Last month, the United States District Court for the Eastern District of North Carolina affirmed the decision in Skumpija v. Warren (In re Skumpija), in which the Bankruptcy Court for the Eastern District of North Carolina held that a lien avoided because it was invalid under applicable state law was preserved for the estate under section 551 of the Bankruptcy Code, but the estate’s interest was subordinate to all other secured interests. The decision provides a good opportunity to understand the extent to which lien avoidance benefits a debtor’s estate, as opposed to other lienholders waiting for a boost up the secured ladder.

The Pittsboro Property and Related Liens

In June 2008, Lisa Skumpija acquired real property in Pittsboro, North Carolina from her brother. A few days later, Ms. Skumpija executed a promissory note in favor of her mother, Janet Abreu. The Abreu note provided that $200,000 would be due upon the sale of the Pittsboro property. The note also provided that it was secured by a deed of trust on the property, but Ms. Skumpija never executed a deed of trust.

Two weeks later, Ms. Skumpija executed another promissory note in favor of the regional bank BB&T in the principal amount of $339,250. At the same time, Ms. Skumpija executed a deed of trust in favor of BB&T, which encumbered the Pittsboro property. BB&T promptly recorded the deed of trust.

More than a year later, Ms. Skumpija executed a deed of trust that purported to secure repayment of the Abreu note by the Pittsboro property. The Abreu deed of trust was recorded the next day.

Chapter 7 – Avoidance of the Abreu Deed of Trust and Sale of the Pittsboro Property

As these stories often go, Ms. Skumpija thereafter filed a chapter 7 petition. The trustee claimed, and the bankruptcy court agreed, that the Abreu deed of trust was invalid because it failed to properly describe or identify the Abreu note and, therefore, was subject to avoidance under section 544(a)(1) of the Bankruptcy Code. Following that avoidance action, the Pittsboro property was subject to the following encumbrances:

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Shortly thereafter, the trustee sought to sell the Pittsboro property, but only if it could obtain a purchase price that was sufficient to satisfy the first lien debt held by BB&T. Ms. Skumpija objected to the sale arguing that the estate would not benefit from the proposed sale because the proceeds would be exhausted by the deed of trust, judgment liens, auction fees, and trustee fees. After a hearing on the matter, the bankruptcy court found that the proposed sale was in the best interest of the estate and authorized the sale. The bankruptcy court’s finding was predicated on its assumption that any sale proceeds over $330,000 would benefit the estate because the Abreu deed of trust would be preserved for the estate under section 551 of the Bankruptcy Code.

Ms. Skumpija subsequently commenced an adversary proceeding in which she sought a preliminary injunction against the sale of the Pittsboro property and a determination as to the priority of the liens encumbering the Pittsboro property.

Reconsideration of the Sale Order

In light of the prior order approving the sale, the bankruptcy court determined that Ms. Skumpija’s preliminary injunction request was “functionally equivalent” to a motion to reconsider its prior sale order and chose to treat it as such. Specifically, the bankruptcy court believed that it should re-examine whether the estate would benefit from the proposed sale to correct a clear error of law or prevent manifest injustice.

Whether the estate stood to benefit from the proposed sale depended on the nature of the estate’s interest in the Abreu lien pursuant to section 551 of the Bankruptcy Code. On the one hand, Ms. Skumpija argued that avoided liens are preserved for the benefit of the estate subject to defects under state law, and, therefore, the estate’s interest in the Abreu lien was subordinate to all other encumbrances, making any benefit unlikely. On the other hand, the trustee argued that avoided liens are preserved for the benefit of the estate without limitation, and, therefore, the estate stepped into the second priority position of the defective Abreu lien, making some benefit quite likely.

Bankruptcy Court Opinion

The bankruptcy court first concluded that section 551 of the Bankruptcy Code cannot give the estate greater rights than the secured creditor would have following avoidance of its security interest. Accordingly, state law determines the nature of the rights to be retained, and “in light of the automatic nature of lien preservation under § 551, ‘the preserved interest need not always benefit the estate.’”

The bankruptcy court differentiated between avoidance due to preferential or fraudulent transfers under sections 547 and 548 of the Bankruptcy Code, respectively, and avoidance due to defects under state law, such as the invalidity of a deed of trust or failure to properly record or perfect the interest. In the case of preferences and fraudulent transfers, a lien is avoided as a result of the operation of the Bankruptcy Code. Therefore, allowing the estate to have a lien with the same priority as existed before the avoidance simply preserves the priority of the avoided lien vis-à-vis other creditors under non-bankruptcy law. Preserving the priority of an unperfected lien, however, involves the rights of existing creditors to have their liens come ahead of the “defective” lien under non-bankruptcy law — and without resort to the avoidance powers under the Bankruptcy Code. To allow the estate to jump ahead of other holders of valid liens in such a scenario would create a windfall for the estatevis-à-vis other creditors as a result of the debtor having filed for bankruptcy protection.

Thus, bankruptcy courts may preserve the priority of an unperfected lien if that priority would or could be maintained under applicable non-bankruptcy law. For example, a junior lienholder may not qualify as a bona fide purchaser — the standard under section 544(a)(3) of the Bankruptcy Code — if it was aware of the senior lien or its defect. Similarly, the first lienholder and, therefore, the trustee may be entitled to maintain priority through “equitable subrogation,” reformation of the instrument, rescinding cancellation, or other such theories.

In its papers, the chapter 7 trustee cited In re Price, in which the Bankruptcy Court for the Eastern District of North Carolina avoided a senior lien under section 544(a)(3) because the senior lender had “accidentally” cancelled the lien before the bankruptcy. The bankruptcy court in Price, though, preserved the priority of the avoided lien for the estate because the senior lender could have rescinded its cancellation under state law, and the second lienholder knew of the senior lender’s first lien and, therefore, was not a bona fidepurchaser with respect to the senior lien.

The bankruptcy court distinguished Price from Skumpija on the grounds that Price “involved avoidance under § 544(a)(3) and rescission of the cancellation of a valid deed of trust.” InSkumpija, the bankruptcy court avoided the Abreu lien pursuant to section 544(a)(1) andnot section 544(a)(3) so the bona fide purchaser reasoning from Price was inapplicable. Additionally, the bankruptcy court rejected the chapter 7 trustee’s argument that section 551 preserves for the estate “all rights of reformation,” and, therefore, the trustee could seek reformation of the Abreu deed of trust — even though the bankruptcy court previously held that Ms. Abreu was unable to reform the deed of trust. The bankruptcy court reiterated its position (from the earlier avoidance action) that “reformation is not available where an intervening lien creditor, without knowledge of the mistake or deficiency, ‘has advanced [some] new consideration or incurred some new liability on the faith of the apparent ownership’” and held that the principles that precluded Ms. Abreu from reforming the deed of trust under state law also precluded the trustee from reforming the deed of trust.  Specifically, “if the trustee sought to reform the Abreu Deed of Trust, reformation would be precluded by BB&T’s and Discover’s status as actual intervening lien creditors based on the judicial liens acquired on September 22, 2010 by BB&T and on November 23, 2010 and November 30, 2010 by Discover.”

Lesson Learned

The bankruptcy court’s decision in Skumpija is instructive with respect to the priority of avoided liens and serves as a good reminder to debtors and their representatives that preservation of avoided liens pursuant to section 551 of the Bankruptcy Code does not necessarily entitle the estate to any recovery ahead of general unsecured creditors. In that situation, though, it is worth exploring other state law theories that permit preservation of an otherwise defective lien and which may allow a trustee or debtor in possession to preserve the priority of a defective lien.