Some of you who read the title of this post may have done a quick double-take, as it is well established that lenders may not collect a deficiency on a nonrecourse loan under state law. However, the Bankruptcy Code provides some relief to a holder of a wholly unsecured nonrecourse loan when the debtor files for Chapter 11 protection.

Nonrecourse loans limit creditors to look only to debtor’s collateral for repayment. This means that after a foreclosure sale, a creditor may not seek a deficiency judgment against the debtor. Because there is no state law right to a deficiency, debtors have argued that the Bankruptcy Code should likewise not permit a wholly-unsecured nonrecourse creditor’s claim to be an allowed claim in bankruptcy.

The Seventh Circuit, in In re B.R. Brookfield Commons, held that by operation of § 1111(b) of the Bankruptcy Code, wholly-unsecured nonrecourse claims are treated as if the creditor had recourse, and its unsecured deficiency claim is allowed.

Section 1111(b) provides that a “claim  secured by a lien on property” of the bankruptcy estate is to be allowed against the debtor, as if the claimant had recourse against the debtor, whether or not by contract or law the creditor actually had such recourse. Application of this section prevents a windfall to the debtor, and “puts the Chapter 11 debtor who wishes to retain collateral property in the same position as a person who purchased property ‘subject to’ a mortgage lien would face in the non-bankruptcy context.”

The debtor in Brookfield Commons relied on In re SM 104, Ltd., a 1993 opinion of the Bankruptcy Court for the Southern District of Florida, which held that a wholly unsecured nonrecourse claim is not a “claim secured by a lien on property” under § 1111(b) and is, therefore, not entitled be treated as a recourse claim. The In re SM 104, Ltd. court essentially disallowed the entire claim, reasoning that because the creditor had no right to payment from the debtor or the debtor’s property, it was not a creditor of the debtor. The Seventh Circuit rejected In re SM 104, Ltd., as an “outlier.” Although the Eleventh Circuit has not ruled on the issue, it should be noted that in In re Tanner, the Eleventh Circuit held that a wholly-unsecured mortgage could be stripped off in a Chapter 13 because it was not “a claim secured…by a security interest in real property” within the meaning of the Chapter 13 anti-modification clause.  It remains to be seen, however, whether the Eleventh Circuit would follow In re SM 104 or Brookfield Commons.

So what is the takeaway? If you are a lender with a nonrecourse junior loan which has become wholly unsecured, a debtor’s Chapter 11 filing might be helpful. Without the ability to collect a deficiency under state law, § 1111(b) operates equitably to allow the nonrecourse claim to be included as a recourse claim in the debtor’s plan of reorganization.