Bankruptcy Sales and Mortgage Boo-Boos: Timing Can Make All the Difference in the World

Trinity 83 Dev., LLC v. Colfin Midwest Funding, LLC, 917 F.3d 599 (7th Cir. 2019) –

A Chapter 11 debtor sought to avoid the cancellation of a mortgage satisfaction as a fraudulent conveyance, contending that the mortgage satisfaction extinguished the debt and security interest. The bankruptcy court disagreed, the district court affirmed, and the debtor appealed to the Seventh Circuit.

The debtor obtained a loan that was evidenced by a note secured by a mortgage on certain real property. In 2013 the servicer erroneously recorded a satisfaction stating that the loan had been repaid and the mortgage released. However, the loan remained outstanding and the debtor continued to make payments.

In 2015 the lender realized the mistake and recorded a document canceling the satisfaction. Shortly afterwards the debtor stopped paying, the lender filed a foreclosure action in state court, and the debtor filed bankruptcy.

The debtor then filed an adversary proceeding contending that the release extinguished the debt and security interest. However, the bankruptcy court found that the release was a unilateral error that could be corrected unilaterally. And since there were no intervening interests, the lender retained its original rights. This decision was affirmed by the district court, and the debtor appealed.

Before the appeal could be heard, the property subject to the mortgage was sold in a bankruptcy sale. Relying on section 363(m) of the Bankruptcy Code and a prior Seventh Circuit decision (River West), the lender argued that the appeal was moot.

Section 363(m) provides that reversal or modification on appeal of a sale authorization “does not affect the validity of a sale” under the authorization to a good faith purchaser unless the authorization and sale are stayed pending appeal. River West held that this blocked challenging not only the sale but also disposition of the proceeds. Thus, the lender argued that the appeal was moot.

The Seventh Circuit first addressed the mootness argument by stating that mootness is a constitutional doctrine that means that the issues are no longer live or the parties lack a cognizable interest in the outcome. This occurs only if a court cannot grant effective relief to the prevailing party. In this case one side wanted money from the other. So, was possible. The request might be denied as a legal matter, but that involved a defense on the merits, not mootness.

The court reiterated prior decisions holding that section 363(m) does not concern mootness but rather a defense, and a defense – unlike mootness – does not defeat jurisdiction. It characterized the River West decision as creating “an unappreciated intra-circuit conflict.” Further, section 363(m) “does not say any one word about the disposition of the proceeds of the sale.” This position proceeds remains within the control of the bankruptcy court. Thus, the River West created a second intra-circuit conflict.

To clear the conflict, the court held that section 363(m) does not make any dispute moot, nor does it prevent a bankruptcy court from dealing with sale proceeds. River West and other decisions holding that the section renders a controversy moot as opposed to providing a defense were disapproved and overruled.

Turning to the merits, the court rejected the debtor’s argument that the erroneous release abrogated the lender’s rights so that proceeds from the sale should be distributed among the debtor’s other creditors. The release was a unilateral mistake without consideration, and no one (including the debtor) detrimentally relied on the release. As a matter of state law, the release was ineffective between the debtor and mortgagee, and there were no third parties that relied on the apparent lack of a senior lien.

The result might have been different if the mistake has not been cured prior to bankruptcy. In that event the debtor might have exercised its strong arm powers asserting the rights of a hypothetical lien creditor to prevent the lender from regaining its original priority. However, in this case the error had been corrected by the time the debtor filed bankruptcy so a hypothetical lien creditor on the date of the bankruptcy would have been junior to the mortgage.

Accordingly, the court determined that the appeal was not moot and it affirmed the lower court decision.

Two lessons illustrated by this case: (1) When a purchaser relies on section 363(m) to protect it from challenges involving a bankruptcy sale, it should be cognizant that the scope of the protection is not always crystal clear. (2) When a lender’s lien gets screwed up (to use a technical term), it is well worth trying to fix it since the effort may be successful.

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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