Trustee Stands in Shoes of Creditor upon Avoidance of Lien

Posted by NCBRC - May 26, 2014

In a methodical and thorough opinion, the First Circuit found that “preservation of a lien entitles a bankruptcy estate to the full value of the preserved lien–no more and no less.” Under this principle, the court found that the trustee did not have the power to sell the debtor’s homestead where the trustee avoided the primary lien on the residence but the debtor was current on the mortgage and her homestead exemption exceeded the value of the property. DeGiacomo v. Traverse (In re Traverse), No. 13-9002 (1st Cir. May 23, 2014).

When the debtor filed for chapter 7 bankruptcy she claimed her Massachusetts homestead exemption which, the trustee agreed, under normal circumstances would have allowed her to retain the residence. However, the trustee discovered that the mortgagee (both the original and subsequent mortgagee) had failed to record the mortgage properly. The trustee avoided the mortgage under section 544 then sought to sell the property for the benefit of the estate. Both the bankruptcy court and the BAP for the First Circuit found that he could do so pursuant to his power to administer the debtor’s estate.

The First Circuit reversed. It began its analysis with reference to the Massachusetts homestead exemption which protects a debtor’s residence against conveyance or levy to pay creditors in bankruptcy except in the case of the mortgagee seeking to recover on the underlying debt. Thus, the power to sell the property under state law rests on the mortgagee’s right to foreclose. Mass. Gen. Laws ch. 188, § 3(b). Additionally, a bankruptcy trustee will sell estate property only where the value of the property less encumbrances and exemptions yields equity. “Where, on the other hand, a property fails to yield any remaining equity for the estate . . . a trustee generally should not sell the home, but should leave the secured creditors to their own legal means of recovering their claims.”

The trustee here argued that when he successfully avoided the mortgage, “the preserved mortgage [] turned some corresponding share of the home’s value into the ‘property of the estate’ to be liquidated through sale.” The court disagreed, finding that the trustee’s “preservation of an undefaulted mortgage on Traverse’s home for the benefit of the bankruptcy estate is not co- extensive with an ownership right over the underlying property. Under § 551, the trustee preserves any liens or transfers avoided under § 544 by claiming those liens for the benefit of the estate, but he preserves the benefit of only that which has been avoided–in this case, the mortgage.” The fact that the trustee’s avoidance of the lien could, as a practical matter, bring funds into the estate which would benefit creditors, does not by itself create “equity” in the property that justifies sale by the trustee. Key to the decision was the court’s finding that “[i]n itself, a mortgage carries neither a right of immediate ownership of Traverse’s property, nor a right of immediate payment of the secured loan’s outstanding value, but only a right to foreclose on Traverse’s property in the event that she defaults on her loan or to receive payment in full when the home is sold through other means. And that is the extent of the rights gained by the estate by through the trustee’s preservation.”

The court also rejected the trustee’s argument, based on Schwab v. Reilly, 560 U.S. 770, 782 (2010), that the debtor’s exemption rights extended only to the monetary value of the property rather than to the property itself. The court distinguished Schwab as applying to cases in which the value of the property exceeded the exemption amount. Here, the exemption amount was greater than the value of the property and Massachusetts courts interpret this situation as one in which the debtor retains a right to the actual property rather than merely its value.

The court concluded that: “It remains a mystery to us why a provision clearly aimed at regulating the distribution of a debtor’s estate among her creditors should exacerbate the debtor’s substantive obligations and vulnerabilities in bankruptcy.” To permit the trustee to sell debtor’s homestead would effectively punish the debtor for the negligence of the lending banks.

NCBRC filed an amicus brief, authored by Ray DiGuiseppe, on behalf of the NACBA membership.

Congratulations to David Baker for this important win.

Traverse Opinion

 

 

 

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One Comment

  • Posted July 12, 2014 at 3:59 pm | Permalink

    And thanks to the NCBRC for a very helpful amicus!

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