Occasionally we have an issue on a file that may have wider implications than simply to that particular bankruptcy or liquidation. This case was one of those times.
We recently concluded the sale of a residential property in a bankruptcy file which had one additional and complicating factor which caused an adjustment to the distribution of the sale proceeds. It is a factor of which most are probably aware of, but one which is uncommon and, without looking at the background information, sellers of property may not recognise.
This factor was the application of the Doctrine of Exoneration.
The complicating factor for us was that two of the co-owners of the property (the mother and father of the bankrupt) were totally unaware of the principle of the Doctrine of Exoneration or what it meant, let alone what impact it would have on them individually on the sale of this property.
The facts are very simple. The mother, father and son (the bankrupt) were the registered owners of residential property held by them for investment purposes. They were all listed as joint tenant owners, but the son’s interest was separated at the time of bankruptcy into a tenant in common holding. This splitting of the joint tenancy is by operation of law given the severing of the ‘interests’ in the property. This severing occurs because the property vests in the trustee in bankruptcy upon the bankruptcy.
A title search of the property showed that a mortgage was registered against the property in the year following the acquisition by the three owners. That immediately indicated to us that the loan was, in all likelihood, not for the purchase of the property. This indication proved to be correct.
Information from the bank showed the amount of the loan to be about $130,000, and a valuation of the property put it at about $300,000, meaning that there was about $170,000 of equity. Prima facie, on these figures, the bankrupt estate would be entitled to about $55,000 of the net sale proceeds.
But, because the loan secured against the property was taken out after the purchase of the property, some further digging was required into what the loan was used for and whether it was for the benefit of all of the owners of the property.
The bank’s documents clearly showed that the borrowers of the loan were the parents and that only a guarantee had been provided by the son, with a mortgage over the relevant property to support the loan and the guarantee.
This is where the Doctrine of Exoneration comes into effect. It says that, in circumstances where security is given by a number of parties, but only some of those parties are the principles to and benefitted from the loan, the other parties are deemed only to be acting as sureties to the loan and the security is only to secure their obligations as surety. That is, the borrowers are liable for the loan in the first instance and the guarantor is only liable for a shortfall (if any).
The practical effect is that the principle borrowers (the parents) are firstly responsible for the loan and that the surety (the bankrupt son) is only responsible for a shortfall. The property was sold cooperatively for $290,000. In this case, the $130,000 loan is first to be paid from the borrower’s (the parent’s) two-thirds share of the proceeds and, only if there is a shortfall, does the surety’s (the son’s) share of the proceeds be used to pay the secured debt.
Therefore, the $160,000 equity is split about $60,000 to the parents (their two-third share less the total mortgage) and about $95,000 to the bankrupt estate (his full one-third share). Only if the secured loan was more than $200,000 would the surety’s share been used to satisfy the shortfall.
The Doctrine of Exoneration generally arises in situations where a property is used as security for a loan taken only by some of the owners, but all of the owners agree to use the property to secure the loan. This was certainly the case in our file.
Sellers of properties just need to be aware that, in these situations, it may not be just simply be an equal splitting of the net proceeds.