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Priority Battle Royale!

A Little Light Reading

Are you excited to read about a dispute between competing secured creditors for the priority of their liens in property of the Bankruptcy Estate? Of course not.

Lucky for you issues such as these are generally heard in State court rather than in Federal Bankruptcy courts. Why? Because real property is considered a unique feature of the state and county in which it is located. Local features get local treatment.

But priority disputes can, and do, get played out in Bankruptcy court. For example take the case of In re Jones, 2011 WL 6140686 (Bankr. SD IL 2011) in which Debtors in a Chapter 11 case owned several pieces of property encumbered with mortgages cross-collateralized with other property of the Estate.

1st mortgage on Property #1 was taken by Bank #1, cross-collateralized, and provided that the maximum secured liability under its terms was approximately $214,000.

2nd mortgage on Property #1 was taken by Bank #2.

Both mortgages were timely recorded and Bank #2 did not contest its priority status. But then something happened.

1st mortgage on Property #2 was taken by Bank #1 and cross-collateralized with its mortgage on Property #1.

Since the interest of Bank #2 was not yet recorded when the additional loan from Bank #1 was taken, Bank #2 found itself in a tentative position.

Got all that? Because here is where it gets interesting…

As part of their reorganization, the Debtors sought lave to sell, and the Court agreed to permit the sale of, Property #1.  But by that time the Great Recession was in effect. Property #1 was not worth nearly what it had been when the loan was taken. In fact, it looked as if a sale of the property would not even generate enough to pay off all the lenders.

That’s when the fighting started.

Eventually Property #1 sold for $388,000. At that time Bank #1 was owed $115,000 under the terms of its 1st mortgage, plus more than $300,000 under the loan against Property #2. Bank #2 looked to be owed more than $300,000. But it was Bank #1 that sought all sale proceeds; so when Bank #2 objected, the battle was on!

Come Out Swinging

At the core of In re Jones was the distinction between 2 equally accepted concepts found in Illinois law:

  • Actual Notice; and
  • Record (“Inquiry”) Notice

There was no denying that Bank #1 and Bank #2 had actual notice of  claims on Property #1. Nor could it be denied that Bank #2 did not know of Bank #1’s claim on the 2nd Property until it was too late.

Rather, the question was whether Bank #2 should have known of the cross-collateralization clause and investigated further. In its opinion the Court noted that the cross-collateralization clause was on the first page of the mortgage document so even a cursory review of the title records would have revealed it. The Court also went through an analysis of Illinois case law and the recording statute in reaching its decision.

The opinion in Jones explains record notice: if a mortgage is properly recorded, then actual knowledge is no longer important. The burden of due diligence shifts to subsequent lenders who can, and should, search public records. The Court explains inquiry notice in a similar way. Where a lender has been made aware of facts or circumstances that lead it to believe there could be other liens on a property, that lender has a duty to perform a diligent inquiry.

The Decision and Appeal

Here, the Court found Bank #2 knew about the senior mortgage and cross-collateralization – the language was on the front page of the mortgage document, which was sufficient to put Bank #2 on inquiry notice that its borrower might have additional loans that could trigger the cross-collateralization. Finally, since Property #2 was in the same county as Property #1, the loan could easily have been discovered.

On appeal, the 7th Circuit affirmed the Bankruptcy Court and found for Bank #1.

There are many instances where priority fights occur in bankruptcies. Cross-collateralization is a frequent case, but refinancing can also trigger such clauses. Generally, the lender who refinances will get a formal subrogation agreement to eliminate a potential priority fight, but even if it doesn’t, equitable subordination will allow it to keep its priority intact.  

Questions about your own situation? Contact us for a no-cost consultation.

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