The doctorine of Exoneration recognises that when two people own a property with a mortgage, and one of then wishes to borrow further money for business purposes, if that person declared bankruptcy, the business loan is applied against his share of equity in the property only rather than the total available equity between the two property owners.
The doctrine only applies in limited circumstances, usually being found in bankruptcy estates and in disputes between co-owners of real property or in a trust situation.
The doctrine is bad news for bankruptcy trustees and creditors of realizing anything from what often is a bankrupt’s only significant asset. Therefore bankruptcy trustees take a great interest in the doctrine when they think that it may apply to property that has vested in an estate.
In its most simple terms, the doctrine dictates that a loan solely to one party’s benefit should firstly be paid out of that party’s share, that the other party to the mortgage should be considered only as a surety, and their share should only be used in the case of any subsequent shortfall. The practical effect and the legal reasoning behind the doctrine are not that simple.
Here is an Example:
John and Mary own a house worth $400,000. Jack borrows $250,000 to finance a business venture that Mary has no financial interest in. This is borrowed against the house that they jointly own 50/50. Soon after venturing into his new business John declares bankruptcy.
The Doctrine of Exoneration will not stop the lender from selling John and Mary’s house to cover his business loan – however the remaining proceeds of the house will not be shared 50/50. The house sells for $400,000. First the $250,000 is deducted for the business loan. What remains is $150,000.
Because originally Mary had $200,000 equity in the property and so did John. Mary keeps the entire $150,000 and John receives nothing. If the bankruptcy trustee or the creditors counted on getting access to some of John’s house to cover other debts – they would be disappointed as John has no equity left in the house to apply to anything other than the business loan.