In re Arnold

• Decision Date: 28 November 2012
• Docket Number: No. 12 B 11838.,12 B 11838.
• Citation: 483 B.R. 515
• Parties: In re Sandra ARNOLD and Donald Arnold, Debtors.
• Court: U.S. Bankruptcy Court — Northern District of Illinois

483 B.R. 515

In re Sandra ARNOLD and Donald Arnold, Debtors.

No. 12 B 11838.

United States Bankruptcy Court,

N.D. Illinois,

Eastern Division.

Nov. 28, 2012.

Ben L. Schneider, Schneider & Stone, Skokie, IL, for debtors.

Andrew E. Houha, Johnson Blumberg and Associates, Marc S. Lipinski, Donnelly, Lipinski & Harris, LLC, Chicago, IL, for respondent.

MEMORANDUM OPINION

DONALD R. CASSLING, Bankruptcy Judge.

The issue in this case is whether an unrecorded Illinois mortgage is “a claim secured only by a security interest in real property that is the debtor's principal residence” for purposes of 11 U.S.C. § 1322(b)(2), which prohibits a Chapter 13 plan from modifying the rights of a holder of such a claim.

It is undisputed that Bank of America, N.A. (the “Bank”), never recorded its mortgage on the principal residence of debtors Sandra and Donald Arnold (the “Debtors”). The parties also agree that under Illinois law: (1) the Bank may not enforce its unrecorded mortgage against creditors, including trade creditors, without actual prior knowledge of the Bank's mortgage, but (2) the Bank may enforce its note and unrecorded mortgage against the Debtors. The parties disagree as to the consequences of this state-law treatment of the Bank's position in determining whether the Bank's claim is protected against modification under § 1322(b)(2), The Debtors take the position that the Bank's inability to enforce its unrecorded mortgage against creditors without actual prior notice of the mortgage is determinative and leaves the Bank without a “claim secured only by a security interest in real property that is the debtor's principal residence.” 11 U.S.C. § 1322(b)(2). As a result, the Debtors argue, their Chapter 13 plan of reorganization (the “Plan”) appropriately treats the Bank's claim as unsecured. The Debtors also argue that, because the Bank did not file proof of an unsecured claim prior to the claims bar date, its unsecured claim has been waived.

The Bank argues that its right to enforce its mortgage against the Debtors is all that matters in determining whether it has a “claim secured ... by a security interest” in the Debtors' home, and that the mortgage's ineffectiveness against subsequent creditors should play no role in the analysis. Id. According to the Bank, the Debtors' Plan modifying the Bank's rights is therefore unconfirmable under § 1322(b)(2). The Bank also argues that, if the Court determines that it does not have a secured claim, its claim should still be allowed as an unsecured claim.

For the reasons that follow, the Court agrees with the Debtors that the Bank's claim is not “a claim secured ... by a security interest” in the Debtors' properly for purposes of the anti-modification provisions of § 1322(b)(2), but agrees with the Bank that it possesses an enforceable unsecured claim against the Debtors, notwithstanding its failure to have filed a proof of an unsecured claim.

I. JURISDICTION AND PROCEDURE

The Court has jurisdiction to entertain this matter pursuant to 28 U.S.C. § 1334 and Internal Operating Procedure 15(a) of the United States District Court for the Northern District of Illinois. It is a core proceeding under 28 U.S.C. § 157(b)(2)(A), (B), and (O).

II. BACKGROUND

The Debtors purchased their home in Carol Stream, Illinois, using funds loaned to them by the Bank. As part of the loan transaction, the Debtors executed both a note and a mortgage on the home in favor of the Bank. Unbeknown to the Debtors then and until after the time of filing of this case, the Bank never recorded that mortgage.

The Debtors filed a Chapter 13 voluntary petition on March 26, 2012, and filed their original plan shortly thereafter.¹ (Docket No. 12.) In that original plan the Debtors treated the Bank as a secured creditor, with post-petition monthly mortgage payments to be sent to it directly by the Debtors. ( Id.) The original plan also provided for mortgage arrears to be disbursed to the Bank by the Chapter 13 trustee. ( Id.)

On July 20, 2012, the Bank filed a motion to have the stay modified so that it could record its mortgage. (Docket Nos. 36 & 38.) The Court denied that motion. (Docket No. 55.) Learning for the first time that the Bank had failed to record its mortgage, the Debtors amended their Schedule A to reduce the amount of the secured claim on the Property to $0.00. (Docket No. 41.) At the same time, they reduced the stated value of the home from $160,000.00 to $125,000.00. ( Id.) In addition, the Debtors then modified and filed the Plan on July 25, 2012, changing the treatment of the Bank's claim from secured to unsecured and eliminating any provision for payment of mortgage arrears. (Docket No. 49.)

In response, on August 1, 2012, the Bank filed an objection to confirmation of the Plan, arguing (1) that the Plan improperly treats its claim as unsecured, (2) that the Debtors' reduced valuation of the home is in error, so that the Plan does not meet the net liquidation test, and (3) that the Debtors failed to adequately justify the reduction in income on their Amended Schedule I. ² (Docket No. 59.)

The next day, on August 2, 2012, the Bank filed its proof of claim number 13–1 (“Claim No. 13–1”) in the sum of $200,318.65 for a “Note and Mortgage dated February 14, 2009.” (Claim No. 13–1.) Notwithstanding that it had already admitted that it had not recorded its mortgage, the Bank filed Claim No. 13–1 as a secured claim and stated that the basis for perfection of the mortgage was “recording with county recorder.” ( Id.) The Bank attached to Claim No. 13–1 a copy of the mortgage, a “mortgage proof of claim attachment,” and an escrow analysis. ( Id.)

Five days later, on August 7, 2012, the Bank amended its Claim No. 13–1 (“Claim No. 13–2”), keeping the secured claim in the same amount as listed on the original claim but leaving the section on the form for “basis for perfection” blank.³ (Claim No. 13–2.) The Bank attached the same exhibits to the amended claim as were attached to the original. ( Id.) Both the original and amended claims reflect an arrearage amount of $16,104.54. (Claim Nos. 13–1 & 13–2.)

On August 22, 2012, the Debtors objected to the Bank's Claim No. 13–2 on the basis that the Bank's mortgage was never recorded and therefore is not a secured debt. (Docket No. 68.) Upon request of the Court, both parties filed briefs in support of their respective positions, and the Court took the matter under advisement.

The Debtors' Plan cannot be confirmed if the Bank has a “claim secured only by a security interest in real property that is the debtor's principal residence” within the meaning of the anti-modification provision of § 1322(b)(2). Resolution of whether the Bank's claim is secured or unsecured requires resort to both the Bankruptcy Code and to Illinois law.

III. APPLICABLE STANDARDS

Section 1322 of the Bankruptcy Code generally permits Chapter 13 debtors to “modify the rights of holders of secured claims,” with one exception: The plan may not modify the rights of “a claim secured only by a security interest in real property that is the debtor's principal residence....” 11 U.S.C. § 1322(b)(2) (emphasis added). The term “security interest” is defined by the Code to mean a “ lien created by an agreement.” 11 U.S.C. § 101(51) (emphasis added). In turn, the Code definesthe term “lien” to mean a “ charge against or interest in property to secure payment of a debt or performance of an obligation.” 11 U.S.C. § 101(37) (emphasis added); see also In re Penrod, 50 F.3d 459, 463 (7th Cir.1995).

State law determines whether the parties have created a “lien” within the meaning of these Code definitions. Bank of Am., N.A. v. Outboard Marine Corp. (In re Outboard Marine Corp.), 304 B.R. 844, 854 (Bankr.N.D.Ill.2004). “Specifically, ‘applicable state law determines the ... validity of liens on property in the bankruptcy estate.’ ” Id. (citation omitted); see also Peterson v. Chas. Bender Co. (In re Lifchitz), 131 B.R. 827, 832 (Bankr.N.D.Ill.1991). Because the note and mortgage in this case were executed in Illinois, the question of whether the Bank has a lien upon the Debtors' home for purposes of § 1322(b)(2) must be resolved by reference to Illinois law.

Illinois has two separate statutes dealing with this issue, and they are consistent in providing that a lien is created upon recording of the mortgage. For example, § 5/15–1301 of the Illinois Code states:

Except as provided in Section 15–1302, from the time a mortgage is recorded it shall be a lien upon the real estate that is the subject of the mortgage for all monies advanced or applied or other obligations secured in accordance with the terms of the mortgage or as authorized by law, including the amounts specified in a judgment of foreclosure in accordance with subsection (d) of Section 15–1603.

735 Ill. Comp. Stat. 5/15–1301 (emphasis supplied). Similarly, § 5/30 of the Illinois Code provides:

All deeds, mortgages and other instruments of writing which are authorized to be recorded, shall take effect and be in force from and after the time of filing the same for record, and not before, as to all creditors and subsequent purchasers, without notice; and all such deeds and title papers shall be adjudged void as to all such creditors and subsequent purchasers, without notice, until the same shall be filed for record.

765 Ill. Comp. Stat. 5/30 (emphasis added).

Under Illinois law, a mortgage must therefore be recorded before a lien arises in the debtor's property that will be effective as to all creditors and subsequent purchasers. “A mortgage becomes effective when it is recorded. This is a long-standing rule that has been codified in our statutes [.]” Firstmark Standard Life Ins. Co. v. Superior Bank FSB, 271 Ill.App.3d 435, 208 Ill.Dec. 409, 649 N.E.2d 465, 468 (1995). Thus, if a mortgage is not recorded, and does not provide notice to a subsequent transferee, it is ineffective as to that transferee. Bank of Ill. v. Covey (In re Shara Manning...