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Reflections on the Dark Side

posted by Susan Block-Lieb

Thanks to all who commented on my earlier post on the interaction of §§ 544(a)(3) and 551 and homeownership in bankruptcy; as hoped, CreditSlip readers helped me frame the questions that I continue to have about Traverse and the larger policy questions it raises. Some readers emphasized the importance of variations in state mortgage law to the trustee’s strong-arm powers; others questioned whether these distinctions should affect the trustee’s power to sell the residence (or the avoided lien) following avoidance.

Clearly, the trustee had the power to avoid the unrecorded mortgage in Traverse; let’s assume for purposes of argument that he also had the power to sell full title to the debtor’s home after avoidance.  For me the more interesting question is whether the trustee should have exercised these powers, and also whether the exercise might be viewed as an abuse of discretion.

Another way to think about this question is from an even broader angle: What position should a trustee play in a individual borrower’s chapter 7 case?  Is a trustee’s role to maximize distributions to unsecured creditors, full stop? Or might the trustee’s fiduciary obligations to the estate sometimes sit in tension with an interest in maximizing creditors’ interests?

Like all of the trustees’ avoidance powers, § 544 provides only that a trustee “may” avoid transfers that are voidable by statutorily specified entities (i.e., a judgment lien creditor, execution creditor and bona fide purchaser of real property); nothing in the Code describes what principles should guide the trustee in exercising this discretion. Section 704, which specifies the duties of a chapter 7 trustee, doesn’t answer the question. At its core, § 704(a) provides that the TIB should “collect and reduce to money the property of the estate.” I don't read this obligation to “reduce to money” as an obligation to bring all feasible avoidance actions, however. Avoidance actions aren’t themselves property of the estate; the proceeds of these actions are POE, but not until after the transaction has been avoided (§ 541(a)(3) and (4)).

Commentators broadly agree that trustees act as fiduciaries for the benefit of the debtor’s estate, both generally and as relates to their avoidance powers. Consistent with this broad notion, courts frequently hold that a trustee’s avoidance powers shouldn’t be exercised for the benefit of a single secured creditor.  And at least one court has held that unsecured creditors’ interests don’t limit the trustee’s authority to act in the interests of the estate, affirming a trustee’s standing to avoid a transfer despite an earlier settlement reached with the debtor’s general body of creditors because it saw avoidance as otherwise beneficial to the estate.

In a business case (whether we are talking about a liquidation or reorganization proceeding), the actions of a trustee in bankruptcy (and so also the debtor in possession) often are described as governed by a business judgment rule.  Litigation strategy motivated by an interest in maximizing the debtor’s likely reorganization generally satisfies this test.

But what about trustees’ duties in consumer cases? If the trustee (or DIP) in a chapter 11 can consider the effect of an avoidance action on the reorganization effort, shouldn’t the trustee in an individual’s chapter 7 consider the effects of avoidance on the debtor’s fresh start?  Should the trustee’s obligations (or the scope of the trustee’s discretion) differ depending on whether the debtor is an individual (and so likely to get a discharge from unpaid debts) or a corporation (and so likely dissolved at the conclusion of a chapter 7)?  Should it matter whether the lien being avoided in a security interest (in personal property) or a residential mortgage (against the debtor’s homestead)?

Let’s return to the trustee’s exercise of this discretionary authority in cases like Traverse.  There, the unrecorded mortgage would have been enforceable against both the debtor and her unsecured creditors under Massachusetts law.  Indeed, absent avoidance of the unrecorded mortgage, the trustee likely would have abandoned the property; the two mortgages were together nearly underwater, and the debtor was entitled to exempt the remaining equity in the homestead. Although the unsecured creditors could not themselves have recovered any of the proceeds of the sale of the home, they stood to receive distributions from the estate as a result of the unrecorded mortgage’s avoidance because § 544(a)(3) also cloaks the trustee with the powers of a bona fide purchaser of the property from the debtor. 

Unsecured creditors often do better than they otherwise would have as the result of a trustee’s exercise of a strong-arm power.  But the trustee’s powers under §§ 544(a)(1) and (2) differ in that an unsecured creditor could have acquired these powers under state collections law; the trustee’s hypothetical powers under these provisions serve dual policy functions in that they provide incentives for recordation and disincentives for unsecured creditors’ dismemberment of the debtor’s assets.  But what is the policy purpose of § 544(a)(3), given that an unsecured creditor’s ability to constitute a BFP would occur, if at all, independent of its status as a creditor?  Section 544(a)(3) encourages mortgage recordation, but it doesn’t discourage unsecured creditors’ efforts to grab the debtor’s assets.

This isn’t just an argument that the policy purposes of § 544(a)(3) are hard to understand.  It’s an argument that the trustee’s fiduciary obligations to the estate include, even in a chapter 7 liquidation, obligations not to undermine the debtor’s fresh start and, in this regard, not to undermine the debtor’s homeownership in circumstances that amount to a windfall to creditors.

My argument isn’t limited to understanding § 544(a)(3).  It would also apply to assessments of the debtor’s ability to reaffirm residential mortgages, and the bankruptcy court’s authority to mediate voluntary modification of residential mortgages under HAMP or HARP or otherwise.  More on these latter arguments in subsequent posts.

 

Comments

After winning the avoidance action the trustee could have said to the debtor, start making your mortgage payments to me as the trustee of the bankruptcy estate. I understand why a trustee would not want to become a mortgage servicer. For one thing it would mean that he would have to keep the bankruptcy estate open for up to 29 years. But there is something in the middle that would not result in the debtor losing the home and would result in a timely distribution to the unsecured creditors. The trustee could sell the mortgage. The buyer could be the original mortgagee or a third party.

There are definitely third party investors who will buy assets like this. Since the mortgage is now nonrecourse it would undoubtedly sell at a discount. However, the sale price may well be comparable to the net proceeds payable to the bankruptcy estate after the sale of the property. The transaction costs of selling real property may be the same or more than the discount that an investor would require when buying the mortgage.

Again, the solution for the debtor is to convert to Ch. 13, pay on the hypothetical Ch. 7 liqidation for 59 months, bulid equity and refinance the balance.

So, yes, trustees should attack mortgages, because its good for the general unsecured creditors AND good for the debtor. All by removing the privileged status of a mortgage.

Now that the 1st Cir. has issued its opinion reversing the Bankruptcy Court and BAP, have you had a chance to consider what this really means? For example, does avoidance of the mortgage lien somehow transfer the rights held by the lender under the note to the Trustee as well? Can you make any demand for payment, contract payments or otherwise, if you do not hold the note? How would the estate ever monitor a default? Can the trustee file a 549 action to recover all post-petition payments from the lender? Could the trustee create a default by making an immediate demand for the borrower to pay legal fees under the mortgage related to the avoidance action? With whom do the rights under the reaffirmation agreement flow, the now unsecured lender? The estate? Since this is residential property, would all the various consumer protections applicable to large residential lenders suddenly be enforceable against the trustee? Is the trustee suddenly operating a business, which would require specific court authorization, by administering the mortgage? Are servicing fees now administrative expenses of the 7 estate? Does this make the bankruptcy estate a lender? In the commercial context, could a trustee elect an insecurity clause to declare a default despite current payments?

Obviously many of these questions are issues that will at some point have to be reckoned with if this result stands. Given the variance amongst the states as to homestead exemptions, (for example, Kentucky, my state, allows you to elect federal exemptions, which are more generous than our state exemptions), will this decision have limited geographic application to those states that have significant homestead exemptions?

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