Avoiding Bankruptcy Traps When Pursuing Joint Borrowers in State Court Collection Actions

Lenders must be cautions not to abandon or forfeit rights against borrowers who file for bankruptcy protection. 

A recent decision by the U.S. Court of Appeals for the Seventh Circuit illustrates this point. In re Matter of Anderson, 917 F.3d 566 (7th Cir. 2019). 

In Anderson, two borrowers jointly borrowed $700,000 from a bank. When the loan subsequently went into default, the lender filed a two-count complaint in a state court action seeking mortgage foreclosure (Count I) and breach of the note (Count II). The bank later moved for a judicial sale and sought a deficiency against both borrowers. It was then that one of the borrowers filed for bankruptcy protection.

In response to this bankruptcy filing, the bank sought and obtained relief from the automatic stay, allowing it to proceed with the mortgage foreclosure. This move is fairly typical and normally in no way problematic. The bank’s mortgage foreclosure proceeded, the encumbered property was sold, and the bank obtained a deficiency against the non-bankrupt borrower.  In so doing, the trial court entered judgment for the bank on Counts I and II of the state court complaint. 

Later, the bank made a claim in the co-borrower’s bankruptcy case for the deficiency due on the note. The bankruptcy court denied the bank’s claim.  Specifically, the court concluded that the application of claim preclusion barred the bank’s deficiency claim because a final judgment had already been entered on the note claim in the state court case. Critically, the bankruptcy court found that when obtaining final judgment on the note the bank had failed to also seek a deficiency judgment against the bankrupt borrower. 

On appeal, the Seventh Circuit upheld the bankruptcy court’s ruling, finding  that the bank could have avoided the preclusive effect of the state court’s judgment simply by reserving the issue of the deficiency against the bankrupt borrower and keeping that issue pending in the state court action. This likely also could have been accomplished with a Rule 304(a) order to make the state court judgment final only as to the non-bankrupt borrower. The bank’s failure to pursue these prophylactic measures was fatal.

The moral of this story is that lenders must be cautious when proceeding against a joint borrower when a co-borrower also is seeking bankruptcy protection. The decision in Anderson demonstrates that rights not properly protected can be forfeited. Plainly, the intersection of state court collection litigation and bankruptcy court procedures can be troubling waters. 

You should not try to navigate this type of issue without competent legal counsel.

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