A chapter 7 trustee sought to avoid an unrecorded first mortgage and to preserve the lien for the benefit of the bankruptcy estate. In response, the debtor sought confirmation that if the trustee was successful, he would not be able to sell the mortgaged property without first foreclosing in accordance with state law. The bankruptcy court and bankruptcy appellate panel ruled in favor of the trustee and against the debtor, and the debtor appealed to the 1st Circuit.
The debtor owned a home that she valued at $223,500 in her bankruptcy schedules. She was entitled to claim a $500,000 homestead exemption. She granted a first mortgage to secure a loan of $200,000 and a second mortgage to secure a loan of $31,000. The first mortgage was never recorded. The debtor was not in default and continued to make payments on the mortgage loans during the bankruptcy.
Generally an unrecorded mortgage can be avoided under Section 544 of the Bankruptcy Code by a trustee exercising the rights of a bona fide purchaser of real estate under state law. And an avoided transfer is preserved under Section 551 for the benefit of the bankruptcy estate. (The purpose of preserving an avoided lien is to avoid giving junior lien holders a windfall.)
In this case it was clear that the trustee was entitled to avoid the first mortgage and to preserve the lien for the benefit of the bankruptcy estate. What was not clear was what this meant. In particular, the trustee contended that he was entitled to sell the property in order to liquidate the value of the preserved mortgage interest.
The 1st Circuit began by noting that Section 363 (regarding bankruptcy sales) does not authorize a trustee to sell exempt property. A trustee also generally does not sell property solely for the benefit of secured creditors. Rather, a trustee will sell property only where the value exceeds both secured liens and a homestead exemption – i.e., there is “equity” available for distribution to the bankruptcy estate.
Given that (1) there was no residual equity after deduction of the $500,000 homestead exemption (much less the secured claims), and (2) the mortgagees were precluded from foreclosing due to the lack of a default, it was clear that if the first mortgage had not been avoided, the trustee would not have been able to sell the property and the debtor would have retained possession of her home.
However, the trustee argued that he should be able to sell the property in order to realize the value of the mortgage interest. The trustee did not suggest that the preserved mortgage freed up equity by eliminating secured debt that must be satisfied, since regardless of the secured debt, there was no equity left after the $500,000 homestead exemption. His argument was also not based on a foreclosure sale of the home using the mortgage, since there was no default. Rather, the trustee’s argument was that the preserved mortgage itself created equity in the home for the bankruptcy estate, which could support a sale by the trustee.
According to the 1st Circuit, the flaw in the trustee’s argument was that only the preserved lien rights became part of the bankruptcy estate, not ownership of the underlying property. The trustee ended up with the same rights in the collateral as the mortgagee had. A mortgage does not give a right to immediate ownership but only a right to foreclose if there is a default. The trustee could sell the mortgage interest, but did not have the ability to sell the underlying property.
Although preserving a mortgage means that the trustee will get the benefit of the mortgage position from any sale, that does not mean that it creates equity that justifies a forced sale of the property by the trustee. The preserved mortgage “cannot double as the unsecured equity triggering the trustee’s sale powers under §363.”
The court found that its decision was not only the best reading of the Bankruptcy Code, but also complied with its sense of fairness. It was not appropriate to punish the debtor for the lack of diligence by the banks that failed to record the mortgage.
The bottom line: Preservation of a lien “entitles a bankruptcy estate to the full value of the preserved lien – no more and no less.” The trustee’s choice was to sell the mortgage, claim first proceeds from a sale, or wait to exercise the rights of a mortgagee in the event of a default. Accordingly the 1st Circuit reversed the lower courts.
Although there are numerous cases that address avoidance actions, there are far fewer decisions that address the aftermath of avoidance, including the mechanics of preserving a lien for the benefit of the estate. As illustrated by this case, the consequences of preservation are not always self-evident.