A foreclosure sale that occurred after a chapter 7 trustee abandoned the foreclosed property (and after the bankruptcy case was closed) unexpectedly resulted in surplus proceeds that were to be returned to the debtor. After the trustee intervened in the state court case to claim the proceeds and reopened the debtor’s bankruptcy case to administer the proceeds on behalf of the bankruptcy estate, the debtor amended his bankruptcy schedules to claim a homestead exemption in the proceeds.
On the date that the debtor filed bankruptcy he owned residential real property. He disclosed the property in his bankruptcy schedules, but did not claim a homestead exemption at that time. The schedules indicated that the property was valued at $360,500 and was subject to liens of ~$618,000. In other words, the property was substantially under water.
One of the creditors with a lien on the property filed a motion for relief from the automatic stay in order to pursue its in rem rights against the property under nonbankruptcy law. At the same time the creditor filed a motion asking the trustee to abandon the property on the basis that there was no equity for the benefit of the bankruptcy estate. There were no objections and the court granted both requests.
A couple of months later the court granted the debtor a discharge and the bankruptcy case was closed.
In the meantime the secured creditor proceeded with a foreclosure and the property was sold at a sheriff’s sale. Prior to the sale the first mortgagee failed to file an answer to the foreclosure complaint. Under state law this meant that the first mortgage lien was extinguished and the first mortgagee was not entitled to receive any portion of the sale proceeds. The net result was that the state court issued an order confirming that after payment of secured claims and foreclosure costs proceeds of ~$80,600 were left over for distribution to the debtor.
The debtor asked the state court to reconsider its order because it provided for payment of lien creditors without making allowance for the debtor’s homestead exemption of $132,900. The chapter 7 trustee also decided to jump into the ring – seeking intervention in the state court proceeding in order to request that the surplus proceeds be disbursed to the trustee on the basis that the proceeds were part of the bankruptcy estate.
The state court (1) denied the debtor’s homestead exemption claim on the basis that it was not asserted in a timely manner and (2) granted the trustee’s requests to intervene and for disbursement of the proceeds to the trustee for the benefit of the bankruptcy estate.
The trustee then filed a motion with the bankruptcy court asking that the case be reopened and the trustee be reappointed so that the proceeds could be administered. After the case was reopened over the debtor’s objection, the debtor amended his schedules to claim a homestead exemption in the property – and thus the sale proceeds – in the amount of $132,900. This triggered an objection by the trustee.
The bankruptcy court began by discussing the nature and scope of the bankruptcy estate: Upon the filing of a petition a bankruptcy estate is created consisting of “all legal or equitable interests of the debtor in property as of the commencement of the case.” This is subject to the debtor’s right to claim exemptions (for example, a state homestead exemption).
There was a twist in this case because it was originally filed under chapter 13 and later converted to chapter 7. The court noted that under these circumstances absent bad faith the estate consisted of “property of the estate, as of the filing of the petition, that remains in the possession of or is under control of the debtor on the date of conversion.”
Thus, the parties agreed that the property was originally part of the bankruptcy estate because the debtor owned it on the date of the bankruptcy filing and continued to own it on the conversion date. The dispute arose when it came to the foreclosure sale proceeds. Resolution turned on the effect of the trustee’s abandonment of the property.
Under section 544 of the Bankruptcy Code a trustee can abandon property of the estate “that is burdensome to the estate or that is of inconsequential value and benefit to the estate.” Property encumbered by liens in excess of its value is a prime candidate for abandonment.
The court explained that the effect was to divest the trustee of control of the property since it was no longer part of the bankruptcy estate. When property is abandoned, it reverts to the debtor. Generally abandonment is irrevocable and neither the trustee nor the bankruptcy court can reassert control over the property based on subsequent events (such as learning that the property is more valuable than the parties thought). The exception is where the property is concealed or information regarding the property is not properly disclosed so that the trustee cannot make an informed decision.
In this case the debtor disclosed the property in his bankruptcy schedules and provided appropriate information on value (which was based on an appraisal) and outstanding liens. So, the property was irrevocably abandoned. This removed the property from the jurisdiction of the bankruptcy court, and revested it in the debtor as if it had never been held by the trustee.
When the property was sold at the foreclosure sale, resulting in surplus proceeds, the proceeds were not part of the bankruptcy estate because the real estate had been abandoned prior to the sale. Any interest of the trustee or bankruptcy estate was “irrevocably terminated” after the abandonment.
The trustee argued that the debtor had a duty to update his bankruptcy schedules after he became aware of the foreclosure sale surplus proceeds. However, schedules must contain information that is accurate as of the petition date. Nothing imposes an ongoing duty to supplement the schedules (analogous to the duty to supplement discovery in litigation litigation) with very limited exceptions (such as property acquired by inheritance, settlement with a spouse, a divorce decree or life insurance). There was nothing to suggest that information in the debtor’s schedules was inaccurate as of the petition date, and the surplus proceeds did not come within the limited exceptions.
The trustee also argued that the surplus proceeds were personal property that were not reflected in the schedules, and since they were not disclosed the trustee did not knowingly abandon them. However, the case the trustee relied on involved a sheriff’s sale prior to bankruptcy where the debtors did not indicate that there is any equity in the foreclosed property or any proceeds owed to the debtors. Thus the schedules did not disclose the debtors’ interest as of the commencement of the bankruptcy. That case also did not involve an abandonment.
Finally the trustee argued that the state court determination that the debtor waived his homestead exemption and the surplus proceeds should be disbursed to the trustee was res judicata and barred any further claims by the debtor. However, the state court did not specifically address whether the proceeds were property of the bankruptcy estate, nor did it explain why it was awarding the proceeds to the trustee. And regardless, the bankruptcy court had exclusive jurisdiction to make that determination. So the state court judgment was not a determination on the merits by a court of competent jurisdiction.
The bankruptcy court’s conclusion was that the trustee irrevocably abandoned the property, so the surplus proceeds were not part of the bankruptcy estate and the bankruptcy court did not have jurisdiction over the surplus proceeds. However, the court allowed the debtor’s claim of exemption in the real estate “and by extension, proceeds thereof.”
If a trustee could undo an abandonment at any time (including after a bankruptcy case is closed) simply because there are subsequent unforeseen favorable developments, other parties who acted in reliance on the abandonment could be severely prejudiced. Absent circumstances such as a failure to disclose information so that the trustee is not able to make an informed decision, there does not appear to be any justification for allowing this result.
Vicki R Harding, Esq.