If a mortgage is ambiguous or contains a mistake, a lender may generally reform the mortgage under state law. [1] But what if a borrower files a bankruptcy petition before a lender does so? In a divided opinion, the U.S. Court of Appeals for the Fifth Circuit confirmed that a lender may not reform a mortgage post-petition. [2] The dissent, however, offers lenders a potential pathway around this prohibition in future cases.
Michael Worley was the sole member of W Resources, LLC. NCC Financial, LLC extended an $8 million loan to Worley individually. Nonetheless, NCC secured the loan by taking a mortgage on W Resources’s real property.
The problem, however, is that the mortgage defined the term “indebtedness” as “all obligations and liabilities of Mortgagor” and defined “Mortgagor” as W Resources — which, of course, owed no debt to NCC. So it appeared that NCC’s mortgage was securing no debt at all.
W Resources filed a chapter 11 petition, and NCC filed a proof of claim that asserted an $8 million claim against the estate, secured by W Resources’s real property. But a competing secured creditor objected, arguing that W Resources owed no debt to NCC. Under Louisiana law, a mortgage without an underlying obligation or debt is invalid and unenforceable. [3]
NCC responded that its mortgage was valid because the parties intended that the mortgage would secure Worley’s individual debt, although it perhaps failed to say so expressly. NCC offered parol evidence to confirm the parties’ intent and clarify any perceived ambiguities in the mortgage.
But the bankruptcy court — as well as the district court on appeal — disagreed, holding that the mortgage was invalid. Both courts refused to consider parol evidence, finding that the language of the mortgage unambiguously excluded Worley’s debt.
On appeal, a divided panel of the Fifth Circuit affirmed.
According to the majority, NCC was attempting to reform its mortgage post-petition. But under § 502(b)(1) of the Bankruptcy Code, “claims are fixed for allowance purposes as of the date of filing of the debtor’s petition.” [4] In addition, § 544(a) empowers a trustee “to invalidate any liens or agreements that were unperfected or unenforceable as of the date of bankruptcy.” [5] So if a lien is unperfected or unenforceable as of the petition date, the bankruptcy court must disallow the claim. [6] This is true regardless of state law that might allow reformation outside bankruptcy.
Judge Stephen A. Higginson dissented. He acknowledged that a lender may not reform a mortgage post-petition. But in his view, NCC was not attempting to do so. If NCC was correct that the parties intended the mortgage to secure Worley’s debt, the mortgage was therefore valid as of the petition date — so reformation was not required.
Judge Higginson then opined that the lower courts erred in dismissing NCC’s parol evidence. Under Louisiana law, parol evidence is prohibited only in disputes between the parties to the contract. Given that the creditor objecting to NCC’s claim was a third party, Judge Higginson reasoned that parol evidence was admissible. Even so, parol evidence is admissible to clarify ambiguous terms, and Judge Higginson found that the mortgage was indeed ambiguous. For example, while the mortgage defined “Mortgagor” as W Resources, the mortgage also provided that “W Resources, LLC,... represented herein by Michael A. Worley, sole Managing Member,” would be “referred to collectively as the ‘Mortgagor.’” [7] Judge Higginson would have therefore vacated and remanded for further proceedings.
Ultimately, both the majority and dissent agreed that a lender may not reform a security instrument post-petition. But Judge Higginson’s dissent charts a path for secured lenders in future cases. This is particularly so given that the opinion is unreported and nonbinding. To the extent a party objects to a secured creditor’s claim based on an ambiguous or potentially mistaken security instrument, the secured creditor should look for arguments concerning the interpretation of the instrument’s terms, as opposed to requesting reformation of the instrument itself — assuming, of course, that applicable state law supports that argument.
[1] See, e.g., Phillips Oil Co. v. OKC Corp., 812 F.2d 265, 274 (5th Cir. 1987) (describing equitable remedy of reformation under Louisiana law).
[2] NCC Fin. LLC v. Investar Bank N.A. (In re W Res. LLC), 21-30291, 2022 WL 1117107 (5th Cir. April 14, 2022).
[3] See La. Civ. Code art. 3282 (providing that mortgage with no underlying obligation is invalid and unenforceable).
[4] In re W Res. LLC, 2022 WL 1117107, at *2 (emphasis added) (citing 11 U.S.C. §§ 506(b), 502(b)(1) and 544(a)).
[5] In re W. Res. LLC, 2022 WL 1117107, at *2 (emphasis added) (citing 11 U.S.C. § 544(a)).
[6] Assuming, of course, that a party objects to the claim.
[7] In re W. Res. LLC, 2022 WL 1117107, at *9 (emphasis added).