When the Debtor Holds a Junior Lien: Can a Senior Lien Creditor March On or Is It Stayed?

Invest Vegas, LLC v. 21st Mortgage Corp. (In re Residential Capital, LLC), 556 B.R. 555 (Bankr. S.D. N.Y. 2016) –

A debtor held a note secured by a first priority deed of trust on property that was also subject to a super priority homeowner’s association lien securing delinquent assessments against the property. The HOA foreclosed its lien after the debtor filed bankruptcy. The issue for the bankruptcy court was whether the HOA violated the automatic stay, and thus whether the deed of trust was extinguished by the foreclosure.

The timeline was as follows:

  • 6/25/09: HOA recorded a lien for delinquent assessments against the property.
  • 5/14/12: Debtor filed bankruptcy.
  • 10/19/12: HOA recorded notice of a non-judicial foreclosure sale, setting the sale date for November 14.
  • 11/14/12: HOA purchased the property at its foreclosure sale.
  • 11/21/12: Bankruptcy court entered on order approving the sale of the debtor’s note and deed of trust to an investor.
  • 12/19/12: HOA foreclosure deed was recorded.
  • 3/20/14: HOA transferred the property pursuant to a quitclaim deed recorded on 3/28/14. On 5/20/14 the property was conveyed again pursuant to a second quitclaim deed.
  • 8/19/14: MERS assigned the deed of trust to the debtor’s buyer, with the assignment recorded on 10/1/14.
  • 1/14/15: the debtor’s buyer brought a quiet title action in state court. The case was removed to federal court and later transferred to the bankruptcy court on 1/25/16.

It was clear that under state law the HOA foreclosure would extinguish the deed of trust. It was also clear that the note and deed of trust were assets of the bankruptcy estate at the time of their sale.

The question before the court was whether the automatic stay applied so that the HOA was barred from completing its non-judicial foreclosure sale. If not, the foreclosure extinguished the deed of trust and the HOA acquired the property free of the debtor’s deed of trust lien.

The debtor’s buyer argued that it acquired the note and deed of trust free and clear of all interests. It contended that the buyer of the property itself was sophisticated and should be charged with due diligence in its purchase. The debtor’s buyer further argued that validating the HOA foreclosure sale and extinguishing the deed of trust would deprive the bankruptcy estate of the value of the note and deed of trust.

On the other hand, the HOA’s buyer argued that the bankruptcy estate was limited to the junior lien interest and did not include the property itself. Since the property was not part of the bankruptcy estate, the HOA foreclosure sale did not violate the automatic stay. In other words “the debtor’s lien interest in property does not convert the underlying secured property owned by a nondebtor into property of the bankruptcy estate.” The HOA’s buyer also argued that the deed of trust did not convey title and was merely a lien interest until the deed of trust was foreclosed.

The court initially noted that property of the bankruptcy estate is very broadly defined as “all legal or equitable interests of the debtor in property as of the commencement of the case … wherever located and by whomever held …” The general rule is that anything not specifically excluded under the Bankruptcy Code should be included as property of the estate.

However, case law establishes that the estate does not include property if the debtor’s only interest in the property is a security interest. Quoting from the US Supreme Court Whiting Pools decision:

Section 541(a)(1) speaks in terms of the debtor’s “interests … in property,” rather than property in which the debtor has an interest, but this choice of language was not meant to limit the expansive scope of the section. The legislative history indicates that Congress intended to exclude from the estate property of others in which the debtor had some minor interest such as a lien or bare legal title. Similar statements to the effect that §541(a)(1) does not expand the rights of the debtor in the hands of the estate were made in the context of describing the principle that the estate succeeds to no more or greater causes of action against third parties than those held by the debtor.

Under state law a deed of trust did not allow the lender to obtain the property without a foreclosure sale. Rather the lender’s interest was merely a lien and not legal title prior to foreclosure.

The court ruled that since the property itself was never part of the bankruptcy estate, the HOA foreclosure sale did not violate the automatic stay even though it extinguished the value of the note and deed of trust held by the debtor. The court specifically declined to adopt a rule that the automatic stay extends to protecting the value of assets of the debtor’s estate.

Given the effect of the HOA foreclosure sale on property of the bankruptcy estate (i.e. extinguishing the deed of trust which rendered the debtor’s interest valueless), one can imagine a bankruptcy court reaching the opposite conclusion. However, it would be hard to draw the line if the stay was supposed to protect the value of the debtor’s interests as opposed to the interests themselves. For example, if the debtor and a third party both made unsecured loans to the same borrower, could the third party’s collection efforts be stayed because the borrower would not have enough assets left to also pay the debtor?

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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