Strong Arm Powers: What Happens When a Mortgage Is Avoided – Does It Go Poof?

DeGiacomo v. Traverse (In re Traverse), 45 B.R. 815 (1st Cir. B.A.P. 2013) –

A chapter 7 trustee sought to avoid an unrecorded first mortgage on the debtor’s property and to preserve the mortgage lien for the benefit of the bankruptcy estate.  The debtor responded by claiming that even if the trustee was successful, he could not sell the property without first foreclosing the mortgage in accordance with state law.  The bankruptcy court rejected the debtor’s claims and granted the trustee’s motion for summary judgment.  The debtor appealed to the bankruptcy appellate panel.

The debtor executed a mortgage on her home to secure a $200,000 loan.  Unfortunately for the mortgagee, the mortgage was never recorded.  The debtor later granted a second mortgage to secure a line of credit (which was recorded), and recorded a homestead declaration under state law.

The debtor’s bankruptcy schedules showed the value of the home as $223,500, the second mortgage claim of ~$30,000 and the unperfected first mortgage claim of ~$186,000.  She also claimed a homestead exemption of $500,000.

Since the first mortgage was unrecorded, the trustee was able to exercise the strong arm powers under Section 544 of the Bankruptcyto avoid the mortgage.  (See Bankruptcy “Strong Arm” Powers: Bye Bye Mortgage.)  Under Section 551 of the Bankruptcy Code, a transfer that is avoided (in this case the grant of a lien pursuant to the mortgage) is “preserved for the benefit of the estate.”  It was clear that the trustee could avoid the mortgage and that some sort of benefit would be preserved for the benefit of the bankruptcy estate.  The question was exactly what benefit.

The trustee’s theory was that in liquidating the bankruptcy estate he stood in the shoes of the debtor/homeowner.  So, he could sell the property, using the proceeds to first satisfy the liens encumbering it, then paying the debtor her exemption amount from any remaining proceeds, and finally holding any surplus for the bankruptcy estate.

In contrast, the debtor argued that avoiding the mortgage and preserving it for the benefit of the estate meant that the trustee simply replaced the lender as the mortgagee.  Consequently, the trustee could not sell the property without foreclosing the mortgage under state law.

The court confirmed that the trustee was correct.  Once the debtor filed her bankruptcy petition, all of her legal and equitable interests became property of the bankruptcy estate.  Her rights of possession and redemption with respect to the property vested in the estate subject to the mortgage liens.  The effect of the homestead exemption was to give the debtor a right to value that might remain after the mortgages were satisfied.

As a result, avoiding the first mortgage did not make the trustee an assignee of the mortgagee.  Rather he remained in the shoes of the homeowner, but with the added benefit that any funds that would have been used to pay off the first mortgage were instead paid to the bankruptcy estate.

So, in connection with a sale of the property:  (1) the first ~$186,000 would be applied to the first mortgage claim, which in turn would be paid to the bankruptcy estate as opposed to the first mortgagee; (2) the next ~$30,000 would be paid to the second mortgagee; (3) next, proceeds would be paid to the debtor until she received her $500,000 homestead exemption; and (4) finally, if there were any surplus proceeds, they would be turned over to the bankruptcy estate.  As a related point, the first mortgagee’s claim itself was not avoided, only the mortgage lien.  So the first mortgagee was treated as an unsecured creditor with a claim of ~$186,000 that would be paid pro rata with other unsecured creditors.

Sometimes when a trustee or debtor in possession exercises strong arm powers, it can be easy to lose sight of what this means.  It is important to focus on exactly what is being avoided (for example, in this case the lien was avoided, but not the claim) and determine the consequences for the bankruptcy estate.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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