Trustee May Not Reform Avoided Mortgage

Posted by NCBRC - February 6, 2015

While a trustee has leeway to compromise an avoidance claim under bankruptcy law, he does not have the right to change the terms of an avoided mortgage to make it more marketable for sale or settlement. In re Dupuis, No. 12-30380 (Bankr. D. Mass. Jan. 8, 2015).

The Debtor owned three parcels of land; parcel 1 included her residence and parcels 2 and 3 were abutting properties. Parcel 1 was mismarked in the registry of deeds as Parcel 2 and when the debtor refinanced the residential property (parcel 1) with Wells Fargo the mortgage identified parcels 2 and 3 as the encumbered property. The debtor defaulted on the mortgage and around the same time became aware of the misidentification on the deed. She corrected the deed but did not likewise correct the mortgage. She later recorded a declaration of homestead on the residence according to Massachusetts law. One week later, the debtor filed chapter 7 claiming a homestead exemption on the property in the amount of its scheduled value.

The trustee filed an adversary proceeding to avoid the mortgage then sought authority to compromise the claim by giving Wells Fargo a corrected mortgage in exchange for $10,000 paid to the estate. Dupuis argued that the trustee could not reform a prepetition agreement over the objection of a party to that agreement. She argued that the adversary proceeding should go forward to invalidate the mortgage as it pertains to the listed properties—parcels 2 and 3, and that because no objection was made to her claimed exemption with respect to the residence on parcel 1, the property has no value to the estate and should be abandoned by the trustee.

The court began with the trustee’s avoidance powers under section 544(a)(3) which places the trustee in the position of bona fide purchaser who, under state law, may avoid a lien that has a defective description such that it does not give constructive notice of the mortgage. Sections 550(a) and 541(a) allow the trustee to gain the fruits of that avoidance for the benefit of the estate.

While these provisions give the trustee authority to avoid the mortgage, the power to change the terms of the avoided mortgage is another matter. Citing Jeffrey v. Desmond, 70 F.3d 183, 185 (1st Cir. 1995), the court set out the analysis for deciding a motion to compromise: “(1) the probability of success in the litigation being compromised; (2) the difficulties to be encountered in the matter of collection; (3) the complexity of the litigation involved, and the expense, inconvenience and delay attending it; and (4) the paramount interest of creditors and a proper deference to their reasonable views in the premise.” The trustee’s judgment is to be treated with deference and need only fall within a “range of reasonableness.” Because, under section 544(a), the trustee stands in the shoes of the bona fide purchaser, however, his powers are limited to those that a bona fide purchaser would have under state law.

To determine whether that power includes the right to reform a mortgage, the court turned for instruction to the recent case of DeGiacomo v. Traverse (In re Traverse), 753 F.3d 19 (1st Cir. 2014) [in which the NACBA membership acted as amicus]. In that case, the trustee successfully avoided a lien that had not been properly recorded but on which the debtor was not in default and for which the debtor had claimed an exemption. The court denied the trustee’s attempt to liquidate the property for the benefit of the estate. The court found that the trustee had the benefit of the mortgage but, because the mortgage was not in default, he did not have any more right to sell the underlying property than the original mortgagee would have had. Though Traverse involved an undefaulted mortgage and Dupuis involves a defective description on the mortgage, the same rule applies: “preservation of a mortgage does not grant the trustee a right to unilaterally alter the terms of the mortgage vis-à-vis the debtor.” The court admonished that, in accordance with Traverse, once the lien is avoided the trustee stands in the shoes of the bona fide purchaser or mortgagee, not the debtor. Any reformation of the mortgage must be done through state court channels rather than through the bankruptcy proceeding.

Turning to Dupuis’ motion to compel abandonment, the court disagreed that because of the debtor’s claimed homestead exemption, the property had no value to the estate. Wells Fargo’s mortgage, albeit defective, predated the debtor’s homestead exemption, and under Massachusetts law, a homestead exemption is not effective against an earlier mortgage. The court found that reformation of the mortgage was still possible under state law, in which case the debtor might not ultimately be able to avail herself of the exemption.

The court denied both motions.

Dupuis Bankr D Mass opinion


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