 |
 |
|
|
Avoiding liens in bankruptcy
In bankruptcy, secured creditors (whether consensual, statutory, or judicial) are much better off than unsecured creditors. To oversimplify for the moment, a creditor with a lien will be entitled, in or after the bankruptcy proceeding, to receive value equivalent to at least the amount of the debt, or the value of the collateral, whichever is smaller. The unsecured creditor, by definition a creditor without a lien, has no such rights. Rather, in the common Chapter 7 bankruptcy proceeding, the claim of the unsecured creditor will be worthless and will be discharged, and in the common Chapter 13 or Chapter 11 bankruptcy proceeding, only a fraction of an unsecured claim may be paid.
Some liens held by secured creditors, athough enforceable outside bankruptcy (i.e. in the state remedies system), may be avoided (i.e. eliminated) in bankruptcy under provisions of the Bankruptcy Code, thus leaving the creditor unsecured. Because debtors who do not pay debts often land in bankruptcy, it is therefore critical for the secured creditor to know whether its lien, although enforceable under the state remedies system, may nonetheless be avoided in bankruptcy and to know what steps it could take, if any, to minimize or eliminate the possibility of avoidance.
We explore here four situations in which liens may be avoided in bankruptcy: (1) where liens impair exemptions; (2) where liens are preferential; (3) where liens are secret; and, (4) where liens are secret too long. To more fully understand this discussion, you may wish to review Commentary. Introduction to bankruptcy.
Liens that impair exemptions
Under bankruptcy law, in personam liability for debt is generally discharged but in rem liability of property subject to a lien arising under state law generally survives. In other words, an unavoided lien passes through bankruptcy. Thus, a secured creditor may, even after a bankruptcy discharge of a debtor's in personam liability, either foreclose or hold the debtor's property hostage and demand payment as a condition to extinction of the lien.
The Bankruptcy Code affords an individual who is a debtor in a Chapter 7 bankruptcy proceeding the right to retain certain property, known as exempt property, free of the claims of the bankruptcy trustee (and the unsecured creditors for whom the trustee acts) in order to facilitate a fresh start. However, if this exempt property is property on which a secured creditor holds a consensual lien, the survival of the secured creditor's lien would allow the secured party to put the debtor to a difficult choice: surrender property that the Bankruptcy Code says should be exempt as against the claims of unsecured creditors because it is important to a fresh start, or reaffirm (i.e. agree anew to pay) a discharged debt, or at least continue paying the debt even in the absence of a new agreement, as the price of keeping the collateral. The secured creditor's power to do this partially undermines the fresh start otherwise afforded by Chapter 7 of the Bankruptcy Code. Congress thought the leverage thus afforded to secured creditors to be too harsh with respect to debts secured by some kinds of exempt property. Thus, for much the same reason (excessive leverage) that motivated the Federal Trade Commission, in 1985, to restrict non-possessory, non-purchase money security interests in household goods, Congress, in 1978, permitted debtors in bankruptcy to avoid some non-purchase money, non-possessory consensual liens on some exempt property. Question A of Problem.Avoiding liens that impair exemptions explores the operation of the relevant section of the Bankruptcy Code, 11 U.S.C. 522(f)(1)(B).
Another provision of the Bankruptcy Code, section 522(f)(1)(A), permits the debtor to avoid most judicial liens that impair an exemption. Suppose, for example, that a creditor with a judgment records the appropriate document (e.g. an Abstract of Judgment) to create a judgment lien on the residence of the debtor. In almost every state at least some of the value of the residence will be exempt from execution. Thus, under state law, the exemption will preclude this creditor from a forced execution sale of the residence at least until the value of the residence exceeds the amount of the debtor's exemption plus the amount of any debt secured by liens recorded prior to the Abstract of Judgment. But the judgment lien will continue to assure the creditor a place in line for payment if and when the debtor sells or tries to refinance the property. However, if the debtor files a bankruptcy petition, the debtor may avoid the judgment lien created by the recording of the Abstract of Judgment to the extent that the lien impairs the debtor's residential exemption. (Bankruptcy Code 522(f)(2) states how one determines the extent to which a lien impairs an exemption.) This avoiding power puts the debtor in the same position she would have been in had she discovered the bankruptcy option earlier. Had the same debtor filed bankruptcy but one day prior to the day on which the creditor would have recorded the Abstract of Judgment, the creditor could never have obtained a lien (see Commentary.Automatic stay) and would be treated as an unsecured creditor in the bankruptcy.
In the state system, with some exceptions, the creditor first to obtain an interest in the debtor's property (by obtaining payment or by obtaining a judicial, statutory or consensual lien) is entitled to satisfy as much of its claim as the value of the property permits before any other creditor may satisfy a different claim from the same property. To the winner of the race (to the holder of a lien) go the spoils.
In contrast, the bankruptcy system treats unsecured creditors collectively and, with some exceptions, equally, without regard to the position that the unsecured creditor held in the race in the state system. The two systems are, therefore, fundamentally inconsistent with one another.
Bankr. Code 547 stands at the intersection of the two systems. It provides, among other things, that an unsecured creditor who had won a race to an interest in the debtor's property using the state remedies system within 90 days of the filing of the bankruptcy petition may have to forfeit its winnings (without compensation for any expenses it may have incurred in winning the race) for the benefit of all unsecured creditors. The section therefore prevents certain creditors from being preferred over others (hence, section 547 of the Bankruptcy Code is titled "Preferences)." An additional effect of the section (and one of its stated purposes) may be to discourage some unsecured creditors from aggressively pursuing the debtor under the state remedies system, thus affording the debtor more breathing space outside bankruptcy, for fear that money spent using the state remedies system will be wasted if the debtor files a bankruptcy petition.
To illustrate the operation of Bankruptcy Code 547, suppose that an unsecured creditor of debtor settles a defamation claim against the debtor for a payment from the debtor of $125,000. If payment of the settlement amount is made within 90 days of the filing of a Chapter 7 bankruptcy petition by the debtor, and assuming other requirements of section 547(b) are satisfied, the payment can be avoided. The creditor to whom the $125,000 payment had been made is liable to the bankruptcy trustee in the amount of $125,000. All unsecured creditors of the debtor in the Chapter 7 case, including the creditor whose preference is avoided, would then share, pro rata, in the assets of the debtor, including the $125,000 recovered upon avoidance of the preference. Bankr. Code 547(c) provides several important exceptions to the preference avoidance power, but we do not consider those exceptions in these materials.
For the same reason, Bankr. Code 547 permits avoidance of liens obtained within the 90 day (or one year) period: the creation of a lien on property of the debtor, whether voluntary, such as through a consensual lien, or involuntary, such as through a judicial lien, would, absent avoidance, have the same preferential impact as a transfer of money from a debtor to a creditor in payment of a debt. To return to the illustration above, suppose that the debtor settles the defamation claim by agreeing to pay $125,000 over several years, secured by a security interest in stock owned by the debtor. If the security interest was created within the 90 day window, and if other requirements of section 547(b) are satisfied, the security interest can be avoided and the stock sold by the trustee free of the security interest. All unsecured creditors of the debtor, including the creditor whose lien has been avoided, will share, pro rata, in the distribution of assets of the debtor, including the proceeds of the sale of the stock.
Secret liens or liens that are secret too long
A creditor may fail to reach the public record with notice of its lien, either inadvertently or intentionally. Liens of which there is no public notice, secret liens, are thought to disadvantage unsecured creditors who might not have extended unsecured credit to a debtor but for an assumption, informed by the public record, that assets of the debtor are unencumbered. With limited exceptions, if the failure to reach the public record with notice of a lien is not cured prior to the filing of a bankruptcy petition the lien may be avoided in bankruptcy.
Under state law, U.C.C. 9-317(a)(2), a security interest in personal property or fixtures that is in effect secret when a creditor obtains a judicial lien on the same property will be subordinate to the judicial lien. The security interest is deemed secret when a creditor obtains a judicial lien if the creditor obtains the judicial lien prior to perfection of the security interest or prior to the time that one of the conditions under U.C.C. 9-203(b)(3) has been met and a financing statement covering the collateral is filed, whichever is earlier. Under bankruptcy law, Bankr. Code 544(a)(1), the bankruptcy trustee (or a "debtor-in-possession" in a Chapter 11 bankruptcy proceeding) may step into the shoes of and use the state law subordinating power of a creditor with a judicial lien to avoid any security interest that would have been subordinate to the judicial lien creditor under U.C.C. 9-317(a)(2). The trustee may avoid the security interest in its entirety, even if there is no such actual creditor and even though the security interest would only be subordinated, not eliminated, under state law. For this reason, Bankr. Code 544(a) is often referred to as the "strong arm clause." Avoidance of the security interest under this section of the Bankruptcy Code has the same effect as avoidance of a security interest under the preference power.
Analogous treatment awaits the real property secured creditor whose interest has not reached the public record. Under state law, the interest in real property of a holder of an unrecorded mortgage or deed of trust will be subordinate to the rights of a bona fide purchaser for value of the real property who is without knowledge of the interest of the holder of the mortgage or deed of trust. Just as section 544(a)(1) of the Bankruptcy Code puts the trustee in the shoes of a hypothetical lien creditor who has certain rights under U.C.C. 9-317(a)(2), Bankr. Code 544(a)(3) puts the trustee (or the debtor-in-possession in a Chapter 11 proceeding) in the shoes of a hypothetical bona fide purchaser of real property. The trustee may, therefore, avoid the unrecorded mortgage or deed of trust, for the benefit of all unsecured creditors of the debtor if, under state law, the interest of a bona fide purchaser of the real property would be superior to the rights of the holder of the mortgage or deed of trust.
Both personal and real property secured creditors would be able to avert the reach of Bankr. Code 544(a)(1) or 544(a)(3), by reaching the public record just prior to the filing of a bankruptcy, but for a provision in the Bankruptcy Code allowing the trustee (or "debtor in possession") to avoid liens which are secret too long. Under Bank. Code 547(b) and 547 (e)(1) and (e)(2), a lien that is secret too long (generally, more than 10 days) but that has been made public by an appropriate filing or other means of perfection within 90 days (or one year if the creditor is an insider) of the filing of a bankruptcy petition, may be avoided.