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Doctrine of exoneration: How it applies in bankruptcy

The principle of the doctrine of exoneration changes respective interests in real property ownership, depending on the conduct of one or more of its owners.

Introduction
The principle of the doctrine of exoneration can change respective interests in real property ownership, depending on the conduct of one or more of its owners, or when an interest in an asset is created.

For example, a joint owner of real property who borrows funds and secures them against the real property and uses these funds for their own benefit to the exclusion of another owner.

This factsheet outlines how the doctrine of exoneration is applied to real property to adjust each owner’s interests in the property’s equity.

Applying the doctrine
The doctrine applies where a number of parties are registered owners of real property, but where borrowed funds secured against it are used for the benefit of some owners, but not all.

For example, Michael and Samantha own their home, subject to a mortgage. The mortgage is for the benefit of both of them. However, Michael takes out an additional loan for his own benefit, and secures it against the family home. Under the doctrine, Michael’s additional loan is for his benefit alone, and Samantha’s interest in the property’s equity is adjusted to reflect this. (The relationship status of Michael and Samantha is not relevant. The doctrine applies in any such similar instance between co-owners regardless of marriage, de facto relationship, etc.)

The doctrine can have a great impact on a bankruptcy trustee (and therefore creditors) if, for instance, the bankrupt—despite being a registered owner of real property with equity—has no equitable interest in that equity because they had previously borrowed additional funds and secured them against the property.

Example of the doctrine
Steve and Robin own their home as joint tenants. The house is worth $400,000. They bought the house with a joint loan secured by a mortgage on the property. They owe $100,000 under the mortgage.

Steve ran a business that Robin had no financial interest in. For the benefit of the business, Steve borrowed $200,000 with a loan secured against their home.

Steve goes bankrupt. The following questions are raised in bankruptcy:

  • What is the impact on the mortgagee?
  • What interest does a bankruptcy trustee have in the real property?
  • What is the impact on the co-owner (Robin)?

The doctrine does not affect the mortgagee’s rights. In a sale, the mortgagee is entitled to the balance of the original loan to purchase the property of $100,000 and the subsequent loan of $200,000. Leaving aside the sale costs, $100,000 remains as the surplus sale proceeds.

In the absence of the doctrine, the surplus funds (of $50,000 each) are split equally between Steve and Robin. However, because the business loan of $200,000 was solely for Steve’s benefit, the doctrine applies and the allocation of the equity is adjusted in Steve’s favour. In this example, the doctrine would apply as follows:

  • The balance of the original mortgage of $100,000 is applied first against the sale proceeds of $400,000, leaving a balance of $300,000.
  • Theoretically, the $300,000 is split equally between Steve and Robin, resulting in a split of $150,000 each.
  • But because the $200,000 business loan was solely for Steve’s benefit, this is applied only against his interest in the property, which means his $150,000 allocation is extinguished.
  • Therefore all of the remaining equity in the real property (the $100,000) is entirely owned by Robin, and Steve in fact owes Robin $50,000, and she can prove in his bankrupt estate for this amount.

In this example, the bankrupt estate would receive nothing from the sale of the real property.

Summary
Whenever dealing with real property interests, trustees are concerned with the re-allocation of equity depending on the nature and use of secured funds to a mortgagee. Owners of real property must ensure they maintain sufficient records to properly record and explain any such borrowings secured against real property, so that they can establish any application of the doctrine to adjust the equity in real property.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Last Updated: 3.11.2017