A chapter 11 debtor filed an adversary proceeding against its construction lender seeking to avoid as a preference a notice of lis pendens filed by the lender. The bankruptcy court granted the lender’s motion to dismiss; the district court affirmed; and the debtor appealed to the 10th Circuit.
The debtor was a real estate developer that obtained a $12 million loan from a bank for construction of a single family home. The bank intended to take a deed of trust on the property to secure the loan. However the deed of trust incorrectly identified the debtor’s sole member as the owner. As a result, the deed of trust was ineffective. The bank filed a state court action seeking reformation of the deed of trust and a declaration that it had a first priority lien. It also filed a notice of lis pendens in the county land records. A couple of months later the debtor filed a chapter 11 bankruptcy.
During the bankruptcy proceeding, the debtor sought to avoid the lis pendens as a preference:
- Section 547(b) of the Bankruptcy Code authorizes a debtor in possession to avoid “any transfer of an interest of the debtor in property … to, or for the benefit of a creditor,” if it meets certain additional statutory criteria.
- Section 101 defines “transfer” to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property” (emphasis added).
- Generally state law defines what is property or an interest in property.
In this case, applicable state law provides that a party may record a notice of lis pendens against property after initiating an action “wherein relief is claimed affecting the title to real property.” This results in “notice to any person thereafter acquiring, by, through, or under any party named in such notice, an interest in the real property… if the interest so acquired may be affected by the action described in the notice.”
Under state law, it was clear that a lis pendens does not constitute a lien, and a judgment lien arises only after a judgment is recorded. Accordingly the 10th Circuit agreed with the lower courts that the bank’s lis pendens merely provided notice and did not create an interest in property. However, the court did acknowledge that a lis pendens does have legal consequences: “Once a lis pendens is filed, it renders title unmarketable and therefore effectively prevents the property’s transfer until the litigation is resolved or the lis pendens is expunged.”
The debtor argued that in effect the lis pendens transferred an interest – namely its right to convey fee simple title to the property free of the bank’s interests. While acknowledging that a lis pendens is a cloud on title, the court did not concede that this constituted “disposing of or parting with” an interest in property, as required to qualify as a “transfer” for preference purposes.
A state court decision on the effect of a notice of lis pendens concluded that it only meant that a subsequent purchaser would be bound by the outcome of the litigation. While a lis pendens may make it more difficult to find a purchaser, the property owner retains the right to transfer title. Thus, the 10th Circuit reiterated that, although the right to convey may become less valuable, “a ‘diminished’ interest does not equate to a ‘transferred’ interest.”
The debtor also argued that the filing of the lis pendens effectively perfected the bank’s lien, and the timing of perfection is determinative in finding a transfer. Specifically:
- Section 547(e)(1)(A) states that: “A transfer of real property… is perfected when the bona fide purchaser of such property from the debtor… cannot acquire an interest that is superior to the interest of the transferee…”
- Section 547(e)(2)(B) states that “a transfer is made… at the time such transfer is perfected, if such transfer is perfected after [30 days after such transfer takes effect]…”
The court rejected this argument on the basis that these sections relate only to the timing of a transfer, not whether a transfer in fact had occurred. According to the court, perfection and transfer are distinct concepts.
The debtor cited a 9th Circuit case in support of its argument that appeared to equate “perfection” of an interest with a “transfer” of the interest. However, the court noted that the creditor had already recorded a judgment in that case. So the question was whether the transfer related back in time to the date of the lis pendens filing, not whether the lis pendens was itself a transfer.
The debtor also attempted to raise an argument based on the fact that any eventual judgment itself would be a transfer that should be considered a present transfer because the transfer would relate back to the date of the filing of the lis pendens. However, since this argument was raised for the first time on appeal, the court declined to consider the issue.
Since the lender failed to record a proper deed of trust, its claim normally would be treated as an unsecured claim. However, in this case the debtor conceded that the lis pendens precluded a bona fide purchaser from acquiring the property free of the bank’s interest; and if it was not able to avoid the lis pendens, the debtor could not use its strong arm powers to avoid the bank’s interest.
The debtor found itself in a catch-22: While the lis pendens itself might not constitute a transfer, it appears that it was the critical element that would allow the bank’s purported lien to survive in the bankruptcy notwithstanding the defective deed of trust. It would have been interesting to see the 10th Circuit’s views on the debtor’s additional attempts to get around this dilemma.