During a financial downturn, even secured creditors often find themselves with no real recourse. Junior lienholders, in particular, are often left in the cold, even when It seems there is enough collateral to go around.
A recent bankruptcy case illustrates this fact.
The debtors in this Chapter 7 bankruptcy case were a husband and wife engaged in a farming operation. They owned farm machinery and equipment, which netted $55,613 in sales proceeds, and a homestead valued at $292,000. Farm Credit had a primary security interest in the debtors’ machinery, equipment, and proceeds, as well as a mortgage on their homestead. Growmark held a second priority security interest in the debtors’ farm equipment, machinery, and proceeds. The debtors owed Farm Credit approximately $210,163.25 and Growmark approximately $37,762.22. In other words, the value of the secured assets (including the value of the homestead) exceeded secured liabilities.
But only Farm Credit had a security interest in the home, which was otherwise exempt from judicial sale by virtue of the Iowa homestead exemption, Iowa Code § 561.16. And that made all the difference.
Growmark argued that the bankruptcy court should apply the equitable doctrine of “marshaling” to ensure that it could collect on its debt. Three elements support a claim of marshaling:
The court and the parties agreed that these elements were satisfied in this case. Farm Credit had a lien against the homestead and the proceeds, and thus a legal right to satisfy its claim against either fund. And, Growmark had only a legal right against the proceeds. Growmark thus argued that the court should “marshal” the funds so that Growmark could satisfy its claim against the proceeds, and Farm Credit could satisfy its claim from the remaining proceeds and any homestead equity required to fully satisfy its claim.
The court, however, ruled that marshaling can be applied only when it can be equitably fashioned as to all of the parties. This includes the debtors. Here, the court ruled that marshaling would not be fair to the debtors because it would dramatically decrease the value of their homestead exemption, thus violating Iowa law.
The court noted that Iowa homestead exemption rights are “jealously safeguarded.”
The only time a homestead may be sold to satisfy a debt is when the debtor has yielded that right via a written contract. And even then, the homestead equity may be used to satisfy only “a deficiency remaining after exhausting all other property pledged by the same contract for the payment of the debt.” Marshaling, the court ruled, could not be applied where, as here, one of the funds was exempt under state law. It did not matter that the debtors were reaffirming their homestead debt to Farm Credit and there would not be an immediate judicial sale. The court found that the Iowa homestead right exists apart from judicial sale or pending sales to satisfy debts.
And so Growmark will not collect on its claim.
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