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Indiana’s Judicial Foreclosure Requirement Not Applicable In Unique Case

Commercial mortgage lenders should remain mindful that Indiana is a judicial foreclosure state.  Essentially, this means that the foreclosure of a mortgage and corresponding sale of the real estate must occur within the court system, which includes the filing of a lawsuit, the rendering of a foreclosure decree by a judge and the auctioning of the property by a sheriff.  In Winforge v. Coachmen, 2008 U.S. Dist. LEXIS 66250 (S.D. Ind. 2008) (Winforge.pdf), an Indiana court permitted a non-judicial foreclosure.  How?  The mortgaged property was in Tennessee.

Improper foreclosure?  The Winforge suit surrounded “a botched business venture involving the development and construction of a hotel in Pigeon Forge, Tennessee.”  The borrower defaulted on a promissory note and a security agreement, so the lender declared the note to be immediately due and payable and sought to sell the Tennessee property.  The borrower filed suit in Indiana on a variety of claims, one of which was in essence to block the Tennessee foreclosure.  The borrower claimed that the lender failed to properly commence foreclosure proceedings in accordance with Indiana law “when it scheduled the real estate for public sale without first filing a complaint commencing a foreclosure proceeding.” 

Statutes.  By Indiana statute, including specifically Ind. Code § 32-29-7-3, a party must judicially foreclose on a mortgage executed on real estate.  The lender contended that it was not required to judicially foreclose on the property, despite I.C. § 32-29-7-3, because Tennessee law, not Indiana law, governed the foreclosure sale.  Tennessee permits non-judicial foreclosures.  T.C.A. § 35-5-501. 

Loan documents.  The loan documents stated that they were to be construed and enforced in accordance with Indiana law.  They contained a forum selection clause, which stated that “any action or proceeding concerning this Agreement or the other Loan Documents or the enforcement thereof shall be commenced in the United States District Court for the Southern District of Indiana, and such court shall have the sole and exclusive jurisdiction over any such proceeding.”  There was no question, therefore, that the case belonged in Indiana and that Indiana law applied to the litigation. 

Parties’ positions.  The borrower asserted that lender’s foreclosure was an “action or proceeding” as contemplated by the loan documents and therefore should have been pursued in Indiana.  The lender claimed it was clear that the term “action or proceeding” referred solely to a “lawsuit or judicial proceeding” and not to a foreclosure sale.  The lender argued it was not required to file any lawsuit or judicial proceeding in order to foreclose “because Tennessee law permits a non-judicial foreclosure.”  In further support of its position, the lender cited to case law holding that the method for foreclosure of mortgages “is governed by the local law where the real estate is located, regardless of mortgage provisions choosing foreign law.” 

Lender prevails.  Judge Barker sided with the lender, concluding:

It is clear to us from the context of the clause that [the terms “action or proceeding”] denote only that any lawsuit or judicial complaint brought needs to be brought in the courts of this district.  However, we do not, as [borrowers] do, read this language to create an obligation for [lender] to bring a complaint in this district prior to foreclosure if it is not otherwise required to bring such a complaint – and [borrowers] do not dispute that Tennessee law, which governs the foreclosure sale, does not so require.

While the lawsuit to litigate the terms and conditions of the loan documents had to be brought in Indiana, one of the remedies allowed by the loan documents (the foreclosure sale) was governed by Tennessee law.  The fact that the property was in Tennessee seemed to be critical to the outcome.  It makes sense to have Tennessee’s rules govern the conveyance of the property, not Indiana’s, so the rules and procedures could be enforced, as needed, by Tennessee officials.

Winforge limited.  One of the points of this post is to remind readers that Indiana is a judicial foreclosure state and to provide a link to I.C. § 32-29-7-3, which in part outlines Indiana’s judicial sale process.  The second point is to show that, with certain contract language and under very limited circumstances, an Indiana-based case could result in a non-judicial foreclosure sale in another state.  Having said that, in my view, Winforge does not mean that lenders can contractually circumvent Indiana’s judicial process concerning property located in Indiana.  I.C. § 32-29-7-3 should preempt any contract provision stating that a lender, upon default, can foreclose its mortgage on Indiana real estate outside of the court system.  When I see such provisions in loan documents, I tell my lender clients that we still must proceed to suit and follow the process through a sheriff’s sale. 

Respect The Automatic Bankruptcy Stay

The purpose of this post is to discuss the automatic stay provision of 11 U.S.C. § 362(a) in the Bankruptcy Code and to provide an illustration of a violation of the stay.  Judge Philip Klingeberger’s 7-25-08 opinion in In Re:  Galmor, 2008 Bankr. LEXIS 2201 (N.D. Ind. 2008) (Galmore.pdf) is a very thoughtful decision intended “to send a clear message” that willful stay violations “will not be tolerated.”

Primer.  Courtesy of Judge Klingeberger, here are some general principles: 

 When a debtor files a bankruptcy petition, the automatic stay takes effect, and Section 362(a) prohibits creditors from taking certain actions to collect their debts.
 The stay is self-executing and is effective upon filing of the bankruptcy petition.
 The stay prohibits, among other things, the enforcement of a deficiency judgment or collection on a claim that arose before the commencement of the bankruptcy case. 
 The rationale behind the stay is, in part, to give the bankruptcy court an opportunity to assess the debtor’s situation and to embark on an orderly course of resolving the estate.  The stay prevents a “chaotic and uncontrolled scramble for the debtor’s assets in a variety of uncoordinated proceedings in different courts.” 
 “The debtor has the burden of providing the creditor with actual notice of the bankruptcy and, upon so providing, the burden shifts to the creditor to prevent violations of the automatic stay.”
 If uncertain about the applicability of the stay, the creditor may petition the bankruptcy court for clarification. 
 Sanctions should not be imposed where there has been a technical violation of the stay.
 However, Section 362(k) provides monetary relief for willful violations of the automatic stay.

Backdrop.  Dykstra held a pre-petition judgment, had filed a motion to enforce the judgment by proceedings supplemental and had requested that defendant/judgment debtor Galmor appear in court to answer as to any assets.  The state court issued an order to appear, which Galmor ignored.  The state court then directed Galmor to appear and show why she should not be held in contempt.  Galmor blew off that hearing too, so the state court issued a bench warrant.  Subsequently, Galmor filed a petition for bankruptcy relief.  Amazingly, Dykstra showed up at Galmor’s Section 341 meeting of creditors in bankruptcy court and facilitated the arrest of Galmor pursuant to the bench warrant previously issued in state court.   

Elements of action.  Galmor sued Dykstra for damages for alleged willful violations of the automatic stay.  Here is what debtor’s must prove in order to recover:

1. That a bankruptcy petition was filed;
2. That the debtor is an “individual” under the automatic stay provision;
3. That the creditor had notice of the petition;
4. That the creditor’s actions were in willful violation of the stay; and
5. That the debtor is entitled to a form of relief provided by section 362(k).

The contested issue in Galmor was #4.   

Be proactive.  One of the interesting questions in Galmor was whether the creditor had a duty to take affirmative action to halt the effect of the pre-petition bench warrant in the wake of the automatic stay.  In Galmor, Dykstra not only permitted but indeed assisted with the arrest - at the first meeting of creditors in bankruptcy court no less.  Judge Klingeberger held:

Galmor was at risk of being arrested on a state court “collection device” bench warrant during her appearance at her section 341 meeting, an appearance mandated by the federal law of the Bankruptcy Code.  This is completely contrary to the purpose of the Bankruptcy Code and has the effect of rendering section 362(a) ineffective as to Dykstra’s debt.  The circumstances in this case raise the issue of whether a creditor, or an attorney, who has notice of a bankruptcy filing and had previously caused a bench warrant to be issued in order to collect a debt, has an affirmative duty to request that the warrant-issuing court recall the warrant.  The court determines that this affirmative duty should be imposed.  . . .   

Willful violation.  Based upon the following rationale, the Court held Dykstra’s actions to be a willful violation of the automatic stay and awarded punitive damages. 

Dykstra was not at all sensitive to any potential violation of the automatic stay, nor did he make any statement at the meeting of creditors that the warrant fell into the hands of federal law enforcement personnel by mere happenstance.  It is clear that it was Dykstra’s intent to appear at the section 341 meeting to have Galmor arrested as either punishment for not paying the debt and/or as a method to attempt to collect the debt.

Secured lenders and their counsel need to be sensitive to the automatic stay and cease all non-bankruptcy collection proceedings.  As Judge Klingeberger noted, the automatic stay “is a powerful tool” and should be respected accordingly.  For more on the automatic stay, please see my 7-18-08 post “Does a Guarantor’s Bankruptcy Stop a Foreclosure Case Against the Borrower?” 

Court Recognizes Prepayment Premiums

In early 2007, I wrote two articles discussing in detail yield maintenance provisions (prepayment clauses) in promissory notes and the applicable Indiana law:  Part I and Part II.  By way of follow-up, I thought it might be worthwhile to write very briefly on the August 12, 2008 decision from the Northern District of Indiana in BKCAP v. CAPTEC, 2008 U.S. Dist. LEXIS 61984 (N.D. Ind.) (BKCAP.pdf), which analyzed a series of promissory notes with prepayment provisions.  This was not a foreclosure case, but rather a contract dispute about how to calculate the prepayment premium called for under several promissory notes involved in the refinancing of a significant portion of the borrower's $110 million bank debt. 

There is no need for me to discuss the case in detail because the prepayment provisions were unique and because the facts were so case specific.  The reason why I'm posting about BKCAP is because Judge Nuechterlein really didn't question the enforceability of prepayment premiums under Indiana law.  Evidently, he presumed such provisions can be valid.  The Judge's recognition of the premiums, or perhaps the borrower's concession of their legitimacy, is good for Indiana lenders.  All the Judge did was interpret the contract and draw a conclusion regarding the amount of the premium.

The Judge adopted the lender's position, so the lender got what it wanted.  As such, lenders drafting or enforcing prepayment provisions can learn from some of the contract language utilized in the promissory notes outlined in BKCAP.  As always, clarity is key.  The Judge seemingly had no choice but to recognize the validity of the prepayment premiums in BKCAP:

The parties specifically included the prepayment premium as a specific bartering tool that provided a benefit to both parties.  The Stated Rate of the notes was at approximately 9% when the parties entered into the contracts in 1999.  Borrowers foresaw that if interest rates dropped, they may want to re-finance their debt under the notes.  Lender would lose funds and possibly even suffer a loss if Borrowers re-financed too early.  Therefore, the parties created a prepayment premium, which allowed Borrowers the freedom to re-finance if they paid a sum of money to the Lender to cover its losses.  A portion of paragraph three memorializes this intent....   

See page 10 of the opinion for the referenced paragraph three.         

The rules, reasoning and conclusion found in the BKCAP opinion may be helpful for anyone struggling with how to draft or enforce loan documents calling for the recovery of fees/premiums in the event a business borrower prepays a loan.

Blog Post On Priority Of Commercial Construction Mortgages “Affirmed On Appeal”

My July 3, 2007 blog post entitled “Construction Mortgage v. Mechanic’s Lien:  Win, Lose or Draw?” addressed Indiana’s rules applicable to a hypothetical priority dispute between a construction mortgage lender and a contractor in a commercial project.  Based upon my research and analysis at that time, my theory was:

2007: Lender Wins.  At least as to a standard commercial project, therefore, the Ward doctrine of parity seems to be a thing of the past.  The lender, in the scenario presented to me, shouldn’t be forced to share equally with any contractors that started construction before the developer closed the deal.  Instead, the lender should hold a superior lien, assuming the lender records his mortgage before a contractor records a notice of mechanic’s lien.  In other words, if the project goes south, the lender should get paid first.  Having done all the research and reasonably assured myself of the answer to the question, therefore, I believe my lender contact can relax.  Minimal delays with the closing should not adversely affect his bank’s mortgage lien.  But, he should make sure he records the mortgage sooner rather than later, and certainly before any of the contractors record a notice of mechanic’s lien.

This past Wednesday, in a case of first impression in Indiana, the Court of Appeals in McComb & Son v. JPMorgan Chase, Case Number 02A04-0802-CV-60 (McComb.pdf), reached the same conclusion I did.

The situation.  The parties involved in McComb & Son were two general contractors (McComb and ARI), who had entered into a construction agreement with the property owner (Indian Village) to develop an apartment complex.  Lender JPMorgan Chase Bank (Chase) extended an $850,000 line of credit and a $2,650,000 construction loan to Indian Village.  Indian Village failed to pay McComb/ARI and also defaulted on its construction loan with Chase.  Significantly, Chase had recorded its mortgages before McComb/ARI recorded their mechanic’s lien notices.

The statutes.  Indiana law is well-settled that Chase had priority over McComb/ARI with regard to the land and the pre-existing buildings.  The only issue in McComb & Son was whether McComb/ARI had priority as to the improvements they constructed.  The Court outlined the three operative statutes and the corresponding rules/exceptions:   

1.  Generally, a purchase money mortgage is superior to a mechanic’s lien “if the mortgage was recorded before the mechanic’s work was begun or materials furnished.”  Provident Bank v. Tri-County South Side Asphalt, Inc., 804 N.E.2d 161, 163 (Ind. Ct. App. 2004); I.C. § 32-21-4-1(b).

2.  But, a mechanic’s lien holder has priority “as to the improvement for which he provided the labor and materials.”  Provident Bank, 804 N.E.2d at 164; I.C. § 32-28-3-2.  “The holder of a mechanic’s lien may sell the improvements to satisfy the lien and remove them within ninety days of the sale date.”  Thus a mechanic’s lien has priority over a purchase money mortgage with regard to “new improvements” even if the mortgage was recorded before the mechanic’s lien notice was recorded and even if the mortgage was recorded before the mechanic’s lien holder began its work or furnished any materials.

3.  On the other hand, as to commercial property (including apartment complexes), the mortgage of a lender has priority over all liens recorded after the date the mortgage was recorded, “to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate.”  I.C. § 32-28-3-5(d)

For the first time, McComb & Son conclusively tells us what Section 5(d) means.  The Court talked about Ward v. Yarnelle, 91 N.E.7 (Ind. 1910) and its doctrine of parity, as well as the dissenting opinion in the Provident Bank case, both of which I addressed in July of 2007.  According to McComb & Son, the Ward doctrine of parity does not apply to commercial construction projects.  The critical rule announced in McComb & Son was: 

With regard to commercial property, where the funds from the loan secured by the mortgage are for the specific project that gave rise to the mechanic’s lien, the mortgage lien has priority over the mechanic’s lien recorded after the mortgage.

The conclusion.  Chase’s mortgages had priority over McComb/ARI’s mechanic’s liens because:

There is no dispute that [Chase’s] mortgages were recorded before the Lienholders’ mechanic’s liens or that the property in question is commercial in nature.  In addition, the trial court … concluded that the funds from [Chase’s] loan were for the specific project that gave rise to the Lienholders’ mechanic’s liens. 

Although McComb/ARI may seek transfer of the case to the Indiana Supreme Court, for now a lender’s construction mortgage lien will prime a mechanic’s lien, if the lender records its mortgage before any contractor records its notice of mechanic’s lien and if the construction project was commercial in nature. 

The survival of the Provident Bank rule (#2 above).  McComb/ARI argued for application of the Provident Bank rule, but Provident Bank did not involve a construction loan but rather a purchase money mortgage.  As such, I.C. § 32-28-3-5(d) did not apply.  Significantly, however, the Court explicitly stated that I.C. § 32-28-3-2 “still provides the general rule” in cases where the funds from the loan secured by the mortgage were not for the construction of the improvement.