A non-debtor party filed a motion to either (1) compel the debtor to assume or reject a settlement agreement, or (2) “dissolve” the settlement agreement based on the debtor’s nonpayment, thus stripping the bankruptcy estate of rights to a mineral lease. The bankruptcy court denied the motion, finding that the debtor’s strong arm powers protected it from the challenge to the lease. The district court affirmed and the non-debtor party appealed to the Fifth Circuit.
A 1954 mineral lease (which was properly recorded) had a five year primary term, and a secondary term that lasted as long as oil, gas or other minerals were being produced. In 2012 the non-debtor party (the Fallon family) sought to terminate the lease and assess damages on the grounds that the debtor ceased continuous operations in violation of the lease.
On the eve of trial the parties settled, as set forth in a settlement agreement. The Fallon family agreed to ratify the lease and release claims against the debtor in exchange for an immediate payment of $650,000 and a promissory note for $1 million. A lease ratification was recorded that stated:
NOW, THEREFORE, for the promises and covenants exchanged below, and other good and valuable consideration exchanged by the Parties on or near this date, the receipt and sufficiency of which is hereby acknowledged, the Parties agree [to the promises and covenants].
In particular, it provided that (1) the lease was affirmed and ratified, (2) the lease “never ceased to be in full force and effect,” (3) the lease was severed by unit for maintenance, and (4) an additional royalty clause was added. The lease ratification did not make any reference to the settlement agreement or promissory note.
The debtor made the initial $650,000 payment and the first $100,000 installment due under the note. However, it failed to make the next payment and filed bankruptcy.
The Fallon family filed a motion seeking to compel the debtor to either (1) assume the settlement agreement – in which case it would have to cure the payment default and perform under the settlement agreement, or (2) reject the agreement – in which case the debtor would relinquish its rights under the lease ratification. Alternatively, it sought to exercise a state law right to “dissolve” the settlement agreement in its entirety based on the payment default, which would result in stripping the debtor of its interest in the mineral lease.
The debtor responded that under section 544(a) of the Bankruptcy Code it could assert rights as a bona fide purchaser of real property. As a BFP it was entitled to rely on the representations in the recorded lease ratification that full consideration had been paid, thus precluding dissolution.
The bankruptcy court ruled that the settlement agreement was not an executory contract, and agreed with the debtor that the Fallon family dissolution rights were not effective against the debtor-in-possession exercising its rights as a hypothetical bona fide purchaser.
The Fifth Circuit determined that the central issue was the interplay between the “strong arm” provision of the Bankruptcy Code and the state public records doctrine. As a starting point section 544(a) provides (emphasis added):
The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by… (3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.
The Fallon family contended that the strong arm authority was limited to avoiding transfers or obligations. Consequently, it was irrelevant to determining whether the Fallon family could exercise a separate state statutory right of dissolution. The Fifth Circuit rejected this interpretation, emphasizing that a trustee or debtor-in-possession has all of the “rights and powers” of a BFP.
In other words, the Bankruptcy Code creates a legal fiction affording the debtor-in-possession the abilities it would have as a bona fide purchaser of the debtor’s interests in immovable property [fn: Louisiana’s equivalent of real property] at the time the bankruptcy is filed.
Next, while the Bankruptcy Code creates the status of a hypothetical bona fide purchaser, state law defines the consequences of that status. Under the Louisiana public records doctrine certain documents affecting real property must be recorded in order to be effective against “third persons.” This includes a lease of real property and a document that modifies or terminates a lease.
Pursuant to the state statute, a third person is one “who is not a party to or personally bound by an instrument.” The court found that it was clear that a trustee or debtor-in-possession exercising rights as a hypothetical bona fide purchaser was a “third person” entitled to rely on the public records. And the debtor-in-possession was a separate entity from the debtor, so the debtor’s prepetition actions did not disqualify it from being a “third person.”
Among other things, the Fallon family further argued that its right to dissolution was effective against third persons regardless of recordation because its right arose by operation of law. However, it was well-established that where there is a public record of title that is valid on its face and the conveyance document indicates that consideration has been paid in full, a third party is not susceptible to the remedy of dissolution.
In this case the recorded lease ratification acknowledged “the receipt and sufficiency” of valuable consideration in exchange for ratification of the lease. In other words, although the debtor as debtor did not pay the full consideration, the debtor as debtor-in-possession, and thus a hypothetical BFP of the lease ratification, was not subject to dissolution because the public record indicated that consideration had been fully paid.
The Fallon family complained that this allowed the debtor to retain the benefits while rejecting the burdens of the settlement. The court responded that “creditors often do not receive the full amount of their claims; however, this is a feature, not a flaw, of the design of the bankruptcy system.”
Accordingly, the Fifth Circuit affirmed the lower court decision.
The “strong-arm” powers are almost always used to avoid a transfer of a debtor’s interest in property or an obligation incurred by a debtor. This case indicates that the reference in the Bankruptcy Code to “rights and powers” may extend far beyond the right and power to undo voidable transactions.
Vicki R Harding, Esq.
Bankruptcy-RealEstate-Insights 