A chapter 7 trustee sought to avoid a judgment, a lis pendens and a foreclosure decree involving the debtor’s property as preferences and/or by exercising the strong arm power of a bona fide purchaser of real estate. The bankruptcy court addressed cross-motions for summary judgment.
The debtor was an owner and co-partner of an unincorporated association (Permacoat). Permacoat sought to enforce a mechanics lien in a state court action. The defendant counterclaimed and obtained a judgment against Permacoat. As an owner of an unincorporated association, the debtor was ultimately found to be personally liable for the judgment.
After the defendant commenced supplemental proceedings against Permacoat, it filed a lis pendens against property owned by the debtor. It then obtained a decree of foreclosure and order of sale for the property to satisfy the judgment lien obtained by the defendant against Permacoat.
Although the original judgment was not recorded and indexed against the debtor, the foreclosure decree stated that the debtor was personally liable for the judgment. The debtor filed bankruptcy before the foreclosure sale could occur.
The chapter 7 trustee sought to avoid (1) the lis pendens and the foreclosure decree as preferences under section 547 of the Bankruptcy Code, and (2) the original judgment and the foreclosure decree using the strong arm powers of a bona fide purchaser of real estate under section 544(a). A key issue was whether the lis pendens constituted a transfer for purposes of section 547.
The trustee argued that under state law the lis pendens placed a cloud on title to the property that prevented the debtor from freely conveying the property to a subsequent purchaser – drawing an analogy to a mortgage. If the lis pendens was avoided as a preference, then there was no record notice of the original judgment so that a bona fide purchaser could acquire the property free of the judgment.
The defendant argued that the lis pendens could not be avoided as a preference because it did not constitute a transfer of an interest in property. It argued that a lis pendens merely provided notice of pending litigation and did not affect the debtor’s ability to convey title. It also argued that there is a difference between an actual transfer and perfection of a transfer, and the lis pendens constituted perfection as opposed to a transfer.
The court began its analysis by considering whether the lis pendens and the foreclosure decree constituted “transfers” that could be avoided as preferences. It noted that the concept of transfer is very broad and includes matters where title is changed in a way that affects creditors even though ownership remains intact. The statutory definition expressly includes involuntary dispositions and transfers clearly include dispositions resulting from state court proceedings.
Courts have disagreed on whether a lis pendens is a transfer that can be avoided as a preference, and those that conclude it constitutes a transfer have used a variety of different theories to reach that result. After reviewing cases on both sides, the bankruptcy court expressed its agreement with the view that a lis pendens is a transfer based on a theory viewing property rights as a “bundle of sticks.”
Under applicable state law a properly filed lis pendens binds subsequent purchasers to proceedings evolving from the litigation (giving the party filing the lis pendens a superior interest) and places a cloud on title which prevents the owner from freely disposing of the property until the litigation is resolved. Thus, filing a lis pendens deprived the owner of one of its fee simple absolute “bundle of sticks.”
The court similarly found that the foreclosure decree was a preferential transfer. The decree found for the first time that the original judgment constituted a fifth lien on the debtor’s property. Accordingly, the court found that the foreclosure decree created a lien, and thus was a transfer that could be avoided as a preference. (Since the court avoided the foreclosure decree as a preference, it did not address whether the decree was avoidable using the trustee’s strong-arm powers.)
The court also noted that avoiding the lis pendens and the foreclosure decree was consistent with the objective of section 547 – namely to protect creditors from secret liens perfected just before bankruptcy and to facilitate equality of distribution.
The trustee further argued that the original judgment was avoidable using the strong arm power of a bona fide purchaser of real estate. Under state law, recording a judgment in the real estate records creates a lien on the real estate of a judgment debtor. However, the judgment was not recorded under the debtor’s name prior to bankruptcy. So, a hypothetical bona fide purchaser at the time of commencement of the case could avoid the judgment.
Thus, the court avoided the lis pendens and the foreclosure decree as preferences and avoided the original judgment based on exercise of the trustee’s strong arm powers, with the transfers preserved for the benefit of the bankruptcy estate under section 551.
The cases discussed by the court present an interesting array of theories for analyzing a lis pendens. While there is likely to be value in recording a lis pendens, it would be difficult to predict with any confidence the effect of that recording.
Vicki R Harding, Esq.