Mortgage Holders --Have a bankrupt borrower? Beware how you file your proof of claim

If you are a secured creditor, holding mortgage on real property as collateral, you will be ahead of the unsecured creditors if the borrower files for bankruptcy. Correct? Sort of, but not completely.  Under the Bankruptcy Code, a secured creditor actually has 2 claims—a secured claim up to the value of the collateral securing the loan, and an unsecured claim for the amount of the obligation, if any, in excess of the collateral’s value. Each claim carries its own control and distribution rights.

Before the collapse in real estate values, mortgagees never had to consider filing two claims when the mortgagor filed bankruptcy. After all, the value of real property typically held steady if not increased in value, so a lender’s claim would be fully covered by the collateral.  Today, everything has changed. It is not uncommon to see property, both residential and commercial, being sold by lenders at a fraction of its original value, leaving a deficiency balance to be collected that is unsecured.

A mortgage holder that wants to ensure it is fully protected when a borrower files for bankruptcy protection should file a proof of claim for both the secured claim and the unsecured portion of its secured claim.

In November 2011, the Eleventh Circuit Court of Appeals handed the IRS an unpleasant surprise when it held that the IRS waived its rights with respect to plan voting and distribution towards the unsecured portion of its secured claim due to its failure to affirmative file a proof of claim for the unsecured portion.  (I confess that I enjoyed the IRS getting smacked down.) The IRS argued that its secured claims were automatically bifurcated into a secured and unsecured claim under Section 506(a)(1) of the Bankruptcy Code. The court disagreed holding that an undersecured creditor must signal its intent to pursue a deficiency claim as this serves an important notice function providing the trustee of the bankruptcy estate and other creditors an opportunity to contest the claim.

For now this decision only controls for those located in the Eleventh Circuit (i.e., Alabama, Florida and Georgia).  Only time will tell whether any of the other Courts of Appeal will follow the Eleventh Circuit or not. In the meantime, it’s best to take care in how your proof of claim is filed to ensure you do not inadvertently waive your rights and end up like the IRS.
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