Secured Creditor Rights in Bankruptcy

By Cara O'Neill, Attorney
A secured creditor gets paid first if the bankruptcy trustee sells the property (collateral) guaranteeing the debt.

Money isn’t always available to pay creditors in bankruptcy. But when it is, it’s the job of the bankruptcy trustee—the court-appointed official responsible for managing the case—to disperse funds to creditors. In many instances, a secured creditor will be at the top of the payment list. Why? Because a secured creditor’s debt is backed by property (collateral). If the trustee sells the collateral, the secured creditor must be paid in full before any other creditor can receive a portion of the proceeds.

How Does the Trustee Know Who to Pay?

The court starts the process by sending out a notice instructing creditors to submit claims on an official proof of claim form. After the submission deadline passes, the trustee reviews the claims and determines how much each is entitled to get paid, if anything.

That said, all debts are not equal in bankruptcy. Some debts have payment priority over others. For instance, child support arrearages would rank higher than a cell phone bill. If the available funds weren’t sufficient to cover the entire support amount, the cell phone bill would be left unpaid.

(Find out what happens if you don’t agree with a claim in How to Object to a Creditor's Claim in Bankruptcy.)

Understanding Secured Claims and Liens

A claim is secured if the creditor has a security interest (a lien) against the property (collateral). The lien establishes an ownership right until the underlying debt is paid. By contrast, an unsecured creditor—for instance, the holder of a credit card debt—has no such right.

Some liens are voluntary, meaning that the borrower agreed to give the creditor a lien when entering into the contract. Examples of documents memorializing a voluntary lien include:

  • a deed of trust or mortgage on real estate, or
  • a personal property (such as a car, truck, boat, or equipment) security agreement.

Additionally, the law gives some creditors the right to an involuntary lien. Examples include:

  • a judgment lien (a creditor sues and wins a money judgment in court), or
  • a tax lien for unpaid income taxes.

In bankruptcy, a creditor with a claim secured by a lien has the right to get paid either an amount equal to the value of the collateral securing the debt, or the amount that’s owed, whichever is less.

(For additional information, read Secured Claims and Liens in Bankruptcy.)

Specific Rights of Secured Creditors

All creditors have rights in bankruptcy. For instance, they’re all entitled to:

  • a priority share of any bankruptcy funds (which could range from all of the available money to none of it, depending on the ranking of the particular claim)
  • object to the debtor's plan and related matters, and
  • challenge a debtor's right to a discharge of the creditor's debt (the most common would be an allegation that the debtor committed fraud).

Secured creditors have additional rights, too. In fact, in bankruptcy, a secured creditor is much better off than an unsecured creditor. The lien entitles the secured creditor to the proceeds from any property serving as collateral for their claim (up to the claim amount).

Example. The trustee sells a vacation home worth $200,000. The property secures the mortgager's debt of $75,000. The trustee must fully pay off the secured lender before distributing funds to other creditors. After paying the $75,000 mortgage, the trustee will distribute the remaining $125,000 amongst the other claims according to the priority rules.

Because of the lien rights, if a secured creditor believes that it's losing money as a result of the trustee holding property in bankruptcy, it can file a motion with the court asking for relief. If the judge agrees, the trustee (or debtor) will likely be required to either make payments to cover any potential losses or release the property. The secured creditor is also entitled to the interest outlined in the contract (with some limitations).

Chapter 7 Bankruptcy

In a Chapter 7 bankruptcy, a secured creditor’s rights limit what a debtor can do with property serving as collateral. Specifically, the filer has the following choices:

  • Surrender the property. If the filer agrees to let the property go, the creditor can seek payment through foreclosure, repossession, or any other collection method available to the creditor.
  • Reaffirm the debt. The filer signs and files a legally enforceable document with the bankruptcy court in which the filer commits to repay all or a portion of the debt that might otherwise have been discharged in bankruptcy.
  • Redeem the debt. A filer can pay the actual value of the property in one lump sum payment. The debt must be a consumer debt used for household purposes.

Chapter 13 Bankruptcy

In a Chapter 13 bankruptcy, a filer whose income is sufficient to cover monthly payments can keep secured property. This chapter is also helpful when a filer has fallen behind on secured property payments. The filer can:

  • surrender the property to the lender, or
  • catch up on missed payments through the three- to five-year repayment plan.

Whether the filer will have to pay off the entire amount owed through the repayment plan will depend on whether the debt is a short- or long-term debt. For instance, a filer will not have to pay off a mortgage—which is considered a long-term debt—in full. Instead, the filer will continue to make the monthly payments either inside or outside of the plan, depending on the rules of the local jurisdiction.

Questions for Your Attorney

  • Do you prepare proof of claim forms on behalf of creditors?
  • Can the bankruptcy court change the terms in a secured creditor’s contract?
  • Who prepares the reaffirmation agreement?
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