In a 2/1 opinion, the Fifth Circuit seemed to hold that a bankruptcy court cannot reform a mortgage to account for a mistake in drafting. In other words, any defects in a mortgage on the filing date, even though they might be corrected in state court outside of bankruptcy, are set in stone as a consequence of the so-called strong-arm clause in Section 544(a).
The dissenter would have reversed and remanded, to permit the bankruptcy court to entertain parol evidence aimed at reforming the mortgage.
The per curiam opinion by the majority was nonprecedential. Consequently, there is no binding precedent in the Fifth Circuit disallowing the bankruptcy court from reforming an instrument.
The majority were Circuit Judges Edith H. Jones and Stuart Kyle Duncan. Circuit Judge Stephen A. Higginson “respectfully” dissented.
The Defective (?) Mortgage
An individual was the sole owner and manager of a corporation that ended up being a chapter 11 debtor. The owner was not in bankruptcy.
Before bankruptcy, the owner took down an $8 million loan from a lender. Alongside the note and loan agreement, the owner, in his corporate capacity, signed a mortgage in favor of the lender secured by the company’s property.
The lender never made any loans to the corporation, only to the owner personally. In short, the mortgage secured any debt owing by the corporation to the lender, but there was no such debt.
In this writer’s view, there is some indication in the loan documents that the mortgage was also intended to secure the owner’s debt to the lender but was mistakenly written only to secure debt owing by the corporation.
In chapter 11, a different creditor with a lien on the corporation’s property objected to the validity of the lender’s mortgage and claim. The lender attempted to introduce parol evidence to say that the mortgage on the corporation’s property was intended to secure the owner’s debt.
Refusing to hear parol evidence, the bankruptcy court held that the mortgage was unenforceable because there was no underlying debt. On appeal, the district court upheld the invalidation of the mortgage and the disallowance of the lender’s claim against the corporation.
The Majority’s Affirmance
The majority said that the lender “essentially seeks to reform the publicly recorded Mortgage to cover [the owner’s] substantial debt.” The majority went on to say in the next breath that what the lender “does not do is grapple with the iron rule of bankruptcy: creditor claims are fixed for allowance purposes as of the date of filing of the debtor’s petition. See 11 U.S.C. §§ 506(b), 502(b)(1), 544(a).”
Continuing the same train of thought, the majority said that the “strong-arm power enables the Trustee to marshal the assets of the debtor as they existed at the date of bankruptcy, and that date furnishes a stable backdrop for valuing the assets according to the priorities established by the Bankruptcy Code and state law.”
Having stated the principles, the majority said that the mortgage “was defective at the inception of bankruptcy because it reflected only an obligation to pay by [the corporation], yet the debtor [corporation] owed it nothing. Louisiana law renders unenforceable such a mortgage that does not support an underlying obligation.”
The majority said it had not found a case even “remotely” similar where “a secured creditor was allowed to clean up its documentation and perfect an otherwise unenforceable claim post-bankruptcy.”
At the end of the opinion, the majority said,
The bankruptcy court acknowledged that parol evidence might have been admissible outside of bankruptcy to demonstrate the incompleteness of the Mortgage, but that exception does not come into play in this bankruptcy case, where the rights of other creditors are involved and the strong-arm clause takes effect.
Upholding the lower courts and insinuating that the result might have been different under Louisiana law, the majority said, “we need not consider whether the Mortgage also failed under the state’s recording law.”
The Dissent
In dissent, Judge Higginson cited testimony and indications in the loan documents that the mortgage may have been written in error. The lower courts, he said, did not consider parol evidence.
In Judge Higginson’s view, the failure to consider parol evidence was error because the rule in Louisiana law only prohibits contradictory testimony by one of the parties to the instrument. In the case on appeal, the parol evidence rule did not apply, in his view, because the mortgage was being challenged by another secured creditor who was not a party to the mortgage.
Judge Higginson would have reversed and remanded for a consideration of parol evidence. He did “not see the Bankruptcy Code as having relevance to the issue of whether the Mortgage is valid under Louisiana law, the only issue presented in this appeal.”
In a 2/1 opinion, the Fifth Circuit seemed to hold that a bankruptcy court cannot reform a mortgage to account for a mistake in drafting. In other words, any defects in a mortgage on the filing date, even though they might be corrected in state court outside of bankruptcy, are set in stone as a consequence of the so-called strong-arm clause in Section 544(a).
The dissenter would have reversed and remanded, to permit the bankruptcy court to entertain parol evidence aimed at reforming the mortgage.
The per curiam opinion by the majority was nonprecedential. Consequently, there is no binding precedent in the Fifth Circuit disallowing the bankruptcy court from reforming an instrument.
The majority were Circuit Judges Edith H. Jones and Stuart Kyle Duncan. Circuit Judge Stephen A. Higginson “respectfully” dissented.