Thursday, March 7, 2019

FYI: 7th Cir Holds Mortgagee's Deficiency Claim in Bankruptcy Was Precluded by Failure to Raise in Foreclosure

The U.S. Court of Appeals for the Seventh Circuit recently held that a mortgagee's failure to take a deficiency judgment against a borrower that filed bankruptcy in a concluded state foreclosure action precluded the mortgagee from making a deficiency claim in the borrower's bankruptcy proceeding.


A copy of the opinion is available at:  Link to Opinion


Two borrowers received a loan secured by a mortgage.  They defaulted on the loan and the mortgagee (Mortgagee) filed a two-count complaint in Illinois state court seeking relief under the mortgage and the note.


One of the borrowers and his wife later filed a bankruptcy proceeding.  The Mortgagee asked the bankruptcy judge to lift the automatic stay, which was granted with relief to proceed with the state foreclosure proceeding "with respect to the property."


The state court judge then put the property up for auction and confirmed the sale.  The Mortgagee asked for a deficiency judgment against the borrower that did not file bankruptcy, but not against the borrower who filed bankruptcy. 


The state court awarded an in personam judgment against the borrower who did not file bankruptcy, and an in rem judgment only against the borrower who filed bankruptcy.  The court retained jurisdiction, but just to enforce the decision and to confirm the sale. The Mortgagee did not appeal and the state litigation concluded with a final judgment in April 2015.


In the bankruptcy proceeding, the Mortgagee made a claim against the borrower for the same deficiency amount that the state court had awarded against the borrower who did not file bankruptcy.  The borrower objected arguing that the state court judgment extinguished the Mortgagee's claim under the claim preclusion doctrine because Illinois does now allow claim splitting. 


The bankruptcy judge overruled the borrower's objection and allowed the claim.  The borrower appealed to the trial court, which reversed holding that the Mortgagee's failure to take a deficiency judgment against the borrower in state court precluded the deficiency claim. 


This appeal followed.


The Seventh Circuit observed that Illinois law governs the effect of an Illinois judgment because state court judgments "shall have the same full faith and credit in every court within the United States and its Territories and Possessions as they have by law or usage in the courts of such State, Territory or Possession from which they are taken." 28 U.S.C. §1738.


Thus, the issue on appeal was whether the Mortgagee could file a new lawsuit in Illinois state court seeking to recover the deficiency amount against the who that filed bankruptcy.


Illinois litigants must present all their theories arising from single transaction "in a single proceeding." See, e.g., GE Frankona Reinsurance Co. v. Legion Indemnity Co., 373 Ill. App. 3d 969 (2007).  This holds true in the foreclosure context where "creditors who do not ask for deficiency judgments in the foreclosure actions cannot seek that relief later, in a different proceeding." See LSREF2 Nova Investments III, LLC v. Coleman, 2015 IL App (1st) 140184.


The Seventh Circuit found it unnecessary to anticipate how the Supreme Court of Illinois would rule "because all of the state's authorities agree that, if a litigant presents both the mortgage and the note in a single action, and fails to seek a deficiency judgment on the note, it cannot do so in a separate suit."  As such, because the Mortgagee could not now obtain a deficiency judgment in state court, "under §1738 it cannot get one in federal court either."


The Mortgagee argued that the state court judgment is not final and lacks any preclusive effect because it "left dangling" the complaint's request to enter a deficiency judgment against the borrower who filed bankruptcy. The Seventh Circuit rejected this argument because once the trial court enters the order approving the sale "Illinois treats a foreclosure action as finally decided."  The trial court entered the final judgment in April 2015 and there has been no activity since.  Thus, the Seventh Circuit held "that the decision is final."


The Seventh Circuit also rejected the Mortgagee's final argument that claim preclusion cannot apply because the automatic stay under § 362(a) divested the state court of "jurisdiction" necessary to enter the final judgment. 


Initially, the Court held, section 362(a) is not jurisdictional.  It merely provides that for certain matters filing a bankruptcy action "operates as a stay." Section 362(a) "does not establish exclusive federal jurisdiction over any of those matters."


Further, the Seventh Circuit note, even federal statutes like antitrust laws that provide for exclusive jurisdiction, "do not supersede §1738."  Marrese v. American Academy of Orthopaedic Surgeons, 470 U.S. 373 (1985). Instead, section 1738 and state-law preclusion rules "govern the defense of preclusion in the federal suit even though federal courts have exclusive jurisdiction" of certain claims.


The Mortgagee "had its chance in state court and did not use it."  Thus, the Seventh Circuit affirmed the trial court's judgment.




Ralph T. Wutscher
Maurice Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct:  (312) 551-9320
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