Avoiding a Foreclosure Sale in Chapter 13 Bankruptcy
The U.S. District Court for the District of Massachusetts recently issued an opinion in an appeal from the Bankruptcy Court denying a Chapter 13 debtor’s attempt to avoid a foreclosure sale that occurred before the bankruptcy case was filed.
The term “avoid” is a bankruptcy term of art akin to “reverse” or “undo” in layman’s terms. Certain sections of the Bankruptcy Code permit a trustee or, in some circumstances, a debtor, to avoid transfers of money or property that occurred before the bankruptcy case was filed. A foreclosure auction is a transfer for bankruptcy purposes. Since at least the decision in In re Mularski, 565 B.R. 203 (Bankr. D. Mass. 2017), many Chapter 13 debtors have been successful in avoiding a foreclosure sale under specific sections of the Bankruptcy Code when the bankruptcy case is filed after the sale takes place, but before the foreclosure deed is recorded.
The legal mechanics to avoid of a pre-petition foreclosure are briefly described as follows.
Bankruptcy Code § 544(a)(3) states:
(a) 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.
Bankruptcy Code § 522(h) states:
(h) The debtor may avoid a transfer of property of the debtor or recover a setoff to the extent that the debtor could have exempted such property under subsection (g)(1) of this section if the trustee had avoided such transfer, if— (1) such transfer is avoidable by the trustee under section 544, 545, 547, 548, 549, or 724(a) of this title or recoverable by the trustee under section 553 of this title; and (2) the trustee does not attempt to avoid such transfer.
Put simply, these two statutes state that a bankruptcy debtor may avoid a pre-petition transfer if the trustee does not elect to do so, as long as the transfer was not perfected under state law prior to the bankruptcy case and there was no notice of the transfer to potential bona fide purchasers prior to the bankruptcy case (note that both perfection and notice must be lacking). The debtor must also comply with § 522(g)(1), which states that the transfer must not have been voluntary, was not concealed, and the property that was transferred would have been part of the bankruptcy estate when the case was filed and exempt from claims of creditors if the transfer had not occurred.
In this case, Tran v. Citizens Bank, the lender conducted a mortgage foreclosure sale of the debtor’s home on August 16, 2022. The debtor filed a Chapter 13 bankruptcy case 28 days later on September 13, 2022 and initiated an adversary proceeding to avoid the foreclosure sale. Before the bankruptcy case was filed, however, the lender recorded a foreclosure deed and other documents required by Massachusetts foreclosure law, including an Affidavit of Sale. The deed apparently lacked proper notarization and the debtor argued that such a defect rendered the deed ineffective to perfect the transfer and convey the property to the buyer, and in the absence of a proper deed, the recording of the Affidavit of Sale alone was insufficient to give constructive notice to third-parties that the debtor’s interest in the property had been transferred. Both the Bankruptcy Court and the District Court held that the recording of the Affidavit of Sale before the bankruptcy case was sufficient notice to third parties under state law because Massachusetts is a “notice” jurisdiction, therefore when the Affidavit of Sale was recorded, it acted as “notice to the world” – including any potential bona fide purchasers – that the foreclosure had taken place. Finding that there was notice of the pre-petition transfer sufficient to defeat avoidance under § 544, the Court did not arrive at any conclusion as to whether the transfer was perfected.
As of the date of this article, the Debtor has filed a notice of appeal to the First Circuit Court of Appeals.
As Tran’s attorney, I would like to add a couple of comments. It is indisputable that the recorded foreclosure deed is void since it was not notarized. Massachusetts case law is abundantly clear on that point. That leaves the question of “so what” if the Affidavit of Sale was valid? The deed isn’t, and the transfer of the property by way of the void deed should be avoidable. The district judge noted that we were focused on the deed, and he’s right because as I said, the deed is void. It will be interesting to see what the First Circuit says.
Indeed! This is an area to watch as it develops as it represents some very powerful relief for debtors.