CRP Holdings, A-1, LLC v. O’Sullivan (In re O’Sullivan), 841 F3d 786 (8th Cir. 2016) –

A chapter 7 debtor sought to avoid a judgment lien on the grounds that the lien impaired the debtor’s exemption. The bankruptcy court granted the debtor’s motion, the Bankruptcy Appellate Panel (BAP) affirmed, and the judgment creditor appealed to the 8^th Circuit.

Prior to bankruptcy a creditor obtained a default judgment for ~$765,000 against the debtor and his business, but not against his wife. The debtor and his wife owned a residence as tenants by the entirety. The judgment creditor filed a notice of foreign judgment with the circuit court for the county where the property was located in an attempt to obtain a judgment lien on the property.

After filing bankruptcy the debtor claimed a $15,000 homestead exemption in the property. He then sought to avoid the judicial lien to the extent of the claimed exemption. The bankruptcy court granted the debtor’s motion on the basis that the judgment lien became affixed to the property upon the filing of the judgment, and thus impaired the claimed exemption even if the lien was unenforceable. The BAP similarly concluded that an unenforceable judgment lien arose and that it was possible for the debtor to avoid it.

The 8^th Circuit described the legal framework as follows:

• A chapter 7 bankruptcy provides a debtor the means for a “fresh start.”
• The Bankruptcy Code allows debtors to exempt certain property from the bankruptcy estate to assist a fresh start.
• Generally “‘liens and other secured interests survive bankruptcy’ and can subsequently be levied against a debtor’s exempt property, thereby impeding a debtor’s ability to obtain a fresh start.”
• Consequently the Bankruptcy Code provides a mechanism to shield exempt property from post-bankruptcy collection of debts that would otherwise pass through bankruptcy.

In particular section 522(f)(1) provides that generally “the debtor may avoid the fixing of a lien on an interest of the debtor in property to the extent that such lien impairs an exemption to which the debtor would have been entitled under subsection (b) of this section [such as a homestead exemption] if such lien is… a judicial lien.”

The court noted that to avoid the judicial lien the debtor had to show that the judgment creditor’s notice of foreign judgment (1) created an avoidable lien that (2) affixed to the debtor’s interest in the exempted property, and (3) impaired the claimed exemption. The only dispute between the parties was whether the lien affixed to the debtor’s interest in the property, and neither addressed whether a judicial lien subject to potential avoidance existed.

For purposes of the avoidance analysis, the court drew a distinction between “an existent but unenforceable lien and a non-existent lien.” All three courts (bankruptcy, BAP and 8^th Circuit) concluded that a judicial lien did not have to be enforceable to be subject to avoidance under section 522: The very broad definition of “judicial lien” in the Bankruptcy Code together with the legislative history supported the view that even unenforceable liens could be avoided. However, a lien must exist before it can be avoidable.

The 8^th Circuit agreed with the BAP that there was a strong argument that the notice of foreign judgment did not create a lien. Entireties property is “owned by a single entity, the marital community.” Under state law the notice created a lien on real estate owned by the judgment debtor. The state statute also narrowly defined “real estate” as “an interest in property ‘liable to be sold upon execution.'”

Because the property was held as entireties property, arguably the debtor did not have a separate interest in the property subject to execution. If there is no lien under state law, there is nothing to “fix” or “fasten” to the property. And if no lien attaches under state law, section 522(f) of the Bankruptcy Code is irrelevant.

The court reviewed 10^th Circuit and 6^th Circuit cases that followed a similar analysis and concluded that judgment liens did not attach to the debtor’s exempt homestead interest. The 10^th Circuit noted that this meant it was not necessary to use section 522 to avoid the judgment lien. In reaching the same result the 6^th Circuit drew a distinction between the exempt present possessory interest held with the spouse as tenants by the entirety (which was not subject to the judicial lien) and the debtor’s nonexempt future interest in the right of survivorship (which was separately included in the bankruptcy estate and subject to the debt).

The court also discussed a 5^th Circuit case permitting a debtor to avoid a judicial lien against exempt property. This decision turned on state law to the effect that a homestead was not exempt from a perfected lien, but only exempt from seizure attempting to enforce the lien – in other words, a lien that exists but is unenforceable may be avoided.

Accordingly, the 8^th Circuit vacated the lower court decision and remanded the case to the bankruptcy court to determine if a judicial lien existed (whether enforceable or unenforceable).

It is important to remember that more often than not a bankruptcy court will look to state law to define the nature and extent of interests in property. It is also important to remember that real estate law can be very state specific. As this case indicates, subtle differences in state law can lead to diametrically opposed results depending upon which state law applies.

Vicki R Harding, Esq.