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Advance To Debtor After Guarantor's Bankruptcy Upheld

by Sam Ott

A bankruptcy trustee cannot not avoid a home mortgage lien that was created by a guarantor home owner prior to a filing of bankruptcy, according to an April 9, 2002 decision of the United States Court of Appeals, Ninth Circuit, upholding the decision of the Bankruptcy Appellate Panel.

The case, Stanton v. Harrison Jewell, arose from the financing of a corporation. The debt was guaranteed by the sole shareholders of the corporation, and, as a condition of the financing, the lender required a second mortgage on the guarantors' home.

The guarantors filed personal Chapter 11 bankruptcy. The corporation did not file and the lender continued to make advances to the corporation secured in part by the home mortgage.

The Chapter 11 was converted to a Chapter 7 and the bankruptcy trustee sold the home. The entity which had loaned money to the corporation (guaranteed by the individuals who subsequently filed bankruptcy and secured by a mortgage on their home) sought to attach the proceeds based on its lien. The trustee attempted to avoid the lien on the theory the guarantors had encumbered bankruptcy assets without court authority when the corporation incurred more debt after the filing of the bankruptcy petition.

The bankruptcy court granted the trustee's motion to avoid the lien and the lender appealed to the Bankruptcy Appellate Panel. The Panel reversed the lower court and held that the guarantors encumbered their house prior to the bankruptcy and the advances to the corporation did not amount to the creation of a new lien in favor of the lender.

The Court of Appeals noted that while the guarantors owned all of the stock of the corporation there was no finding or contention that the corporation was a sham or that the corporate veil should be pierced for any reason. The guarantors went bankrupt -- not the corporation. The trustee argued that the lien on the house could be avoided because the lien secured advances the lender made to the corporation after the filing of the bankruptcy petition. The Court upheld the ruling of the Appellate Panel that the lien could not be avoided because it was created when the guarantors granted the mortgage and not when the advances were made. Neither the lender nor the corporation needed the bankruptcy court's approval for the advances, since they were made to the corporation and the corporation itself was not in bankruptcy.

The Court rejected the contention of the trustee that the advances violated the automatic stay and subjected the lender to the applicable penalties. The Court noted that a business relationship of stock ownership does not by itself extend the automatic stay to non-bankrupts. The lien was created when the mortgage was given (prior to the bankruptcy). The subsequent advances merely affected how much money the lien secured. A new lien was not created each time an advance was made because the deed of trust contained a future advance clause that secured "any and all indebtedness of the corporation incurred at any time in the future".

The Court noted that if applicable state law did not recognize a future advance clause and treated each subsequent advance as a new lien, a different analysis would apply. In this case, state law recognized that a mortgage containing a future advance clause becomes an effective lien as to subsequent encumbrances from the time of its recordation, rather than from the time when each advance is made.

Even though the lender's lien was not avoided, the Court also held the lender was not entitled to recover all funds that were advanced after the filing of the bankruptcy. If the advances were made at the option of the lender, the extent of the subsequent advances was junior to the priority of the trustee's intervening claims. Regarding the proceeds from the sale of the house, the trustee was senior to the lender for the advances made after the filing of bankruptcy by the guarantor. The lender's lien preexisted the bankruptcy and the advances did not violate the automatic stay. The priority of the lender to the proceeds of the sale of the home became limited to the extent of the advances made prior to bankruptcy, because the subsequent advances were optional. The Court did not specifically address the question as to the result if the subsequent advances were mandatory. Also of note is the presence of a strong dissent by one member of the Court who argued the decision of the bankruptcy court in favor of the trustee.

First published on 4/11/02

First published on 04/11/2002

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