Sam Smartbuyer received a notice from an attorney that said they were instituting foreclosure proceedings against the house he had purchased a couple of months back.  He took the notice to the attorney who had closed his purchase to see what this was about.  His attorney advised him that the bank that was foreclosing had been the seller’s lender, but that the seller had filed bankruptcy and had wiped out that deed of trust.  The attorney showed Sam a copy of the Order of Discharge in Chapter 7 Bankruptcy.  The bankruptcy petition had listed the deed of trust as a debt to be discharged and the order had said  the debts of the seller had been discharged or as Sam’s attorney put it “wiped out”.  He told Sam not to worry about the foreclosure, it was all a mistake and that he would send a copy of the bankruptcy order to the foreclosing attorney and get things straightened out. 

            The foreclosing attorney received Sam’s attorney’s letter and Order of Discharge, but proceeded with the foreclosure.  The question for us to consider is whether it is proper for the foreclosure to go forward once the foreclosing attorney has been placed on notice that the deed of trust being foreclosed upon was the subject of a Chapter 7 Bankruptcy.

            A relatively common misunderstanding of the effects of a discharge under Sec. 524 of the Bankruptcy Code (11 U.S.C. 524) can lead to a serious omission on a title opinion.  The purpose of this article is to attempt to help point out the issues that should concern a title examiner when a closed bankruptcy case is discovered in the chain of title. 

     The basic principle at play here is how bankruptcy treats judgments and/or liens and that will differ according to the personal liability and the in rem liability of the judgment/lien.  Once docketed, judgments acquire two personalities, personal and in rem.  The personal liability relates to the ability of the judgment debtor to satisfy the debt by payment.  The in rem liability is that liability that attaches to all real property owned or subsequently acquired by the judgment debtor while the judgment remains unsatisfied.  It is this second liability that survives the discharge since Sec. 524 of the Bankruptcy Code only provides relief from the first liability, the personal obligation of the debtor to pay the judgment debt.   There are some exceptions under Sec. 522(f), which we will discuss at a future time.

            And in fact the copy of the Bankruptcy Order that Sam’s attorney produced said exactly that.  It said the personal obligation of the debtor had been discharged.  It did not mention that the deed of trust was discharged, although the deed of trust had been listed as a debt in the Chapter 7 petition.  The effect of this means the deed of trust remains a lien on the property and once released from the automatic stay, the bank is free to foreclose their lien.  If the sale does not raise enough money to satisfy the lien and associated costs the bank is prevented from pursuing the debtor on a deficiency since the debtor’s personal liability was discharged in bankruptcy.  In other words, the personal liability (ie, obligation on the note) is wiped out in bankruptcy, whereas the in rem liability (ie, the lien against real estate) remains in place after the bankruptcy.

            For the real estate practitioner and title examiner, whenever you come across a bankruptcy in a title search give careful reading to what that order says so as to avoid the kind of problem Sam’s attorney caused him.