Secured Creditors’ State Court Rights Affected By Proof Of Claim Choices

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Secured creditors have many choices when it comes to how to file a proof of claim in bankruptcies. Those choices should be weighed carefully, however, because certain choices can have important unexpected consequences that outlive the bankruptcy and affect a secured creditor’s subsequent rights in state court actions.

When a debtor files a bankruptcy in which proof of claims are allowed, secured creditors have four options. They can (1) disregard the bankruptcy proceedings and just rely on their security; (2) file a secured proof of claim with the bankruptcy court; (3) waive their security interest and declare their claim as unsecured through a proof of claim in the bankruptcy court; or (4) file a proof of claim declaring their security interest but also availing themselves on the general assets of the bankruptcy estate as to the unsecured balance.

Once a creditor elects one of these options, especially electing to share in distributions from the general assets of the bankruptcy estate as a wholly unsecured creditor, it may not necessarily change its position and later ask to be treated as a secured creditor. This is especially true when a secured creditor files an unsecured proof of claim in the bankruptcy and then attempts to recover as a secured creditor in a subsequent state court action or to receive insurance proceeds if the collateral is destroyed. In re Bailey, 664 F.3d 1026 (6th Cir. 2011); In re Taylor, 280 B.R. 711 (Bankr. S.D. Ala. 2001).

For example, in In Re Taylor, a mortgage lien holder filed an unsecured non-priority proof of claim in a Chapter 13 bankruptcy. When the Plan was completed, there was still a balloon payment due. Had the creditor filed the proof of claim as a secured claim, the lien would have survived the plan and discharge of the debtors. Because the creditor filed an unsecured proof of claim, it waived its secured status and the lien ceased to exist upon the completion of the plan payments, which essentially released the mortgage in state court.

Filing unsecured proof of claims will also effect a secured creditor’s lien priority in a state-court foreclosure action. Even though title searches do not always check for the treatment of secured claims in bankruptcy cases, secured creditors involved in state foreclosure actions should pay attention to how other secured creditors filed their proof of claims because it is possible that some state court liens are still on record with the Register of Deeds Office which were actually waived and/or released in a prior bankruptcy case.

This was the issue in a recent South Carolina state foreclosure action. In South State Bank v. Greer et. al, Civil Action Number 2019-CP-23-00720 (Mar. 25, 2021), the foreclosure sale of commercial property resulted in surplus funds. American Express National Bank (“AMEX”) had previously filed a state court judgment against the landowner, which was first in line in the state records office after the mortgage that was foreclosed. Clayton Tile Distributing Co., Inc. (“Clayton Tile”) had filed a judgment against the landowner, which was technically filed after AMEX’s judgment. During the landowner’s Chapter 7 bankruptcy, assets were declared. AMEX filed an unsecured proof of claim while Clayton Tile filed a secured proof of claim. The Master in Equity for Greenville County held that:

[T]his Court finds that any claim by AMEX to the surplus funds has been waived or abandoned. AMEX had notice of the existence of the foreclosure action through the schedules filed in the Bankruptcy by Cameron H. Greer in July of 2019. AMEX did not assert a lien claim against the subject property in its Proof of Claim filed in the Bankruptcy. Accordingly, AMEX waived any claim to the surplus funds by filing its claim in the Bankruptcy as unsecured. See In re Devey, 590 B.R. 706 (Bankr. D.S.C. 2018); see also In re Workman, 373 B.R. 460 (Bankr. D.S.C. 2007).
Id.

The courts have reasoned that when a secured creditor makes a deliberate choice to make a claim as an unsecured creditor in hopes of participating in the distributions of a bankruptcy estate, it waives its right to also seek collection from the collateral.  Therefore, the creditor cannot change its position from unsecured to secured when it discovers an unforeseen benefit in the collateral.

For these reasons, secured creditors should be thoughtful and deliberate when deciding whether how to file proofs of claims in bankruptcies.  And, in state court actions, competing (and seemingly junior creditors) should pay close attention to how competing secured creditors filed claims in intervening bankruptcies because priorities may have shifted.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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