Summary of a Recent
Judicial Development in
Secured Transactions

Exception to Res Judicata for Junior Lienholders

Walt McCarter
National AgLaw Center Research Associate

Summary of Decision

In In re Hagedorn, No. 02-40505, 02-7033, 2004 WL 2040909 (Bankr. D. Kan. May 20, 2004), the United States Bankruptcy Court for the District of Kansas held that an exception to res judicata applied when a junior lienholder did not seek any affirmative relief in a prior state court proceeding, and thus allowed that lienholder's claim.

Background

Debtors obtained loans from the Farm Service Agency (FSA) in 1997 and pledged mortgages on two tracts of real estate and a security interest in crops, equipment, livestock, and other farm products as collateral. Id. at *1. The FSA's security agreements were properly perfected, and there was a cross-collateralization of the notes providing that default upon one note constituted default upon all. Id. The Debtors later defaulted on their loans and the FSA issued a letter informing them of their refinancing options, and warning them that if they did not take action, the notes would be accelerated and they would take legal action to collect on the loan. Id. Farm Credit Bank of Wichita subsequently filed a mortgage foreclosure action on one tract of the Debtors' land against which the FSA also held several mortgages, and the FSA was named as a defendant in order for the Bank to obtain clear title. Id. The state court ordered the sale of the property with the proceeds to go to the Bank, and any amount in excess of the Bank's claim awarded to the FSA. Id. Meanwhile, the Debtors had failed to refinance and the FSA sent them another letter threatening foreclosure and informing them of their options and administrative rights. Id. at *2. The Debtors then filed for bankruptcy and the FSA filed its proof of claim, seeking reclamation of certain property in satisfaction of its lien. Id.

Arguments

The FSA argued that it was entitled to certain personal property in which it had a perfected security interest. Id. at 3.

The Trustee argued that the prior state court foreclosure proceeding operated as a bar to the FSA's claim under the theory of res judicata. Id.

Analysis and Holdings

The court held that even if the Trustee could establish all the elements of res judicata, an exception to res judicata adopted by the Kansas Supreme Court that applied to junior lien holders who do not seek any affirmative relief in the initial state court proceeding was applicable. Id. at *5. The exception provides that "the holder of a note, secured by a second real estate mortgage, cannot be compelled, even where made a party and served with summons, to file answer and accelerate against his desire his right of action against the mortgagor, simply because the holder of the first mortgage has elected to institute foreclosure proceedings to secure judgment on his debt, sell the property and bar inferior lien holders. The second mortgagee may, under such circumstances, if he desires, permit judgment to be rendered by default against him, thereby raising no issue as to his rights under his note and mortgage except insofar as they pertain to the status of his lien as against the first mortgagee. Under such conditions his claim does not become res judicata in a future action." Id. at *3. Therefore the court held that the FSA held a valid security interest in the property and its claim was not barred by res judicata, and granted the FSA summary judgment. Id. at *5.

The case was decided on May 20, 2004.