6th Cir. BAP Holds BK Court Lacked Jurisdiction to Void Mortgage Lien Signed Before but Recorded During Bankruptcy

The Bankruptcy Appellate Panel of the U.S. Court of Appeals for the Sixth Circuit recently held that the bankruptcy court lacked subject matter jurisdiction under the Rooker-Feldman doctrine to void the foreclosure of a mortgage lien that was executed by the debtors before bankruptcy, but recorded while the automatic stay was in effect.

In so ruling, the BAP held that the mortgage was effective upon signing, the pre-petition lien survived the bankruptcy, the creditor’s exercise of its in rem rights did not implicate the discharge order, and the bankruptcy court incorrectly applied the exception to the Rooker-Feldman doctrine recognized in In re Hamilton, 540 F.3d 367 (6th Cir. 2008).

A copy of the opinion in In re Isaacs is available at:  Link to Opinion.

The debtors obtained a home equity line of credit secured by a second mortgage containing the following language:  “The lien of this Mortgage will attach on the date this Mortgage is recorded.”

In March 2004, the debtors filed a chapter 7 petition and listed their debt owed to the mortgagee.  Unknown to the debtors, the mortgagee did not record the mortgage until June 2004, three months after they filed bankruptcy and while the automatic stay was in effect.  The mortgagee did not seek an order to modify, lift, or annul the automatic stay.  Nor did any party seek to avoid the mortgage during the chapter 7 case. The debtors received a discharge and the case was closed in August 2004.

In August 2005, the debtors reopened the case and successfully avoided two judgment liens.  The case was closed again in January 2006.  Subsequently, the mortgagee transferred its interest in the mortgage to the creditor.  More than 10 years after the debtors’ first bankruptcy filing, in April 2014, the creditor filed a foreclosure proceeding.

The creditor obtained a default judgment in August 2014.  To stop the foreclosure sale, one of the debtors filed a chapter 13 petition and proposed a plan which stated that the lien at issue “shall be avoided pursuant to 11 U.S.C. § 522(f), or other applicable sections of the Bankruptcy Code.”  In October 2014, the debtors filed an adversary complaint and requested relief under 11 U.S.C. § 544(a)(1) and (a)(3) to avoid the mortgage lien.

On cross motions for summary judgment, the bankruptcy court held that under the terms of the mortgage, the lien was not effective until the mortgage was recorded.  Thus, the bankruptcy court concluded that the mortgagee did not have a security interest in the property before the debtors filed their chapter 7 petition, and therefore the mortgagee was an unsecured creditor whose debt was discharged in bankruptcy.

In so ruling, the bankruptcy court also held that the state court’s default judgment had no bearing on the validity of the discharge order and voided the foreclosure judgment.

On appeal, the dispositive issue was whether the bankruptcy court lacked subject matter jurisdiction to consider the claims in the debtor’s complaint on the basis of the Rooker-Feldman doctrine.

As you may recall, the Rooker-Feldman doctrine derives from two opinions issued by the Supreme Court of the United States, Rooker v. Fidelity Trust Co., 263 U.S. 413, 44 S. Ct. 149 (1923), and District of Columbia Court of Appeals v. Feldman, 460 U.S. 462, 103 S. Ct. 1303 (1983).  The doctrine bars lower federal courts from exercising appellate jurisdiction over final state-court judgments.  McCormick v. Braverman, 451 F.3d 382, 391-92 (6th Cir. 2006).

The bankruptcy court held that the Rooker-Feldman doctrine did not apply based on the Sixth Circuit’s decision in Hamilton, which recognized an exception to the Rooker-Feldman doctrine as applied to bankruptcy discharge orders.  In re Hamilton, 540 F.3d 367 (6th Cir. 2008).  In Hamilton, the Sixth Circuit held that while state courts have jurisdiction to construe a bankruptcy court’s discharge order, they did not have jurisdiction to modify a discharge order to permit collection of a personal debt.  Id., 540 F.3d at 375.

The bankruptcy court considered the Hamilton exception along with the mortgage, and concluded that the mortgage lien never attached to the property.  Because the mortgage never attached, the bankruptcy court held that the underlying debt was unsecured and discharged through the chapter 7 discharge order. The bankruptcy court also held that the foreclosure judgment impermissibly modified the discharge order because it found the mortgage valid and secured a discharged unsecured debt.

The BAP disagreed with the bankruptcy court’s reasoning.  In Hamilton, the bankruptcy discharged the debtor’s personal liability for the debt and then the state court found the debtor personally liable for that same debt, which acted as a modification of the discharge order.  In this case, the creditor only sought in rem relief and did not pursue judgment against the debtors for personal liability on the debt.  Thus, the BAP found that Hamilton was inapposite.

Additionally, absent avoidance by the bankruptcy court, a valid lien survives and rides through bankruptcy unaffected.  See, e.g., Dewsnup v. Timm, 502 U.S. 410, 417-18, 112 S. Ct. 773, 778 (1992); Johnson v. Home State Bank, 501 U.S. 78, 84, 111 S. Ct. 2150, 2154 (1991).

In the BAP’s view, both the automatic stay and the discharge order could have been implicated if the mortgage did not become effective as a lien against the property until after the chapter 7 petition date.  Thus, the date the mortgage became effective as a lien on the property was of vital importance to whether the Hamilton exception to the Rooker- Feldman doctrine applied in this case.

If the lien evidenced by the mortgage was effective prior to the chapter 7 petition date, and was not avoided in the course of that bankruptcy case, then the mortgage would still exist as an in rem obligation even after the discharge order relieved the debtors of their personal liability on the underlying indebtedness.  And, because no personal liability would be implicated, no modification of the discharge order would be implicated through enforcement of that lien, and the Hamilton exception to the Rooker-Feldman doctrine would not apply.

Thus, the BAP turned to the mortgage, and Kentucky law applicable to mortgages, to determine whether the mortgage was effective prior to the chapter 7 petition date.

Under Kentucky law, the mortgage was binding as to the debtors as of the time they signed the mortgage.  First Commonwealth Bank of Prestonburg v. West, 55 S.W.3d 829, 835 (Ky. Ct. App. 2000) (a mortgage is a contract subject to normal rules of contract interpretation); In re Williams, 490 B.R. 236, 239 (Bankr. W.D. Ky. 2013) (an unrecorded mortgage is valid between the parties to the mortgage).  Moreover, “the lien of the mortgage … shall be superior to any liens … created or arising after recordation of the mortgage” even if the lender advances funds with “notice of a subsequently created lien.”  Ky. Rev. Stat. § 382.385(3).

The bankruptcy court concluded, based on the language in the mortgage, that the parties did not intend on immediate attachment but intended attachment to occur at the time the mortgage was recorded.  As a result, the bankruptcy court held that the foreclosure judgment revived and secured a discharged debt, as opposed to merely enforcing existing valid in rem rights.

However, the BAP noted that the mortgage contained two provisions pertaining to the date on which the mortgage lien, securing a line of credit, would be effected.  The “Description of Security” section suggested that the mortgage was effected on signing.  The mortgage’s “Priority of Advances” section, however, states that the lien of this mortgage will attach on the date this mortgage is recorded.  Analyzing the two provisions within the context of the entire instrument and under Kentucky law, the BAP concluded that the mortgage was effective as of the signing date for two reasons.

First, in the BAP’s view, it was logical that the first provision expressed the intention that the mortgage was effective as to the debtors upon signing.  It was also logical that the second provision, for “Priority of Advances,” expressed the intention that the mortgage lien became effective as to third-party creditors upon recordation.

More specifically, the BAP explained that the line of credit mortgage anticipated the advancement of funds to the debtors, with the mortgage being effective as to third parties acquiring liens against the property upon recordation – even if no funds were advanced as of the time of the signing of the mortgage and even as to funds advanced subsequent to the perfection of the later liens.  Thus, according to the BAP, the “Priority of Advances” section was intended to provide notice to third parties and establish the mortgage lien’s priority.

The BAP concluded that the terms of the mortgage and Kentucky law established that the mortgage was binding at the time it was signed.  Because the state court judgment only foreclosed on a valid, pre-petition lien, there was no modification of the discharge order and the Hamilton exception did not apply.  Therefore, the BAP held that the Rooker-Feldman doctrine barred the bankruptcy court from any further jurisdiction to review the state court judgment.

Accordingly, the BAP vacated the bankruptcy court’s judgment, and remanded the case with instructions to dismiss the adversary proceeding for lack of subject matter jurisdiction.

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Eric Tsai practices in Maurice Wutscher’s Commercial Litigation and Consumer Credit Litigation groups, and in its Regulatory Compliance group. He concentrates his practice primarily on the defense of consumer and commercial financial services companies, including mortgage lenders and servicers, mortgage loan investors, third party debt collectors, and other financial services providers. He also counsels clients on regulatory compliance, licensing, and other consumer protection matters. Eric earned his undergraduate degree from the University of California, Irvine. Prior to attending law school, he worked as a loan officer for national direct lenders. He earned his Juris Doctor from California Western School of Law and thereafter obtained a Master of Laws (LLM) in Taxation from the University of San Diego School of Law. Eric publishes extensively on various issues affecting consumer lending and litigation, including both federal and California-specific developments. He is licensed to practice law in California, Nevada, and Oregon, and is admitted in all United States District Courts in the State of California, the United States District Court for the District of Oregon, the United States District Court for the District of Nevada, the U.S. Tax Court, and the Ninth Circuit Court of Appeals. He is also a licensed real estate broker in the State of California.