Unrecorded Homestead Mortgage Not Protected from Modification in Bankruptcy

Image Credit: Long Island Bankruptcy Blog

Image Credit: Long Island Bankruptcy Blog

A case from western suburbs of the Windy City provides some lessons for both debtors and creditors.

The issue before the Bankruptcy Court in the Arnold case was whether an unrecorded homestead mortgage was entitled to treatment as a mortgage protected from modification in a chapter 13 case. [FN1] The Court found that the claim was not secured for the purposes of 11 U.S.C. § 1322(b)(2), as the mortgage would not be enforceable against creditors without actual notice under state law, but the bank had an enforceable unsecured claim against the debtors.

The facts in the case were straightforward. Prior to filing chapter 13, the debtors purchased their home and granted a mortgage to the bank for the funds loaned to them to purchase the home. Unbeknownst to the debtors, the bank never recorded that mortgage.

In their bankruptcy case, the debtors originally scheduled the bank as a secured creditor, and proposed a plan providing to cure the mortgage arrearages and maintain the regular monthly payments on the mortgage.

That all changed after the bank filed a motion to have the stay modified so that it could record its mortgage, which the Court denied. The debtors subsequently amended their schedules to reduce the amount of the secured claim to 0, reduce the amount due under the claim to the value of the home, eliminate any payment on the mortgage arrears and treat the mortgage as unsecured.

The bank objected to this treatment. It argued that the lien did not need to be recorded to create a valid and binding lien in property under Illinois law, and therefore, as the holder of a homestead mortgage, the claim could not be modified in chapter 13. The primary support for this argument was the following dictum from an 1894 Illinois Supreme Court decision called Haas v. Sternbach [FN1]:

We are aware of no principle, outside of self-interest and prudence in business, that requires the holder of a mortgage to put it on record at any particular time. By not doing so promptly, he runs the risk of having it postponed to junior liens, and even of losing the benefit of it altogether. As to subsequent purchasers and creditors without notice, such securities take effect from the time of filing for record only.” The correctness of this statement of the law in view of our statute cannot be seriously questioned. No one will contend that the recording of a mortgage is, in this state, necessary to its validity. Recording such instruments serves but one purpose, and that is to make them valid as against creditors and subsequent purchasers without notice.  Section 31, c. 30, Rev. St. provides that they shall take effect as to such persons from the time of filing for record, and not before. No time is fixed within which the filing for record must take place in order to give such an instrument validity.

The Court had no quarrel with the observations of the Supreme Court in Haas, as the principles cited are provided for in current statutory law at 765 ILCS 5/30. [FN3] However, it disagreed that Haas supported the bank’s argument that its unrecorded mortgage is “a claim secured only by a security interest in real property that is the debtor’s principal residence” that may not be modified in a chapter 13 plan – in particular, a plan which included payments to subsequent unsecured creditors without notice of the bank’s unrecorded mortgage. Under Haas and Illinois statutory law, the Court concluded that it would be improper to permit an unrecorded Illinois mortgage to take priority over subsequent creditors without notice of the mortgage.

The Court also found support for its conclusion in the provisions of the Bankruptcy Code. For example it noted that the Code uses the phrase “charge against or interest in property” in its definition of “lien.”  [FN4] This therefore indicated that the term lien refers to an in rem rather than an in personam claim, which would require that the lien be properly recorded to be good as against the world and not just personally against the debtors.

The Court also noted that an unsecured lien could easily be avoided by a chapter 7 trustee, and avoidance of the lien would typically increase the amount available to unsecured creditors. As a result, it found that the bank’s arguments ran afoul of the best-interests-of-creditors test which must be satisfied in order to obtain approval of a chapter 13 plan. [FN5]

Here are a few observations from the case.

First, the bank’s motion for relief filed in this case expresses the desire to to protect its position against junior liens or alternatively establish an unsecured claim. [FN6] But these arguments do not seem to provide a great rationale where the debtors were already in bankruptcy. Prepetition creditors would be prohibited from taking actions to improve their position and debtors would be limited in their ability to incur further debt while in chapter 13; the effect of the filing of the case would preserve the status quo.

In addition, since the creditor was taking the position that its claim was secured so all it had to do was file it. The mortgage instrument had been in existence between the parties since February 2009 and a claim is deemed valid until someone objects. [FN7] The creditor here did it the other way around by highlighting the defects in its claim and virtually asking for an objection to its claim before even filing it. Since the creditor was taking the position that it was secured despite lack of recording, it would likely have fared better by accepting the plan’s original treatment of it as a secured creditor and/or waiting for the case to be discharged or dismissed so it could record its mortgage to perfect the original intent of the contract between the parties.

Third, while debtors in bankruptcy will want to check their security agreements for proper perfection, they will also want to consider carefully what they ask for. In this case, the debtors proposed a plan payment of $2,003 for 60 months. [FN8] So as long as the value of all of their non-exempt property is less than the amount to be paid into the plan (in this case, $2,003 x 60 months, or $120,180), the plan would pass the best-interests-of-creditors (or liquidation) test. The debtors originally scheduled the property with a value of $160,000, and it is unclear what the bank’s position with respect to the valuation is and confirmation is still pending. [FN9] With property unencumbered by any lien, due to the liquidation test and need to repay modified claims over the life of the plan, debtors will want to make sure they are able to afford a payment high enough to satisfy the liquidation analysis to avoid getting stuck with a plan payment that they cannot afford.

[FN1] In re Arnold, 483 B.R. 515, 2012 WL 5945101, No. 12-11838 (Bankr. N.D. Ill. November 28, 2012).

[FN2] Haas v. Sternbach, 156 Ill. 44, 54 (1894) (quoting Field v. Ridgeley, 116 Ill. 424, 431 (1886)) (emphasis in original).

[FN3] 765 ILCS 5/30 provides: “All deeds, mortgages and other instruments of writing which are authorized to be recorded, shall take effect and be in force from and after the time of filing the same for record, and not before, as to all creditors and subsequent purchasers, without notice; and all such deeds and title papers shall be adjudged void as to all such creditors and subsequent purchasers, without notice, until the same shall be filed for record.”

[FN4] 11 U.S.C. § 101(37).

[FN5] 11 U.S.C. § 1325(a)(4).

[FN6] No. 12-11838, Doc. No. 36.

[FN7] 11 U.S.C. §§ 501(a), 502(a).

[FN8] No. 12-11838, Doc. No. 49.

[FN9] 2012 WL 5945101 at *2.


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