The Filing of Claims: How Secure is a Secured Creditor?

How Secure is a Secured Creditor?

The theory of bankruptcy holds that the “secured creditor” is not involved in bankruptcy. His debt is secured by real property or some other property of value. Bankruptcy is the process of fair sharing among “unsecured creditors,” those individuals whose debts are not collateralized or otherwise secured by prior arrangement with the debtor.

The theory does not hold in practice. An example is the lien holder for whom the designated collateral does not meet the amount of debt that it was meant to secure. One example would be real estate that has devalued, so that the mortgage amount on it is more than the current value of the property. When a situation like this exists in a bankruptcy filing, the mortgage holder is a secured creditor for the true value of the real property. For the remaining amount owed, he becomes just another creditor whose claim will be allowed in the distribution of assets if he files the requisite proof of claim.

Can the Debtor Re-adjust the Allowed Property Value?

Under the bankruptcy umbrella, debtors have sought to force realignment of their debt on real property to conform to the actual property value. One debtor sued, asking that the court recognize the actual value of the land as full satisfaction of a loan that was tens of thousands higher, because the creditor was only a “”secured creditor” for the actual value of the land. The debtor’s intent was then to retain ownership of the land outside of bankruptcy, paying for it at the reduced figure. The court ruled that the full lien was an allowed secured claim, exempt from language which prohibited such inflated secured claims, based on its interpretation of the term “allowed secure claim” as meaning one thing in one section of the Code, and something else in another. A divided Supreme Court upheld the bankruptcy court’s ruling; the result is that the creditor benefits from any future rise in the real property’s value.

A Code that Needs De-coding

Confusion over the Bankruptcy Code has led to other odd outcomes. Poor Code language cause one court to hold that a secured creditor who failed to file a proof of claim in a Chapter 11 proceeding had lost the lien. The decision was overturned on appeal. This particular secured creditor participated in the Chapter 11 plan, which promised full payment. However the plan upon issuance failed to mention continuation of the secured status of the lien, so the court found that the collateral property was therefore freed from the secured claim.

All of this confusion resulted from a double negative in one of the relevant sections of the Bankruptcy Code. In the case discussed above, if the debtor had won his case and been given the option to pay off his creditor at the current value of the collateral property, he would have had to switch from liquidating his assets under Chapter 7 to rehabilitating his holdings under either Chapter 11 or 13. The Reform Act of 1984 was a major step in clarifying some of the more archaic provisions of the Bankruptcy Code, but changing economic times and circumstances suggest that more frequent realignment of the Code may be in order.