Even though mortgage was properly rescinded after closing the debtors in Bankruptcy could not claim they were free of all secured debt where the prior mortgage was mistakenly paid off

In In re Thayer, 07-6045, (March 31, 2008. 8th Cir. BAP (Minn.)) Chapter 7 debtors/mortgagors timely cancelled their prepetition refinancing transaction with lender pursuant to the Truth in Lending Act (TILA). However, the closing agent, unaware of the cancellation, paid off the debtor’s prior mortgage. The mortgagee then assigned its rights under the note and mortgage to the lender/creditor. When the debtors filed a Chapter 7 bankruptcy they listed the creditor as an unsecured non-priority creditor. The debtors argued that creditor’s mortgage had been released pre-petition and whatever in personam liability it may have had on the debt was dischargeable in bankruptcy. They also argued that the closing agent’s payment to mortgagee extinguished their obligation on creditor’s note such that they had no further payment obligations. The appellate panel for the bankruptcy court found that the bankruptcy court properly unwound the rescinded transaction by setting aside the release of the prior mortgage and reinstating it. To unwind the rescinded transaction, the pay-off of the prior mortgage was treated as a purchase of the original lender’s rights under the original mortgage. That purchase created a new creditor-debtor relationship between creditor’s and the debtors. The bankruptcy court’s focus on the substance of the transaction and the windfall that debtors would have received if the prior mortgage was released and the creditor’s mortgage was extinguished was correct and consistent with equitable principles involving rescission. The court found this was the only way the debtors were returned to the status quo ante.