Code Does Not Entitle Trustee to Sell Free and Clear of Creditor’s Judgment Liens

Posted by NCBRC - January 11, 2018

The bankruptcy estate’s interest in property does not become superior to a valid senior judgment lien even though the bankruptcy trustee took the steps necessary to avoid a fraudulent transfer and bring the property into the estate. In re Knight, No. 16-584 (Bankr. D. S.C. Nov. 6, 2017).

Apex Bank obtained two judgments against Talmadge Knight in state court. By operation of state law, the judgments resulted in liens on Mr. Knight’s property. Shortly thereafter, Mr. Knight transferred his farm property, Saluda, to Ambler Road, LLC., an entity owned solely by Mr. Knight. Mr. Knight later filed for chapter 7 bankruptcy. Apex filed two proofs of claim totaling approximately $1.9 million. The trustee filed an adversary proceeding to avoid the transfer of the Saluda property from Mr. Knight to Ambler. That proceeding was settled and the transfer avoided. The trustee then arranged a sale of the property for $146,000 and moved the court for permission to sell free and clear of liens. The motion contained some inaccuracies about the property and did not mention Apex’s judgment liens.

Section 363(b)(1) permits the trustee to sell estate property. Under section 363(f)(4), he may do so free and clear of another interest in the property if that interest is subject to genuine dispute. Rule 6004 provides that a motion to sell property free and clear of liens be served on parties holding liens. Once proper notice has been made, the sale must pass the “business judgment” test to determine if the proposed sale is in the best interest of the estate.

The trustee argued that Apex’s interest in the property was in dispute under both section 551, which provides that a transfer that is avoided is preserved for the benefit of the estate, and the “diligent creditor doctrine,” which rewards the creditor, or in this case the trustee, who undertakes the risks and expense of litigation to bring property into the estate.

The court turned to state law to determine the extent and priority of Apex’s interest in the Saluda property. In South Carolina state court judgments automatically result in a lien on the judgment debtor’s property which continues to encumber the property upon its sale. The court explained that the purpose behind section 551 is to prevent a junior lienholder from improving its position at the expense of the estate when a senior lienholder’s lien is avoided. It does not, however, position the estate’s interest over a valid senior lien.

The court also disagreed with the trustee’s position that Apex slept on its rights by allowing the trustee to take steps to avoid the transfer and arrange the sale of the property. Apex’s lien was automatic upon entry of the state court judgments, Apex did not collude with Mr. Knight in the avoided transfer, and Apex preserved its interest in the bankruptcy case by filing proofs of claim and by objecting to the trustee’s motion to sell. It fulfilled all requirements necessary to preserve its interest.

The court concluded that it “lack[ed] the authority to impose the equitable relief requested, which would require approval of distribution contrary to the express provisions of the bankruptcy Code.” It denied the trustee’s motion to sell free and clear of liens.

Knight Bankr D SC opinion Nov 2017

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