310,000, and was subject to a first mortgage of approximately $400,000, and a second mortgage of approximately $75,000. The plan thus provided for avoidance of a wholly unsecured second mortgage lien.

As a complete defense, the Bank argued that the first mortgage did not encumber the interest of one of the joint debtors. The issue was that while the joint debtors each signed the mortgage as “borrowers,” the mortgage instrument itself only defined one of the joint debtors as a “borrower” in the body of the instrument.

The Bank primarily relied upon a case from the Northern District of Illinois, in which the District Court affirmed the bankruptcy court’s determination that a party who was not named in a mortgage as a borrower but signed the mortgage did not encumber his interest in jointly owned property. [FN2]

While the Court acknowledged the conclusion in Wirth, as well as courts from other jurisdictions considering a similar issue, it found the facts in the case before it distinguishable. First, the Court noted that a rider to the mortgage clearly defined the borrowers under the mortgage to refer to both of the signatories. Second, it found that the note unambiguously provided for personal liability of all the signers.

On these facts, it found evidence of the joint debtor’s intent to mortgage her interest in the note. The Court noted the principles under Illinois contract law that a note and mortgage made at the same time and as part of the same transaction are ordinarily to be read and construed as constituting a single instrument, especially when they mutually refer to one another. [FN3]

As a result, with a proper first mortgage encumbering the debtors’ property, there was no equity left to support the Bank’s second mortgage, and the second mortgage was consequently avoided. A nice try by the Bank though.

[FN1] Stephens v. Regions Bank (In re Stephens), 2012 WL 4086767, Bankr. No. 11-31062, Adv. No. 11-3302 (Bankr. S.D. Ill. 9/17/12) (“Opinion”).

[FN2] Opinion, p.6, citing Wirth, 335 B.R. 60 (N.D. Ill. 2005).

[FN3] Opinion, pp.5-6, citing Straus v. Anderson, 366 Ill. 426, 9 N.E.2d 205 (1937); Chicago Title & Trust Co. v. Robin, 361 Ill. 261, 198 N.E. 4 (1935).

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