Lenders and other creditors often obtain consent judgment liens against an individual guarantor’s residence as additional security during or after commercial foreclosure proceedings against real estate or other assets owned by an affiliated corporate borrower. Is this type of consensual lien against a guarantor’s home at risk if the guarantor later files for protection under Chapter 7 of the U.S. Bankruptcy Code (Bankruptcy Code) and seeks to set aside or avoid the lien because it impairs the guarantor’s homestead exemption? The answer is yes according to most, but not all, of the bankruptcy courts that have decided this question.
This article discusses (i) two bankruptcy court opinions on this issue decided at the end of 2024, and (ii) a strategy for creditors to limit their risk of lien avoidance by obtaining, if possible, a non-judicial mortgage lien against a guarantor’s home.
Recent Bankruptcy Court Rulings Avoiding Liens under Consent Judgments
In December 2024, two bankruptcy judges addressed this issue in Chapter 7 bankruptcies filed in Connecticut (In re Gramigna[i]) and Ohio (In re Dulaney[ii]) by individual debtors who had guaranteed their companies’ business loans. In each case, the debtors sought to maximize the equity in their homes which they claimed as exempt under the Bankruptcy Code. The obstacle each debtor faced was that before their bankruptcy filings each had granted the lender a lien against his residence.
In the Gramigna case, the debtor-guarantor agreed to a stipulated deficiency judgment against him after the lender obtained a foreclosure judgment against commercial property securing the underlying business loan. In the Dulaney case, the debtor-guarantor agreed to a consent judgment against him and his business. Each such judgment (Consent Judgment) resulted in the recording of a judgment lien against the guarantor’s residence. The liens eliminated the equity in the homes that the debtors sought to protect through homestead exemptions in their bankruptcy cases. If the lien of the Consent Judgments remained, each lender would likely obtain approval from the bankruptcy court to sell the debtor-guarantor’s home to recover amounts owed under its respective Consent Judgment.
In an effort to preserve the benefit of their homestead exemptions, each debtor-guarantor filed a motion to avoid or set aside the lien of its Consent Judgment pursuant to Section 522(f)(1) of the Bankruptcy Code. This section allows a debtor to avoid “a lien on an interest of the debtor in property to the extent that such lien impairs an exemption to which the debtor would have been entitled . . . if such lien is . . . a judicial lien . . .”[iii] If the debtor-guarantors’ motions succeeded, the equity in their residences would remain exempt and prevent the Chapter 7 trustees from selling their residences to obtain the value of the equity (after paying off any pre-existing first or second mortgage liens) to distribute to unsecured creditors in the bankruptcy proceedings.
The bankruptcy judges in Ohio and Connecticut granted the motions and avoided the lien under each Consent Judgment. Following the decisions of judges in many other jurisdictions, both bankruptcy judges ruled that the lien constituted a “judicial lien” because the lien was created or entered by a court or judicial process even if the underlying judgment was created by consent or stipulation. In doing so, they rejected the lenders’ argument that the liens were consensual liens granted by the guarantors similar to the lien of a consensual mortgage. The judges also disagreed with the lenders’ position that the Consent Judgments were judgments arising out of a mortgage foreclosure (which are excluded from avoidance under Section 522(f)(2)(C) of the Bankruptcy Code) because the Consent Judgments were separate and distinct from mortgage foreclosure judgments against the corporate borrowers and the lenders had no judgment in foreclosure of a mortgage granted by the guarantors.[iv] Neither lender has appealed these adverse decisions.
Creditor Strategies to Limit Risk of Lien Avoidance in Bankruptcy
Creditors can take certain actions to enhance their collateral position against an individual guarantor and, at the same time, limit the risk of lien avoidance if the guarantor later asserts a homestead exemption in a Chapter 7 bankruptcy. The most effective strategy is for a creditor to obtain a non-judicial, consensual lien against the guarantor’s home through the recording of a mortgage or deed of trust (Mortgage). The guarantor may grant the Mortgage either at the inception of the credit transaction or during post-default workout/forbearance negotiations with or without an accompany consent judgment.
Assuming the Mortgage is enforceable and properly recorded under applicable state and local law, the creditor can avoid or significantly limit the risk that the lien of the Mortgage would be avoided as impairing the guarantor’s homestead exemption under Section 522(f)(1) of the Bankruptcy Code if the guarantor challenges the lien in a subsequent Chapter 7 bankruptcy.[v] This is because (a) the lien against the guarantor’s residence would be created by a non-avoidable consensual Mortgage, instead of a “judicial lien” under a consent judgment which is avoidable under Section 522(f)(1) of the Bankruptcy Code, and (b) the lien of a judgment in foreclosure under the Mortgage could not be set aside because it would fall within the exception to avoidance in Section 522(f)(2)(C) of the Bankruptcy Code as a lien arising out of a mortgage foreclosure. It is critical for lenders and other creditors to take into account potential bankruptcy issues when seeking and structuring additional collateral before or during collection proceedings.
For more information, contact Steven E. Ostrow, Partner at ostrows@whiteandwilliams.com. Or you may reach out to another member of our Financial Restructuring and Bankruptcy Practice.
[i] Gramigna v. Roumeliotis (In re Gramigna), 2024 Bankr. LEXIS 3054, 2024 WL 5248223 (Bankr. D. Conn. December 20, 2024).
[ii] In re Dulaney, 2024 Bankr. LEXIS 3025 (Bankr. S.D. Ohio December 18, 2024).
[iii] See 11 U.S.C. §522(f)(1).
[iv] Interestingly, the ruling by Connecticut Bankruptcy Judge Manning in the Gramigna case was contrary to earlier decisions of former Connecticut Bankruptcy Judge Dabrowski before his retirement in 2015: In re Vincent, 260 B.R. 617 (Bankr. D. Conn. 2000) and In re Criscuolo, 386 B.R. 389 (Bankr. D. Conn. 2008). In each case, Judge Dabrowski had ruled that a lien against a debtor-guarantor’s residence under a deficiency judgment was a lien arising out of a mortgage foreclosure and, therefore, was not avoidable under Section 522(f) of the Bankruptcy Code. As a result of the opposing rulings of retired Judge Dabrowski and Judge Manning, there will remain a conflict of law on this issue in the Connecticut bankruptcy court unless and until the issue is finally determined in a future Chapter 7 case filed in Connecticut bankruptcy court by the U.S. Court of Appeals for the Second Circuit.
[v] The debtor-guarantor may also separately move to avoid the lien of the mortgage or deed of trust if there are sufficient grounds to assert that the lien constitutes an avoidable preferential or fraudulent transfer to the creditor of the debtor’s interest in the residence under applicable bankruptcy and/or state law. This issue, however, is beyond the scope of this article. The creditor should obtain, if feasible, the security of a mortgage or deed of trust notwithstanding this future, hypothetical risk of avoidance, as there are potential defenses to preferential or fraudulent transfer claims and the guarantor might not file for bankruptcy.
