Salyersville National Bank v. Bailey (In re Bailey)

• Decision Date: 12 December 2011
• Docket Number: No. 10–5505.,10–5505.
• Citation: 664 F.3d 1026,66 Collier Bankr.Cas.2d 1261
• Parties: In re Jackie BAILEY; Peggy Bailey, Debtors.Salyersville National Bank, Appellant, v. Jackie Bailey; Peggy Bailey, Appellees.
• Court: U.S. Court of Appeals — Sixth Circuit

66 Collier Bankr.Cas.2d 1261

664 F.3d 1026

In re Jackie BAILEY; Peggy Bailey, Debtors.Salyersville National Bank, Appellant,

v.Jackie Bailey; Peggy Bailey, Appellees.

No. 10–5505.

United States Court of Appeals, Sixth Circuit.

Argued: Oct. 6, 2011.Decided and Filed: Dec. 12, 2011.

ARGUED: John T. Hamilton, Gess Mattingly & Atchison, PSC, Lexington, Kentucky, for Appellant. Carolyn M. Friend, Friend & Associates, Georgetown, Kentucky, for Appellees. ON BRIEF: John T. Hamilton, Gess Mattingly & Atchison, PSC, Lexington, Kentucky, for Appellant. Carolyn M. Friend, Friend & Associates, Georgetown, Kentucky, for Appellees.Before: KEITH, SUTTON and McKEAGUE, Circuit Judges.

OPINION

SUTTON, Circuit Judge.

Jackie and Peggy Bailey fell on hard times, forcing them to seek protection from their creditors through the bankruptcy laws. In the course of the bankruptcy proceeding, they signed a reaffirmation agreement with their mortgage lender, which allowed them to stay in their home, obligated them to continue making their full mortgage payments after the bankruptcy and was premised on the assumption (later proved false) that the lender had properly perfected the mortgage. Because the parties premised the contract on a mutual mistake—that the bank was a secured creditor—it is unenforceable under Kentucky law. We affirm.

I.

In 2001, Jackie Bailey and his wife Peggy borrowed $157,291.77 from Salyersville National Bank, pledging their home and 40 acres of land as security. In 2004, they took out a second loan from the bank for $15,870, this time pledging their 1998 Chevrolet pickup truck as security. The Baileys encountered marital and financial problems, filing for divorce in January 2005 and for Chapter 7 bankruptcy protection four months later.

Less than one month after seeking bankruptcy protection, the Baileys and the bank signed a reaffirmation agreement committing the Baileys to pay those two debts, which would otherwise have been dischargeable in bankruptcy. Under the agreement, the Baileys “reaffirm[ed] certain secured indebtedness” (the 2001 and 2004 loans) and “maintain[ed] possession of property secured thereby” (their home and truck) in return. R.11 Ex. D at 1.

Not long after signing the reaffirmation agreement, the Baileys stopped paying back the loans. The bank tried to repossess the truck. When it learned that the truck had a “blown engine and transmission” and, worse, had been stolen (the thief perhaps getting what he deserved), the bank gave up on the quest. R.14 Ex. 4 at 1. The bank filed a “wholly unsecured claim” against the bankruptcy estate because “its collateral was not available to be repossessed and sold.” Id. As for the real property, the bankruptcy trustee sued the bank, seeking a declaration that the lien on the property should be avoided—thus preserving the property for the benefit of the bankruptcy estate—because the bank had not properly perfected the mortgage. The trustee's suit was ultimately settled by an agreed judgment. The agreed judgment provided that the real property would be sold by the trustee at an auction with the proceeds going to the estate, and, in the event the bank purchased the property, “the portion of the Trustee's Complaint relating to avoidance of the mortgage of Salyersville National Bank shall be considered dismissed with prejudice, and the mortgage shall remain in effect.” R.11 Ex. F at 2.

The bank bought the property at the auction, re-sold it to a third party at a profit of $33,400 and filed an unsecured claim with the bankruptcy estate for the full balance the Baileys owed on the mortgage. The bankruptcy court allowed this claim and in the process determined that the bank was an unsecured creditor. In doing so, the bankruptcy court made explicit what the agreed judgment had established implicitly. The bank received a total of about $37,000 in payments from the bankruptcy estate as an unsecured creditor on the two loans.

The end of the bankruptcy case in December 2007 sparked the beginning of a new lawsuit in January 2008. The bank sued the Baileys in Kentucky state court, seeking about $89,000 on the real property loan and about $11,500 on the truck loan. In response, the Baileys moved the bankruptcy court to reopen their case under Rule 60 of the Federal Rules of Civil Procedure (applicable via Rule 9024 of the Federal Rules of Bankruptcy Procedure) and to declare the reaffirmation agreement void. The bankruptcy court obliged. It voided the reaffirmation agreement on the ground of mutual mistake because the parties signed the agreement based on the false assumption that the bank held secured interests in the real property and the truck, which would have allowed the Baileys (rather than the bankruptcy estate) to retain ownership of those items. The district court affirmed on the same grounds.

II.

A reaffirmation agreement selectively excludes some debts from the effect of a bankruptcy discharge. In its classic form, the debtor agrees to remain on the hook for an obligation that otherwise would be dischargeable in bankruptcy in exchange for the right to keep collateral that he otherwise would have to give up. See Pertuso v. Ford Motor Credit Co., 233 F.3d 417, 420 (6th Cir.2000). Under the Bankruptcy Code, such agreements bind the parties if they are “enforceable under applicable nonbankruptcy law,” including state contract law. 11 U.S.C. § 524(c).

The lower courts held that this reaffirmation agreement is unenforceable under Kentucky law because the parties premised it on a mutual mistake: that the bank had secured interests in the Baileys' real property and truck. The bank asks us to reverse that decision for two reasons: (1) there was no mutual mistake because the bank in truth was a secured creditor, and (2) even if the bank was an unsecured creditor, the reaffirmation agreement is still valid under Kentucky contract law. The first argument is procedurally lost, and the second one is substantively wrong.

A.

The bank insists it has always been a secured creditor with respect to the two loans. But the history of this litigation forecloses that possibility.

Under the Bankruptcy Code, “there are several avenues of action open to a secured creditor of a bankrupt.” U.S. Nat'l Bank in Johnstown v. Chase Nat'l Bank of N.Y.C., 331 U.S. 28, 33, 67 S.Ct. 1041, 91 L.Ed. 1320 (1947). Generally speaking, a secured creditor: (1) “may disregard the bankruptcy proceeding,” subject to the provisions of 11 U.S.C. § 362(a), “and rely solely upon his security”; (2) may file a secured claim with the bankruptcy court; (3) may “surrender or waive his security and prove his entire claim as an unsecured one”; or (4) may “avail himself of his security and share in the general assets [of the bankruptcy estate] as to the unsecured balance” of the debt. Johnstown, 331 U.S. at 33, 67 S.Ct. 1041. Once he selects one of these options, he may not disavow that choice and proceed down a different path. In particular, “participation by a secured creditor in distributions from the general assets [of the bankruptcy estate] on the basis of his full claim [generally] indicates a waiver of the security and an election to be treated as an unsecured creditor.” Id. at 35, 67 S.Ct. 1041; see also United Sav. Ass'n of Tex. v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 379, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988).

Just such a waiver happened here. As to the truck: although the bank apparently believed it had a perfected security interest in the 1998 Chevy pickup, it came to view the loan as being “essentially unsecured from the outset” because the truck was in poor condition, to say nothing of stolen, making it unattractive as collateral. R.14 Ex. 4. Rather than file a claim as a secured creditor or attempt to recover insurance proceeds for the stolen truck, the bank “filed [its] claim as a wholly unsecured claim.” Id. It received about $2,400 on this claim from the estate. The bank cannot complain that it now should be treated as a secured creditor after all. See Morrison v. Rieman, 249 F. 97, 102 (7th Cir.1917) (“[W]here a secured creditor deliberately, and not through error or inadvertence files his claim as unsecured ... he thereby waives it in favor of the estate, and cannot, after adjudication, assert it.”).

As to the real property: a dispute arose between the bankruptcy trustee and the bank about whether the bank had a valid security interest in the Baileys' home. After litigation that cost the bankruptcy estate more than $31,000 in attorney's fees, the bank entered into an agreed judgment that, as the bankruptcy court noted, effectively ceded the property to the bankruptcy estate, which “[sold] the subject real estate free and clear of the Bank's putative mortgage” and collected all proceeds from the sale of the property at auction. R.14 Ex. 5 (Bankr.Ct. Order, 12/12/06) at 4–5. The bank filed an unsecured claim for the full amount of the debt in question and received around $35,000 on this claim. On this record, the bank's argument faces two insurmountable obstacles: (1) the bank waived the right to proceed as a secured creditor with respect to the real property, see Johnstown, 331 U.S. at 35, 67 S.Ct. 1041; Morrison, 249 F. at 102; and (2) the bankruptcy court's final, unappealed 2006 order treated the bank as an unsecured creditor, precluding the bank (or us) from revisiting the issue, see Katchen v. Landy, 382 U.S. 323, 334, 86 S.Ct. 467, 15 L.Ed.2d 391 (1966).

The bank insists that, rather than waiving the security interest, it pursued the fourth avenue open to secured creditors under Johnstown: availing itself of its security and filing as an unsecured creditor with respect to the balance of the debt. Not true. The bank relinquished its collateral in the agreed judgment and became an unsecured creditor. Had the bank successfully exercised its lien on the real property, it would have sought only the amount remaining on the Baileys' debt after liquidating the...