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01 May 2007

Whose mortgage is it anyway? - The Doctrine of Exoneration


3 min

We have previously written on the Doctrine of Exoneration, but a current bankruptcy file has again raised this issue and we thought that it was a good opportunity to revisit the position.

The doctrine can apply to any type of asset, but for ease of discussion we will relate it to the family home. The family home is commonly the only significant asset that people own jointly with another party, usually their spouse. It is also common that small business owners will offer the family home as security when seeking finance for business ventures. Creditors and bankruptcy trustees also look towards this asset when the business has gone bad.

Let's consider a situation where the husband ran a business and, with the consent of his wife, secured a $300,000 loan for that business against the family home that was worth $400,000. The house is owned in equal shares. The business fails and the husband is made bankrupt. The creditor holding the security over the property can rely on it, sell the property and recover their $300,000. Who gets the $100,000 surplus? The first thought is that the bankrupt estate will get $50,000 and the non-bankrupt wife will get $50,000. But this is not automatically correct.

The Doctrine of Exoneration looks at who were the principals to the loan and whether one party was only a surety. The doctrine provides a presumption of the intentions of the two parties and their roles in the transaction.

The doctrine provides that the party receiving the benefit of the loan, in this case the husband, is the principal in the loan, and the other party, the wife, acts only as a surety. The debt is to be sought firstly from the principal and his share of the asset, to the exoneration of the other share, and any shortfall is sought from the surety. This is put into practical effect by granting the surety a security over the principal's share of the secured asset. Effectively, the wife's beneficial interest is only offered as security for the husband's loan and she may recover monies paid from the husband's interest.

In our example, the husband's one-half interest ($200,000) is used to partially satisfy the secured debt, and the wife's one-half interest is used to satisfy the $100,000 shortfall. The entire $100,000 surplus would then be paid to the non-bankrupt wife.

The over-riding factor is that the secured debt must be used for an individual purpose, separate from and not involving the other co-owner. If the loan was directly beneficial to the co-owner they would both be principals and the doctrine will not apply.

Creditors should not be too excited solely on the basis of a property search finding a property registered in a bankrupt's name. When the Doctrine of Exoneration applies, the equity available to an estate may not equal the legal share of any surplus after any secured debt has been satisfied. Trustees in bankruptcy must first determine how the secured debt was used and adjust equity calculations accordingly. The right of exoneration is a presumption only and may be rebutted, so the trustee will also look for that evidence.

When using a jointly owned asset as a security, business owners should ensure that business loans are not mixed with non-business joint loans. Proof of the separation of loans may be the only evidence that the doctrine should apply.

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