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Sixth Circuit Upholds Cancellation of Mortgage Debt Because Lien Was Never Perfected - Salyersville National Bank v. Bailey

December 27, 2011

In legal terms, a lien -- a legal encumbrance on property that secures a debt, like a house or a car -- cannot be enforced unless it is "perfected" by meeting standards set out by state law. Since the housing downturn began, some bankruptcy filers have sought to avoid debts by claiming they are based on liens that were not perfected, but this is a tough claim to prove. That's why the Claremont foreclosure defense lawyers at Howard Law, P.C., were interested to see a case where the Sixth U.S. Circuit Court of Appeals agreed that a lien had not been perfected, canceling a large debt owed by a couple from Kentucky. In Salyersville National Bank v. Bailey, Jackie and Peggy Bailey took out two secured loans from the bank, but were unable to pay even in bankruptcy and ultimately had their home repossessed and sold. They had reaffirmed the debts, thinking the loans were secured, but this was later proven false. In this action, the Sixth voided their reaffirmation based on mutual mistake.

The Baileys filed for bankruptcy four months after filing for divorce (actions that often go together, in our experience as Anaheim foreclosure defense attorneys). They had taken out a loan secured by their home and another secured by their truck, and reaffirmed both debts in the bankruptcy. However, they stopped paying after reaffirmation, in part because the truck had been stolen and partially destroyed. For the truck-secured loan, the bank then filed an unsecured claim. The bankruptcy trustee sued to avoid the mortgage because it had never been perfected, an action that was settled by an agreement to sell the property at auction, with the proceeds going to the estate. If the bank bought the property, the agreement said the avoidance action would be dismissed and the mortgage still in effect. The bank bought the property from the trustee at auction and immediately sold it to a third party for a $33,400 profit, then filed an unsecured claim in the bankruptcy for the full balance owed on the mortgage.

The Baileys paid $37,000 toward the unsecured debts in bankruptcy. After the bankruptcy ended, however, the bank immediately sued them for balances owed on both loans. They moved to reopen their bankruptcy case and have their reaffirmation declared void. The bankruptcy court agreed to void the reaffirmation on the grounds of mutual mistake -- both parties had incorrectly believed the bank had security interests in the debts when the debt was reaffirmed. The district court in Kentucky affirmed, and the bank appealed.

In a reaffirmation, the Sixth Circuit observed, bankruptcy filers agree to exclude some debt from discharge at the end of their bankruptcy, a sacrifice they make in order to keep the property. On appeal, the bank argues that it was in fact a secured creditor, so there was no mutual mistake. This argument contradicts the past history of the case, the Sixth said. The bank had elected to treat the truck loan as an unsecured claim, in part because the vehicle's bad condition made it bad collateral. It cannot legally change its mind later, the court said. On the real estate, the trustee had disputed whether there was a perfected lien, resolved by the sale and the bank's unsecured claim. Again, the bank had waived its right to pursue a secured claim by acting as an unsecured creditor, the Sixth said, and being treated like one. The court also rejected the bank's argument that Kentucky law allowed it to enforce the reaffirmation even if it's a unsecured creditor. Reaffirmations of debt must be enforceable under state law, and Kentucky law allows cancellation of contracts made when both parties were mistaken about a material fact. In this case, they were mistaken as to whether the debts were secured, an extremely material fact for the Baileys. Thus, it affirmed the district and bankruptcy courts.

Our Escondido foreclosure defense lawyers are pleased that the Sixth chose to protect this couple from the legal maneuverings of their mortgage lender. As the Sixth noted dryly, "people do not generally agree to pay more than $150,000 in exchange for nothing." It's also worth noting that the bank was attempting to collect the full unpaid balance of the loan despite having collected $33,400 in the foreclosure sale -- essentially squeezing a profit from recently bankrupt (and divorced) people. Reaffirming a debt may make sense in bankruptcy cases where the filer wants to keep the home, but doesn't have a big enough exemption to do it. However, this puts the filer on the hook for large payments, and as this case shows, those payments will continue to be enforceable after bankruptcy.

Based in Anaheim and led by experienced bankruptcy attorney Vincent Howard, Howard Law, P.C., represents clients across California who are considering bankruptcy as a way to deal with debt they can no longer handle on their own. For a consultation or to learn more about your options, call us toll-free at 1-800-872-5925 or send us a message online.

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