A Dark Side to the Trustee's Strong Arm Powers

Conventional wisdom views bankruptcy as a place that protects homeowners and homeownership.  One of the primary reasons Chapter 13 allows debtors to retain all property of the estate, whether exempt or not, is to allow debtors to hang on to their personal residences even though applicable exemption law would not otherwise allow this.  OK Chapter 13 doesn’t permit modification of residential mortgages, but it does allow debtors to decelerate and cure mortgages in default, providing some consumer debtors some protection from foreclosure.  Chapter 7 is traditionally viewed as less protective of the homestead – that is, it protects residences only to the extent of applicable homestead exemption law, but it has been widely accepted that debtors might protect their homes in chapter 7 by combining a discharge from unsecured debts with reaffirmation of a residential mortgage. 

The recent financial crisis has strained both the state court foreclosure process and the federal bankruptcy system, raising questions about the continuing accuracy of the notion that bankruptcy provides a safe place for homeowners.  Whether bankruptcy does or even should protect homeownership is a very big question, one undoubtedly best answered in combination with careful analysis of data, and I won’t presume to tackle that question in a blog.  But I do want to use this format as a safe place for thinking about these issues.

As a first step, I propose looking into a couple of recent cases that prompted a double take from me.

The first case I want to discuss in this vein (and the only case today) is DeGiacomo v. Traverse (In re Traverse), 485 B.R. 815 (Bankr. 1st Cir. 2013). Traverse asks whether the trustee in a chapter 7 bankruptcy case should be allowed, after avoiding an unrecorded mortgage on the debtor’s home under his strong arm powers (§544(a)(3)) and preserving that lien for the benefit of the estate (§551), to force a sale of the residence, although the debtor in this case had recorded a homestead declaration under Massachusetts law well before filing for bankruptcy and was not in default under her mortgage.  Traverse, the debtor, sought a declaration from the bankruptcy court (i) that the trustee could not sell her home without first foreclosing the mortgage under state law and (ii) that the remedy of foreclosure was not available to the trustee, even given the avoidance and preservation of the mortgage, because she was not in default.  The bankruptcy court granted summary judgment in favor of the trustee and the BAP affirmed this judgment.

Let’s start with the court’s legal analysis.  In holding that the trustee could see the residence, the BAP thought several preliminary issues clear: “There is no dispute that the trustee successfully and lawfully avoided JP Morgan Chase’s mortgage under §544, or that he is able to preserve some benefit to the estate pursuant to §551.  The only dispute is exactly what that benefit may be.”  While the debtor argued that following avoidance a trustee stands in the shoes of the mortgagee and that the mortgagee could not have forced a sale of the home since the mortgage was not in default, the BAP declined to characterize avoidance as a simple assignment of the mortgagee’s interests to the estate. “Rather, [the avoidance] left [the trustee] in the homeowner’s shoes, with the added benefit that funds that would otherwise be allocated to ‘pay off’ the JP Mortgage Chase mortgage would enrich the estate.” The debtor’s only method of benefitting from the lien avoidance, held the court, was under the limited circumstances set forth in §522(f), (g), (h), (i), none of which applied in this case given the voluntary nature of the lien created by the residential mortgage.

The statement in Traverse that the avoidance and preservation of the unrecorded mortgage put the trustee in the shoes of the debtor caught my attention; this remark seemed inconsistent with what I’d been taught (and what I teach) in law school, namely, that §551 puts the estate in the shoes of the creditor whose lien is avoided. Courts often state that avoidance places the trustee in the shoes of the avoided mortgage (or security interest) to explain why it is that junior liens don’t benefit from the trustee’s avoiding powers, and why it is that a trustee’s position under an avoided unperfected security interest is still subordinate to a later, perfected security interest: Following avoidance, the preserved lien should enjoy no greater rights than it enjoyed under the unperfected secured creditor or unrecorded mortgagee. 

But Mrs. Traverse also questioned the source of the chapter 7 trustee’s ability to sell her residence (or foreclose against the avoided mortgage).  The BAP thought the trustee held this authority because the residential property was property of the estate under §541, given the preservation of the avoided lien under §551. But §§541, 544 and 551, even when read together, do not fully respond to Traverse’s argument that the trustee should enjoy no greater rights under the avoided mortgage than the mortgagee itself was entitled to enforce. I’d agree that after the unrecorded mortgage was avoided, the mortgagee’s legal title and the debtor’s equitable interests in the property both constituted property of the estate, but under Massachusetts law, these two interests could only be joined through the process of foreclosure, which among other things requires proof of the borrower’s default on the mortgage debt.  While not every state is a “title state” like Massachusetts, I’m not convinced that §544(a)(3) avoids the state law requirements associated with enforcement on an unrecorded mortgage.  The trustee should have no greater rights against the debtor than the mortgagee enjoyed outside of bankruptcy.

While under 363(f)(1) the trustee might sell property free and clear of mortgage interests, he can do so only if applicable nonbankruptcy law permits such a sale – and it’s not so clear that Massachusetts law would have. In fact, courts differ on whether a trustee can “force” on a debtor a short sale of her residential mortgage, a topic on which I’ll have more to say in later posts.

OK, the law here is complicated. To complicate things further, there are only a few cases on the question of the trustee’s authority to force a sale of residential property following avoidance of an unrecorded mortgage, and they are both unpublished and distinguishable. The BAP’s decision in Traverse has been appealed to the First Circuit.   NACBA has filed an amicus brief in support of reversal.   I look forward to hearing the result in this case.

In reaching its decision, I’m hoping the First Circuit doesn’t ignore the policy consequences of Traverse, which are enormously problematic in the current post-Financial Crisis state of affairs.  Individuals struggling with unsecured debt they cannot repay may look to preserve their home with a chapter 7 filing.  Because unrecorded mortgages are fully enforceable against the borrower, and because mortgagees hire humans, it’s not that unusual for the mortgagee to fail to formalize the transaction through recordation.  In the absence of the trustee’s avoidance of an unrecorded residential mortgage, the debtor’s unsecured creditors would not have been affected by the failure of the mortgagee to record the mortgage; and the debtor’s discharge from unsecured debt and reaffirmation of the mortgage might well have permitted the debtor to save her home.  Avoidance of these unrecorded mortgages may serve mostly to throw out the baby with the bath water. Or, more immediately, for debtors' attorney to advise consumers not to file a chapter 7 if their mortgage was unrecorded.

So two questions for the blog: First, thoughts on Traverse?  Second, thoughts on the larger question of the role of bankruptcy as a forum for protecting homeownership?  More on the second question in later posts…….

Comments

[Ed Boltz]

It is not accurate to categorically state that Ch. 13 does not permit modification of residential mortgages- many courts have held that additional collateral securing the mortgage note, from appliances to escrow accounts, take away the protections of 1322b2.

This case, in fact, also gives an example of how Ch. 13 could be used to modify a mortgage. Being unrecorded, the debtor would have equity above exemptions and would have to ay a decent dividend to unsecured creditors, but would in effect get to cram down the house to its liquidation, and not replacement, value, a better deal than any mortgage mod proposal. The debtor might get his or her exemption and definitely wouldnt pay interest on the EAE, since it wouldn't be a 100% payout. Further, EAE doesn't require equal monthly payments, so it could be ballooned to late in the case with a refinancing.

[John Rogers]

Chapter 7 trustees have regularly avoided unrecorded mortgages in Kentucky and then sold the homes with their authority to sell assets of the estate, with distribution going to unsecured creditors, which would include the bank holding the unrecorded mortgage. In some cases, the debtor will convert to Chapter 13 to avoid this result.
Interesting and thought provoking post !

[Ken T]

I think a couple of separate concepts are being mixed together here, but perhaps I am wrong. Here is how I see it:

I think that you misstate the ruling when you say that it held that "The BAP thought the trustee held this authority because the residential property was property of the estate under §541, given the preservation of the avoided lien under §551" The Debtors claim of a $500,000 exemption only withdrew up to $500,000 in non-voluntarily surrendered (through the first and second mortgages) equity from the estate. Regardless of lien avoidance, the personal residence remained property of the estate. Absent avoidance, if the Trustee could find a buyer that would pay $1 million for the home, the Trustee would sell it, pay off any liens, pay off the $500,000 homestead, and disburse the rest after administrative costs. So the avoidance and preservation of the lien is, and was, wholly irrelevant to whether the home is property of the estate.

Under 541, the Trustee is automatically in the shoes of the homeowner. By avoiding and preserving, they also stand in the shoes of that creditor. It's not a one or the other scenario and the Trustee does not abandon powers as the homeowner simply by avoiding a lien on the home and preserving it for the estate.

But for 363(f), the Trustee can sell the property. Whether or not the Trustee meets 363(f)(1), the Trustee is not foreclosing on an avoided lien. The Trustee is selling under 363(b).

Looking to 363(f), you say that it's unclear if applicable State non-bankruptcy law would allow the Trustee to sell free and clear of the mortgage interests. You focus on the unrecorded mortgage, but even if the unrecorded mortgage creditor has standing to object under 363(f)(1), how does the Debtor have standing to object on its behalf?

Further, the first mortgage creditor certainly wants the property sold. With the lien avoided, it's not as if they can simply record after the discharge is filed -- the unsecured debt will be discharged upon completion of the case. The Debtor would have no reason to reaffirm an avoided mortgage. So, even if the first mortgage creditor has "an interest" under 363(f), they will certainly consent to sale under 363(f)(2) to hopefully get something instead of nothing.

Similarly, regarding the second mortgage, if they are going to be paid in full by virtue of being a later, but perfected, mortgage, why would they even object? And even if they wanted to do so, how does the Debtor have standing to raise their objection?

Finally, there's the argument that unsecured creditors would not have missed out on anything, relative to a recorded mortgage, if the Trustee did not avoid the mortgage. Isn't that true with respect to all of the Trustee's avoiding powers?

Are you taking the position that a Trustee should never avoid a lien unless there exists independent non-exempt equity that could be gained in a sale? Or that a Trustee can never sell property, even after avoiding a lien, if non-bankruptcy law would not allow such a sale and there was not such pre-existing non-exempt equity? It's not clear to me, but it appears to be the argument based on your comparison to a short sale, which generates nothing for unsecured creditors.

The Trustee-as-homeowner can sell the property under 363(b), regardless of whether the estate's "equity" is just value above all liens and exemptions or that non-exempt "equity" is the result of avoiding a mortgage. The Trustee-as-lienholder can consent to the sale under 363(f)(2). Even if the other mortgage holder could object, the Debtor has no standing to object on their behalf. To me, the BAP got this right.

A good attorney should conduct a property records search to determine whether all mortgages are recorded as well as whether there are unknown, possibly avoidable judicial or other liens. And, if there is an unrecorded mortgage, the advice might be to file Chapter 13, not file bankruptcy at all, or notify the creditor, wait for them to record, and then wait the requisite preference time to avoid avoidance.

[Ken Doran]

I agree that the best reading of the statutes is that the trustee acquires the mortgagee's rights; the debtor retains the exemption and rights to perform the mortgage; and the trustee should have only the right to sell the mortgage, not the underlying property. However, confusing results are common, and I do not find this one all that surprising. These situations are how panel trustees make a substantial part of their livings. Here in Wisconsin, a fairly settled formula has evolved in which the holder of the unrecorded mortgage often buys off the trustee's avoidance claim on terms involving waiver of what would otherwise become a very large unsecured claim, and a payment to the estate calculated to make the remaining creditors whole for the net dividend they would otherwise receive. As others have noted, Chapter 13 (including by conversion) can be a useful option for the debtor, as can be the perfect-and-wait tactic described by Ken T.

[mt]

I agree with Ken T. The trustee taking title to non-exempt property and the status of liens on that non-exempt property are different questions. The latter is just a distribution of proceeds of sale issue; the former is where the power to sell arises. Imagine if there were no lien at all on the home. Would you say the trustee did not take title to it? The result sucks for the homeowner but it seems to be the law, fairly clearly.

[Jan Sensenich]

Conversion to Chapter 13 provides a means of dealing with this dilemma. In Vermont we have avoided numerous defective mortgages, paid an enhanced dividend to the unsecured creditors and had the debtors refinance for small amounts at the end to complete the plan (to meet the best interests test). Typically the debtors and unsecured creditors both benefit from the avoidance, which makes it better than the wait and cure approach.

Jan Sensenich