Divided Fifth Circuit Panel Suggests Bankruptcy Power Prevents Mortgage Reform After Petition Date | King and Spalding

[co-author: Frank DeBorde]

On April 14, 2022, in an unpublished and divided opinion affirming lower court orders denying a creditor’s claim and declaring the creditor’s mortgage invalid and unenforceable, the United States Court of Appeals for the Fifth Circuit ruled suggested (but did not finally rule) that a bankruptcy court cannot reform a mortgage to correct clerical errors in that mortgage after the date of the bankruptcy petition. Michael Worley was the sole owner and managing member of W Resources, which filed for bankruptcy in July 2018. Prior to bankruptcy, the owner obtained an $8 million personal loan from NCC Financial and signed a promissory note in his name only. On the same day, the owner (in its capacity as managing member) executed a mortgage in favor of NCC, which sought to encumber the property of W Resource and secure any debt that the company (as mortgagor) owed to NCC . Notably, NCC never made a loan to W Resources, only to the owner personally. W Resources subsequently filed for Chapter 11 bankruptcy and in a challenge to NCC’s proof of claim of over $8 million supported by the promissory note and mortgage, the bankruptcy court granted summary judgment in favor of Investar Bank, a competing creditor, with respect to the mortgaged properties, invalidating CNC’s mortgage as unenforceable and dismissing CNC’s claim. On direct appeal, the district court upheld the bankruptcy court. Both courts agreed with the competing creditor that the mortgage (i) was clear and unambiguous, thus precluding extrinsic evidence to construe the mortgage, and (ii) secured only the debt of W Resources, not the debt Worley’s personal account (including the note), making the mortgage unenforceable under Louisiana law because there was no underlying debt (i.e. no debt of W Resources to NCC).

On appeal, the Fifth Circuit’s split panel rejected NCC’s arguments to clarify the mortgage to correct an “obvious scrivener’s error” as ignoring “the iron rule of bankruptcy: creditors’ claims are fixed for purposes compensation from the date the debtor’s petition was filed.” Further, the committee noted that there were no remotely similar cases where “a secured creditor was permitted to cleanse its documentation and to perfect an otherwise unenforceable claim after bankruptcy”. Since Section 544 of the Bankruptcy Code “force clause takes effect” to invalidate any lien or agreement that was not perfect or unenforceable at the date of the petition (including NCC’s defective mortgage), the majority held that the exception allowing extrinsic evidence to demonstrate the incompleteness of the mortgage outside of bankruptcy does not apply in the context of bankruptcy.

In a dissenting opinion, Justice Higginson found that the mortgage documents were ambiguous as to the definition of mortgagor, noting that it would be “absurd if a document purporting to be a mortgage did not secure any underlying debt”. The dissenting opinion asserted that the court erred in refusing to consider parol evidence as to whether the mortgage gave third parties, like Investar, sufficient notice of the charge under Louisiana law. because the dispute was between two competing non-debtor creditors (i.e., Investar and NCC), one of which was not a party to the mortgage in dispute.

The case is In re W Resources, LLC, no. 21-30291 (5th Cir. 2022). INCC is represented by Chaffe McCall, LLP Investar is represented by Akerman, LLP. W. Resources is represented by Stewart, Robbins, Brown & Altazan, LLC Ordering is available here.

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