American College of Mortgage Attorneys


Four Seasons Las Vegas

October 29, 2005

 

A Critical Analysis of Recent Cases

 

 

 

 

 

 

 

Roger Bernhardt

Patrick Randolph

Dale Whitman

 

 

 

 


THE SPEAKERS

 

Roger Bernhardt

 

Roger Bernhardt is Professor of Law at Golden Gate University in San Francisco. He is the author of two California Continuing Education of the Bar books: California Mortgage and Deed of Trust Practice, and Bernhardt’s California Real Estate Cases. He is also the Editor (and commentator) of CEB’s California Real Property Law Reporter.  His other publications for attorneys include Bernhardt’s California Real Estate Codes and Deskbook of Federal Real Estate Laws.  In addition to these books for attorneys, Professor Bernhardt has also written for law students: Casebook on Real Property, Real Property in a Nutshell, The Black Letter Law of Real Property, all for West,  and also a Casebook on California Real Estate Finance.

Bernhardt is admitted to practice in the states of California and New York, and is also licensed as a real estate broker in California. He is Advisor to the Executive Committee of the Real Property Section of the California State Bar, Chair of the Legal Education Committee of the Real Property Probate and Trust Section of the American Bar Association, and a member of the American College of Real Estate Lawyers, the American College of Mortgage Attorneys, and the American Law Institute.

 

Patrick A Randolph, Jr.

 

Patrick A.  Randolph, Jr., , a graduate of Yale University and the Boalt Hall Law School at the University of California, Berkeley, is currently the Elmer E. Pierson Professor of Law at the University of Missouri, Kansas City.  He  has taught at UMKC since 1980.   He is of counsel to the law firm of Blackwell Sanders Peper Martin, Kansas City, Missouri.  He has published eight books and scores of articles on real estate topics, and  regularly appears as a speaker on real estate issues around the country.

 

Professor Randolph is particularly well known as the Editor and founder of DIRT, the internet discussion group for real estate legal  professionals. He also has just completed work on a three volume treatise:   Friedman on Leases - Randolph Edition, published by the Practicing Law Institute.  In addition to his American real estate work, he writes and speaks about real estate law in China, and has established and directs  the Peking University Real Estate Law Center in Beijing, China.

 

REALTOR magazine recently named Professor Randolph as one of the 25 Most Influential People in American Real Estate.

 

 

Dale A. Whitman

Dale A. Whitman is the James Campbell Professor of Law at the University of Missouri in Columbia MO.  He received his B.E.S. degree in Electrical Engineering from Brigham Young in 1963 and his law degree from Duke University in 1966.  After practicing for a short period with the firm of O'Melveny and Myers in Los Angeles, Whitman began his academic career at the University of North Carolina in 1967.  He was a member of the original faculty when the Brigham Young University law school was founded in 1973. He has since been a faculty member at the University of Washington (where he served as associate dean) and the University of Missouri-Columbia (where he served as dean from 1982 to 1988).  He has also been a visiting professor at the University of Tulsa, the University of Utah, and UCLA.

Whitman's principal fields of interest are property and real estate finance.  He is a co-author of five books in these areas and has also written numerous articles.  During 1971-73 he was involved with the nation's housing programs, serving in Washington with the Federal Home Loan Bank Board and the Department of Housing and Urban Development.  He was co-reporter, with Professor Grant Nelson of UCLA, of the American Law Institute's Restatement (Third) of Property (Mortgages), published in 1997. He was a member of the Executive Committee of the Association of American Law Schools from 1994 through 1997, and will serve as President of the Association for the year 2002.  He is currently a member of the Joint Editorial Board for Uniform Real Property Acts, and is the reporter for the Uniform Power of Sale Foreclosure Act, currently in the drafting stage.  He is a member of the Order of the Coif, the American Law Institute and the American College of Real Estate Lawyers, and is a Fellow of the American Bar Foundation.

Note: Case summaries below are by Professor Patrick Randolph except as noted.

1. In re AE Hotel Venture, 2005 Bankr. LEXIS 166 (Bankr. N.D. Ill., Feb.  16, 2005).

MORTGAGES; INTEREST; DEFAULT INTEREST: Where mortgagor has collected a one-time 5% late payment charge, bankruptcy court will not approve default interest of 5% in excess of contract rate as a "reasonable charge" arising from default.

AE Hotel Venture ("AE Hotel") owned and operated a suburban Chicago hotel property and obtained a mortgage loan on the property in 1997, in  the amount of $7.6 million, from LaSalle National Bank ("LaSalle").  LaSalle was the trustee for a securitization trust, and the loan was subsequently securitized; i.e., pooled with other loans and sold to  investors pursuant to the issuance of mortgage-backed pass-through  certificates. LaSalle designated GMACCM Commercial Mortgage Corp.  ("GMACCM") to act as special servicer of the trust; the court in this  case discusses the claim of the mortgagee as if it belonged to GMACCM.

Several years later AE Hotel defaulted under the loan, and GMACCM  accelerated the debt and filed a foreclosure action in Illinois State  court. A few days later, AE Hotel filed a Chapter 11 bankruptcy proceeding, in order to gain time to sell the hotel.  The bankruptcy  court subsequently approved a sale of the hotel property for $7.8  million. Prior to the sale, GMACCM filed its proof of claim, seeking (as set forth in the loan documents): (1) a late payment charge equal to 5% of the unpaid balance of the loan (2) default interest at the rate of  14.72% (a 5% increase over the contract rate of 9.72%); and (3) a  prepayment premium based on a yield-maintenance prepayment formula,  discounted to present value. AE Hotel objected to GMACCM's request for payment of the default interest and prepayment premium as part of its allowed claim (but not to payment of the late charge).

The bankruptcy court noted that no facts were in dispute and that AE  Hotel had conceded, as a factual matter, that the yield-maintenance  prepayment-premium provision in the loan documents (which the court  "translated roughly into English") provided a "precise method" of  determining GMACCM's loss and was "an exact calculation of the damage"  that would result from prepayment of the loan.

The borrower did not contest the 5% late charge based upon the unpaid premium amount, perhaps because it was of the view that the default interest fee posed the greater threat.

The court denied that GMACCM's claim to post-petition default interest.  The court stated that this claim was really not for default interest at all, but rather a claim for a "charge" for extra costs incurred after  default, and was not "reasonable" under sec. 506(b) of the Bankruptcy  Code. While acknowledging that case law to the contrary existed, the  court reasoned that the original contract rate was designed to  compensate the lender for the loss of the time value of money and that  "[t]he time value of money of GMACCM's value of money . . . did not  magically increase by 5% once AE Hotel defaulted." The court found that  this charge would be "reasonable" under Sec. 506(b) only if the lender  was not compensated under some other provision of the loan documents,  and that several courts have held that when a creditor is paid late  charges (which AE Hotel did not contest in this case), it could not also  claim default interest ( which would, according to the bankruptcy court,  result in a "double recovery).  The court ruled that although GMACCM would be able to collect all or some portion of the default interest "charge" if it could demonstrate that payment of the late fee failed to compensate it fully  for some loss, GMACCM had waived this argument by failing to supply any  evidence in this regard.

Reporter's Comment 1: The bankruptcy court in the AE Hotel case ruled that under Illinois law, GMACCM could not collect default interest in  addition to the late fee - unless it could prove that collection of the  late fee was insufficient to compensate it for its actual damages. But  this also is less than clear. In the recent Broadway Bank bankruptcy  case (see Reporter's Comment 1, supra), which applied Illinois law, the  loan documents stipulated a five-percent late charge and a  default-interest rate of ten percentage points over the contract rate  upon default, as well as payment of attorneys' fees involved in the  bank's collection efforts. The Iowa appellate court held that the  language of the promissory note regarding late charges and default  interest was clear and unambiguous, and that the settlement agreement  between the parties did not extinguish the bank's ability to collect  late charges and default interest. The case was remanded to the trial  court to compute the amount of the award of late fees, default interest, and attorney fees.

The bankruptcy case law in general is split on the issue of whether a  lender should be able to collect both a late fee and default interest  (and whether a late fee or default interest is a "charge" as opposed to  interest), and the reasonableness of such charges, although the majority  of decisions prohibit the recovery of both. See, e.g., In re Route One  West Windsor Limited Partnership, 225 B.R. 76 (Bankr. D.N.J. 1998), in which the court, applying New York law (the parties had stipulated New  York law would apply in a choice-of-law provision in the loan  agreement), held that a provision in the debtor's mortgage-loan  agreement with an oversecured creditor to pay interest following default  at the post-default rate of 15.125% was not an unenforceable penalty and  must be paid by the debtor. The court found that the increased default  rate of interest was justifiable and reasonable because it merely  compensated the mortgagee f or the increased risk and expense of  collection. The court also held that the allowance of default interest on a claim in bankruptcy is determined by federal law, but noted that state law would be relevant  because if the amount exceeded the allowable legal rate, then the  bankruptcy court would not permit the mortgagee to recover such a  windfall amount in a bankruptcy proceeding. The court also noted that  the principal of the debtor was a sophisticated businessman who had  knowingly and freely allowed the debtor partnership to contract for the  post-default interest rate. The court further found that no other  non-insider creditors of the debtor would bear the adverse effects of  the increased rate of interest paid to the mortgagee. The bankruptcy  court also noted that under New York law default interest rates as high  as 25% had been consistently held to be reasonable. But the court also  held that the mortgagee would not be permitted to receive both interest  at the post-default rate an d late charges. The court therefore upheld  the enforceability of the default-interest provision but not the provision for the  payment of late charges by the debtor. See also In re Wines, 239 B.R.  703, 709 (Bankr. D.N.J. 1999) ("courts have traditionally allowed late  charges according to the contract of the parties"). In a similar  decision, In re Dixon, 228 B.R. 166 (Bankr. W.D. Va. 1998), the court  held that although the default interest rate of 36% (double the  pre-default rate) was high, it would accept the creditor's  representation -- without requiring testimony or evidence -- that the  default rate was proportionate to the reasonably anticipated damage from  default and was not a penalty. The court stated that it did not have the  "power to alter commercial contracts or to substitute [its] judgment for  that of the parties" where the transaction was lawful, no other  creditors were harmed, the default rate did not violate state usury  laws, and there was no threat to the reorganization of the debtor by  imposition of the default rate. The court, citing In re Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994), cert. denied sub nom Invex Holdings, N.V. v. Equitable Life Ins. Co. of Iowa, 513 U.S. 948 (1994) and In re Consolidated Properties Ltd.  Partnership, 152 B.R. 452, 457 (Bankr. D.Md. 1993) (both of these  cases  were cited by the bankruptcy court in the AE Hotel case), also stated  that "[d]efault interest rates are also necessarily higher than basic  interest rates in order to compensate creditors for both the predictable  and unpredictable costs of monitoring the value of collateral in default  situations." The court noted, however, that "[e]ven when the late charge  is reasonable . . . a creditor may be denied recovery where it also  asserts a claim to a default rate of interest". See also Greenwood Trust  Co. v. Commonwealth of Massachusetts, 971 F.2d 818, 825 (1st Cir. 1992)  (holding that late charges are a form of interest, and that the State of  Massachusetts could not bar an out-of-state bank from charging late-payment fees on delinquent credit-card accounts, and stating that "federal case law has long suggested that, in ordinary usage, interest may encompass late fees and kindred charges," 4 A. Resnick and H. Sommer, Collier on Bankruptcy P506.04[2][b][ii] at 506-112 (15th rev. ed. 2004 ("in general a default rate of interest is properly a form of  interest").

Editor's Comment: This court, and perhaps some others, are not quite  getting the arguments right. The earlier cases striking down default  interest rates when late fees also were charged dealt with late fees  charged on a late balloon payment - in other words applied to the whole  principle amount, or late fees that were compounded - charged every  month as additional defaults were claimed.  To the extent such claims  are valid (and many common law courts have found these sorts of fees  invalid), they are valid because the operate exactly like default  interest - compensating the creditor for the additional risks of  carrying the loan.

But in this case, it appears (from the size of the charge), the late  charge was a more typical late charge - charged only upon the amount of  a single late payment.  This fee is designed to compensate the lender  only for administrative expenses related to that fee, and not to the  additional risk of carrying the whole loan.

The cases that the court relies upon here talk about late fee provisions  and default interest provisions that each compensate the lender for the  same risk or cost.  The rule, properly, that the lender shouldn't be  able to get both.  But that was not the situation here.  The two  provisions compensated for two quite different costs, and charging the  late fee should not have precluded the lender from charging for default  interest.

The Reporter for this case was Jack Murray of First American Title Insurance Company.


2. Baskurt v. Beal, 101 P.3d 1041 (Alaska 2005).

Nonjudicial foreclosure set aside because of inadequate price.

Annette Beal bought two parcels of land in 1991 for $225,000, taking subject to a blanket deed of trust in favor of the sellers on both parcels.  There were two promissory notes:  Note 1, for $95,000, associated with the first parcel, and Note 2, for $135,000, associated with the second parcel.  Beal paid off Note 1 in 1994, but continued to make payments on Note 2 until she fell behind in 1999.  The sellers’ daughter, Sarah Baskurt, as trustee of their inter vivos trust, commenced foreclosure of both parcels by trustee’s sale of the deed of trust.

Baskurt formed a partnership with a friend, Joyce Wainscott, and they decided to try to buy the property at the foreclosure sale.  They brought cashiers’ checks in the total amount of $251,000 to the sale.  While waiting for the sale to begin, they encountered Allen Rosenthal, who Baskurt knew had considerable real estate experience.  On the spot, Baskurt and Wainscott expanded their partnership to include Rosenthal, who had been prepared to bid up to $95,000 himself.

When biding was opened Baskurt bid $26,781.81, one dollar above the outstanding balance on the note. There were no other bids, and Baskurt, on behalf of her partnership, was declared the successful bidder.

Beal brought an action to have the sale set aside.  The trial court found that the property’s fair market value was the same as the 1991 selling price, or $225,000.  Because the high bid at the sale was so low in comparison, the trial court set the sale aside.

The Alaska Supreme Court held that, while an inadequate price alone was not a sufficient ground to set aside a foreclosure sale, it would be grounds to do so if it was (a) “grossly inadequate” or (b) accompanied by other defects in the sale.  It found both of these tests were satisfied in Baskurt, although satisfaction of either one would have warranted setting aside the sale.

On the “grossly inadequate” issue, the court quoted with approval the Restatement (Third) of Property (Mortages) Sec. 8.3 cmt b, which adopts a figure of 20 percent of the property’s market value as a rule of thumb for “gross inadequacy” of price.  The bid in Baskurt, which was 11.9% of the market value, easily satisfied this test.  (Inexplicably, the court refers to the bid as “less than fifteen percent” of market value; can the court really be so bad at arithmetic?)

The court also found the sale was defective because the trustee who conducted it failed to meet his fiduciary obligations – obligations that the court said were owed to both the trustor and the beneficiary.  In part, these duties included taking “reasonable and appropriate steps to avoid sacrifice of the debtor’s property and interest.”  Since the trustee conducted the sale of the two parcels in bulk when the sale of either parcel alone “would likely have generated sufficient proceeds to satisfy the amount due,” the court found the sale defective.  That defect, in combination with the inadequacy of the price (even if it had not been “grossly” inadequate) justified setting aside the sale.

Comment 1.  The case is significant because it clearly identifies two distinct bases for setting aside the sale: (a) gross inadequacy of price alone, and (b) inadequacy, even if not gross, accompanied by other defects – here, the trustee’s sale in bulk when a sale of either parcel alone would have been sufficient.  See also Krohn v. Sweetheart Properties, Ltd.. 203 Ariz. 205, 52 P.3d 774 (2002) (employing both “gross inadequacy” and “shock the conscience” terminology in setting aside a trustee’s sale for 18.07% of fair value despite absence of any other defect in the sale);  In re Edry, 201 B.R. 604 (Bankr. D.Mass. 1996) (setting aside sale for 45.5% of fair value, where the mortgagee failed to advertise in any manner other than that required by the statute).

Comment 2.  The case is one of several in recent years that imputes real duties owed by the foreclosing trustee to the trustor.  Other examples include Cox v. Helenius, 103 Wash.2d 383, 693 P.2d 683 (1985); Wansley v. First National Bank of Vicksburg, 566 So.2d 1218 (Miss. 1990) (imposing a duty of commercially reasonable sale, but only for purposes of denying a deficiency judgment, not setting the sale aside); In re Edry, supra.  The California approach is much less pro-debtor:

The similarities between a trustee of an express trust and a trustee under a deed of trust end with the name. "Just as a panda is not a true bear, a trustee of a deed of trust does not have a true trustee's interest in, and control over, the trust property. Nor is it bound by fiduciary duties that characterize a true trustee."

Monterey S.P. Partnership v. W.L. Bangham, Inc., 49 Cal.3d 454, 261 Cal.Rptr. 587, 777 P.2d 623 (1989).

Comment 3.  The court makes no reference to the fact that the mortgagee, immediately before the opening of bidding, made a deal with the only other bidder present (Rosenthal) to form a partnership with him, thus taking him out of the bidding.  Moreover, Baskurt testified Rosenthal had been planning to bid up to $95,000 ($68,000 more than the bid entered by Baskurt on behalf of her partnership).  Doesn’t this constitute “chilling of bidding” by the mortgagee?  Wouldn’t that be an additional reason to consider the sale defective, and thus to set the sale aside even if the inadequacy of price had not been “gross?”  While other bidders are certainly free to form whatever combinations they wish, doesn’t the mortgagee have some obligation to avoid ruining the competitive bidding process?

The reporter for this case was Dale Whitman


3. Broadway Bank v. Star Hospitality, Inc., 2004 Iowa App. LEXIS 1294 (Nov. 24, 2004).

MORTGAGES; PREPAYMENT; PREPAYMENT PREMIUMS; ACCELERATION: Prepayment penalty provision in mortgage loan agreement was unenforceable where clause did not distinguish between voluntary and involuntary prepayment and bank's decision to accelerate debt and file foreclosure action resulted in involuntary prepayment.

In a case with confusing and sketchy facts, certain of the defendants executed a mortgage for $3,494,000 to Broadway Bank in 2001 on a hotel property in Davenport, Iowa. An individual, Syed Quadri, subsequently assumed the existing mortgage. According to the court, as collateral for the loan Quadri granted the bank a "first interest and assignment of rents against the hotel." Additional collateral, in the form of "CDs held in the name of the debtors and guarantors" (including a CD from Quadri in the amount of $532,229) as well as assignments of rents and second mortgages on Quadri's residential properties in Illinois, was also obtained by the bank. The aggregate value of this collateral was approximately $20 million.

The prepayment provision in the loan documents provided that if the principal amount of the loan was reduced by twenty percent in a one-year period, the prepayment penalty would be assessed equal to six months' interest. The loan documents also provided for a late charge of five percent and default interest of "ten points over the index upon default," and for the collection of attorney's fees if collection was necessary.

As a result of the occurrence of flood damage at the hotel and the terrorist attacks of September 11, 2001, the revenue from the hotel plunged and the bank granted Quadri a delay of three to four months to make payment on the loan. Quadri asked the bank to apply his CD to bring the past-due balance current and make future loan payments (the loan called for monthly payments of $33,014.99). The bank refused to do so, apparently believing that it would be left with insufficient collateral, and no payments were made on the loan.  Quadri subsequently contacted the bank and inquired whether he could use the CD as collateral to secure a new loan at another bank and refinance the debt.  The bank informed him that it had in fact converted his CD to a non-interest bearing account and had applied $192,574 to the outstanding loan balance, which brought the loan current within 30 days (but not completely current).  The bank continued to charge default interest on the unpaid principal.

In March 2002, the bank filed a foreclosure action. The parties negotiated a settlement agreement providing for a "settlement sum" of $3,250,000 to be paid by the defendants. But the agreement also acknowledged that the defendants continued to owe an unpaid principal balance on the loan of $259,672, interest thereafter at 10.5%,  mortgage release fees, and legal fees. The issues of the late fees, default interest, attorney's fees and, the prepayment penalty were preserved for later resolution, and were to be submitted by the defendants to arbitration, mediation or litigation within sixty days - but the defendants failed to do so.

The bank then filed a declaratory action, seeking the amount of $524,479, which included the outstanding principal due as well as late charges, default interest, attorney's fees, and the prepayment premium. After an evidentiary hearing, the trial court awarded the bank only $80,661, which included the principal owed of $70,493, interest on that amount from September 9, 2002 until the time of the ruling in the amount of $5168, and $5000 in attorney's fees. The court subsequently modified this ruling to allow a one-time late fee of five percent of the unpaid principal balance and increased the award of attorney's fees to $50,000 (increasing the total award to $129,186). The trial court made no award for the prepayment penalty, finding that the payment was "involuntary" and that to award the prepayment penalty would constitute unjust enrichment. The trial court reasoned that because the bank chose to accelerate the debt and commence a foreclosure proceeding, the defendants had not voluntarily "prepaid" the loan and the bank was not entitled to collect the prepayment penalty.

The appellate court reversed the holding of the trial court with respect to default interest, rejecting the trial court's finding that the bank had not acted in good faith in deeming itself insecure because the defendants were not in default due to Quadri's attempts to make payment on the loan by applying his CD. According to the appellate court, "The language of the promissory note regarding late charges, and default interest are [sic] clear and unambiguous. The settlement agreement between the parties did not extinguish [the bank's] ability to collect late charges and default interest. Rather, the agreement reserved defendants' right to adjudicate the issues at a later time. The availability of collateral to be used as a set-off is irrelevant to the issue of whether defendants were in default." The court further noted that even though Quadri was allowed to delay his loan payments for three or four months, he had failed to make any payments beyond that time.

With respect to the prepayment penalty, the appellate court concurred with the trial court's analysis and refused to permit the bank to collect the penalty, stating that "[t]he language of the promissory note does not distinguish between voluntary and involuntary prepayment." The court cited  a Seventh Circuit bankruptcy decision, In re LHD Realty Co., 726 F.2d 327, 330 (7th Cir. 1984) for the proposition that "where a lender accelerates a debt, the right to prepayment is lost." The court also found that "under the Illinois law governing the action [the bank] is not entitled to the prepayment penalty."

Reporter's Comment 1:  Prepayment provisions, both yield-maintenance and otherwise, have been challenged by borrowers on the basis that the prepayment was "involuntary" and therefore not covered by the provision. A lender is always well advised, from a drafting standpoint, to specifically state in the prepayment provision in the loan documents that the lender will be entitled to collect the contracted-for prepayment premium if it subsequently  accelerates the loan upon default by the borrower. The prepayment provision in the loan documents in the Broadway Bank case is one of the goofier clauses encountered by the reporter. The prepayment provision provided that if the principal amount of the loan was reduced by twenty percent in a one-year period, the prepayment penalty would be assessed equal to six months' interest. This is, frankly, a poorly drafted clause. It is not related in any manner to the lender's actual costs or damages and therefore is even less justifiable than a yield-maintenance formula (if the court chooses to apply a liquidated-damages analysis or "reasonableness" standard). The use of this type of provision is not recommended, because (as with a "sliding percentage" clause, which was common before the advent of yield-maintenance prepayment provisions in the 1980s) it invites this argument by the borrower.

[The editor notes that, although this clause is "goofy" from the standpoint of modern commercial mortgage law, the "six months interest" penalty is a pretty standard formulation based upon residential mortgages, and in fact is a "safe harbor" penalty in some state statutes limiting prepayment premiums in residential loans.  Further, the definition of prepayment as a reduction of more than 20% also is not unusual. The combination of the two might be seen as unusual, but not to a drafter who was not sensitive to the new thinking that emerged in the mid-80's concerning judicial restrictions on prepayment clauses.]  Comment 2: The LHD case (referred to by the court in the Broadway Bank case) was decided by the Seventh Circuit in 1984, and all (rational) institutional lenders quickly learned to include language specifically stating that the lender was entitled to the prepayment premium if it accelerated the loan.  It is inexcusable that any institutional lender (such as the bank in the Broadway Bank case) would fail to include this additional language. ["Inexcusable," perhaps, but not impossible.  The editor has seen other examples, in and out of litigation.]  If the right to collect a prepayment premium upon acceleration of the loan is not stated in the loan documents, courts generally will not permit the lender to collect it. But the appellate court in the Broadway Bank case mischaracterizes the holding of the Seventh Circuit in the LHD case. The court in that case did not make a blanket statement that "where a lender accelerates a debt, the right to prepayment is lost."   Rather, the court in the LHD case refused to permit the lender to collect a prepayment premium after the borrower's default because the prepayment clause did not clearly provide that the premium could be collected upon acceleration after default. See In re LHD Realty Co., 726 F.2d at 330.

See also Tan v. California Fed. Sav. & Loan Assoc., 140 Cal. App. 3d 800, 824, 189 Cal Rptr. 775, 809 (1983) (concluding that the terms of the prepayment penalty provision applied only when the borrower voluntarily exercised the prepayment option, and stating that "[t]he language of the 'prepayment privilege' provision rather clearly makes a prepayment penalty payable only upon the debtor's exercise of the reserved privilege to prepay");  Rogers v. Rainier Nat'l Bank, 111 Wash. 2d, 232, 238, 757 P. 2d 976, 979 (1988) (holding that because the promissory note did not provide for any specific penalty as the result of acceleration upon default as the result of acceleration upon default, the court "cannot supply a provision which the parties omitted").

The appellate court in the Broadway Bank case also stated that "under the Illinois law governing the action [the bank] is not entitled to the prepayment penalty." The court likely is referring to Slevin Container Corp. v. Provident Federal Sav. & Loan Ass'n, 98 Ill. App. 646, 648, 424 N.E. 2d 939, 940 (1981), which held that  acceleration, by definition, advances the maturity date of the debt so that payment thereafter is not prepayment but instead is payment made after maturity, and perhaps In re Maywood, Inc., I210 B.R. 91, 94 (Bankr. N.D. Tex. 1991) ("[w]hen acceleration of the loan is triggered by the lender, Illinois law does not enforce termination fees").  But these cases involved prepayment provisions that did not provide for collection of the prepayment premium upon acceleration of the debt.  See Baybank Middlesex v. 1200 Beacon Properties, Inc., 760 F. Supp. 947, 966 (D.Mass. 1991) (same; but noting that the parties "could have expressly provided for such a contingency [involuntary prepayment] in their agreement" and "the inclusion of such a provision in the Indenture would have entitled the [mortgagee] to the damages they now seek"); Coca-Cola Bottling Co. of Portland, Indiana, Inc. v. Citizens Bank of Portland, 583 N.E.2d 184, 190-91 (1991) ( "[a]n election to accelerate a debt may become irrevocable if the election reasonably causes the defaulting party to rely and act upon the acceleration to its detriment; the court noted that the parties could presumably have waived the protection provided by detrimental reliance by "clear and unequivocal language to that effect," but the loan documents did not contain such language); Zwayer v. Ford Motor Credit Co., 279 Ill. App. 3d 906, 909-10, 665 N.E.2d 843, 845-46 (1996) ("[t]here is no provision specifying that the [prepayment-premium provision] will be applied . . . upon acceleration.  Since payment upon [the mortgagee's] choice to accelerate the loan is not prepayment, [the mortgagee] is not entitled to assess a prepayment penalty"); cf. 22 Gifford Associates v. Citicorp Mortgage, Inc., A-5381-96T3 (N.J. Super. App. Div. 1998) (unreported decision) (holding that language requiring the payment of a prepayment fee "whether or not the payment is voluntary or involuntary" was not sufficient to permit the mortgagee to collect the fee where the loan had been accelerated by the mortgagee, because no "prepayment" had occurred; the court noted that if the mortgagee expected to enforce the prepayment-penalty provision in the event of its own action (accelerating the loan), the provision should have specifically so stated).

See also Mutual Life Ins. Co. of New York v. Hilander, 403 N.W.2d 260, 264 (Ky. App. 1966) (upholding right of mortgagee to collect prepayment premium where mortgagor paid off mortgage, including prepayment premium under protest, in response to mortgagee's threat to accelerate defaulted loan, even though prepayment provision did not specifically mention involuntary prepayments); West Portland Dev. Co. v. Ward Cook, Inc., 246 Ore. 67, 71, 424 P.2d 212, 214 (Or. 1967) (rejecting mortgagor's argument that once mortgagee elected to accelerate the debt its election was irrevocable and no prepayment was due when mortgagee subsequently rescinded its election, and ruling that because there was no evidence that mortgagor changed its position or was prejudiced the mortgage payoff must include the prepayment penalty).

Courts have generally upheld the enforceability of a prepayment provision where the clause clearly states that it applies if the loan is accelerated as the result of the mortgagor's default under any of the terms and conditions of the loan documents. In Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F.2d 349 (5th Cir. 1991). In this case, the court reversed the holding of the District Court, which had denied enforcement of a contractual yield-maintenance prepayment provision based solely on the fact that the prepayment by the borrower was "involuntary," i.e., that the provision provided for collection of the premium upon acceleration by the lender, rather than upon the borrower voluntarily making the payment. The borrower had sued the lender to recover payment of the premium, alleging that it was a penalty under Texas law.  The court noted that it could find no Texas case law holding that prepayment provisions are only valid when a voluntary prepayment is made by the borrower, and stated that parties to a contract have the right to contract for any provisions they wish, so long as the contract does not violate public policy and is not illegal. The court also found that the prepayment provision, which was "unambiguous, clear and unequivocal," did not constitute a usurious contract or an illegal restraint on alienation, was not "unreasonable or oppressive," and did not violate public policy.

Comment 3: For other cases permitting the imposition of a prepayment premium where the loan documents provided that was due upon acceleration of the loan, see Pacific Trust Co. TTEE  v. Fidelity Sav. & Loan Assn., 184 Cal. App. 3d 817, 824, 229 Cal. Rptr. 269, 274 (1986) (permitting acceleration upon default by the borrower and acceleration of the debt by the lender where the prepayment clause by its terms applied to an acceleration by the lender after default; the court stated that, "[t]he instant clause is intended to apply in the event the lender elects to accelerate and describes such a payment as an involuntary payment. . . . [T]here is no ambiguity which may be resolved against the lender who presumably drafted the note. ... Thus, we find that the clause applicable to the facts of the instant case"); LaSalle Bank Nat'l Ass'n v. Sleutel, 289 F.3d 837, 842  (5th Cir. 2002) (ruling that under the language in the loan documents, the prepayment consideration could be accelerated  along with the debt upon an event of default); Biancalana v. Fleming, 53 Cal. Rptr. 2d 47, 50, 45 Cal. App. 4th 698, 703 (1996) (upholding the enforceability of a prepayment charge after acceleration of the debt by the lender, and noting that "the note in this case indicates that the prepayment penalty is intended to apply when the lender accelerates"); Ridgely v. Topa Thrift & Loan Ass'n., 54 Cal. App. 4th 729, 738, 62 Cal. Rptr. 2d 309, 318 (1997) ("The instant provision indicated the prepayment penalty was intended to apply when defendant accelerated the note"); Virginia Housing Dev. Authority v. Fox Run Ltd. Partnership, 497 Va. 356, 365, 97 S.E.2d 747, 753 (1998) (holding that because the note provided that the mortgagee was entitled to a prepayment premium if it accelerated the debt as the result of a default, the mortgagee "was not required to include notice of its election to assess the prepayment fee as part of the debt owed upon acceleration of the principal debt"); Citicorp Mortgage, Inc. v. Morrisville Hampton Village Realty Ltd. Partnership, 443 Pa. Super. 595, 599, 662 A. 2d 1120, 1122 (Pa. Super. Ct. 1995) (holding that, with respect to a prepayment provision that required payment of the contractual premium regardless of whether the prepayment was voluntary or involuntary, the matter was governed by contract law and the parties, as sophisticated participants in a commercial loan transaction, were bound by the provision); Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423, 428 (E.D. Ken. 1992) (holding that prepayment premium providing for payment if indebtedness is accelerated is enforceable as means of insuring the lender against loss of its bargain if interest rates decline); United States v. Harris, 246 F.3d 566, 573 6th Cir. 2001)  (rejecting government's argument that prepayment premium could not be collected because acceleration of the loan was "involuntary" as the result of a criminal forfeiture action; the court noted that the parties expressly provided for the payment of a prepayment premium in the event that the mortgagor lost ownership of the property through acceleration of the loan or foreclosure); MIE Md. Executive Park Gen. Partnership v. LaSalle Nat'l Bank, 2000 U.S. App. LEXIS 11558, No. 99-2066 (4th Cir. May 22, 2000) (unpublished per curiam) (finding that because the parties had bargained for the payment of a prepayment premium, the obligation survived the loan modification where the modification did not did not expressly address the prepayment premium); Westmark Commer. Mortg. Fund IV v. Teenform Asssocs., 362 N.J. Super. 336, 344  ( 2003) ("we can perceive no reason why the debtor should be relieved of the terms of the contract freely entered into," and overruling Clinton Capital Corp. v. Straeb, 248 N.J. Super. 19, 32-33, 589 A.2d 1363, 1371 (1990), which prohibited, on equitable grounds, enforcement of prepayment penalty of 10% upon mortgagee's acceleration of defaulted loan, even though mortgage prepayment provision stated that "[t]he premium shall be paid whether prepayment is voluntary or involuntary, including any prepayment made after any exercise of any acceleration provision . . ."; the court in Clinton Capital stated that "the court construes the word 'involuntary' to mean actions taken by third parties which force the payment of the mortgage prematurely"); MONY Life Ins. Co. v. Paramus Parkway Bldg., Ltd., 364 N.J. Super. 92, 104 (2003) ("We can see no reason why the debtor should be relieved of the terms of the contract freely entered into. The terms were clear and unambiguous, the parties clearly experienced and sophisticated in loan transactions of this type").

Reporter's Comment 4: See also  Restatement (Third) of Property: Mortgages § 6.2 comment c (1997) (permitting collection of prepayment premium upon acceleration of the loan unless found to be "unconscionable or to violate the duty of good faith and fair dealing").

Comment 1: Note that here we had a substantial default interest charge as well as a late payment penalty.

The Reporter for this case was Jack Murray of First American Title Insurance, Chicago office.


4. First Citizen’s Nat’l Bank v. Sherwood, 879 A.2d 178 (Pa. 2005)

RECORDING ACTS; NOTICE; CONSTRUCTIVE NOTICE; INDEXING: Pennsylvania Supreme court rules that “index is not part of the record” in Pennsylvania.  Misindexed mortgages still provide constructive notice.

This case resolves, presumable permanently, the construction of the present Pennsylvania scheme of recording laws.  The court holds that a mortgagee provides constructive notice by properly delivering a proper document for recording, and the fact that the Recorder’s office later misindexes the mortgage, so that it can’t be found by subsequent title searchers, does not affect the priority of the first mortgage against subsequent purchasers.

This decision places Pennsylvania with the majority of jurisdictions that interpret their own recording acts to provide that the “index is not part of the record.”  There is a substantial and respectable minority, however, and many scholars are of the view that making the index part of the record is the best result from a policy standpoint.  They argue that, as between two innocent parties, the party that ought to bear the consequence of the potential error by the recorder’s office is the one in a position to cure that error.  A mortgagee that records its mortgage can later return to the recorder’s office to check the index and, if necessary, to request its correction, in order to be sure that there is proper constructive notice of its claim.  A subsequent purchaser has no ability to correct that which, to it, is as a practical matter undiscoverable.  Therefore, scholars argue, the burden ought to be on the recording mortgagee, and the way to accomplish this is to rule that  a mortgage is not constructive notice if not discoverable in the index.

The court does not pick sides in this policy debate, at least not openly.  It purports simply to interpret the Pennsylvania statute, 21 P.S. Sec. 357, to provide that recording is not necessary.  It states simply that when a a written instrument relating to real property  is recorded, the effect is to give constructive notice to subsequent parties.

The opposing interests, and two judges in dissent, argued that this statute is superceded in application by a more specific statute, 16 P.S. 9853, which states that when a written instrument is indexed, such indexing will be notice to all parties of the recording itself.  The proponents of the “index” view argued that the obvious obverse of this precept is that unindexed instruments to not provide constructive notice.  The dissenting judges noted that this statute appears in a chapter denominated “mortgages” in the statute book, while Sec. 357 appears in a chapter denominated “deeds and conveyances.”    The dissent further argued that chapter 357, because of the location in the conveyancing chapter, applies only to permanent interest in real property.  The majority responded that indeed a mortgage in Pennsylvania is permanent, because Pennsylvania has adopted the “title theory” of mortgages, giving the mortgagee good title to the property itself when the mortgage arises.  Thus, the mortgage should be evaluated by the conveyancing statute’s terms, and in any event Section 357 is much newer and therefore supercedes Section 9853 to the extent that they are in conflict.

Comment 1: Certainly this case is not about statutory interpretation.  The court could easily have interpreted the statutes to require proper indexing.  The majority attempts to reconcile the two chapters before it concludes that one superceded the other.  In fact, they could peacefully coexist if the dissenters’ view was adopted.

This has got to be about policy - and the concern that to make the index part of the record would render all title plants in limbo for a longer period of time as the documents are recorded and then delivered out to the title plants.   The title companies are likely to be the ones who would have been condemned to this limbo, as they’d be expected to insure good title to the property and bear the risk of unrecorded mortgages later popping up.  Unlike ownership or leasehold estates, mortgage holders do not take possession, so there is no opportunity to learn of them except through recording.

Comment 2: The more important aspect of this case is that it reverses, and thus removes from precedent, the absolutely horrible lower court decision, reported as the DIRT DD for 6/30/03.  The decision held that whether or not an misindexed deed ought to provide constructive notice depended upon whether it reasonably could be found through a search of an electronic index - leading to courts to decide on a case by case basis whether a reasonable search was possible.  The injury done to predictability of title was patent in this case, and the editor tap danced all over it.  He is happy to see this decision chase the earlier Sherwood case into oblivion.

Comment 3: Note that the case also eradicates the danger to attorneys who fail to follow up to be sure that indexing did occur, as happened to the Pennsylvania attorney in Antonis v. Liberati, the DIRT DD for 6/18/03, a case whose precedential significance now also vanishes. .   All DD’s can be found on the DIRT website https://e2k.exchange.umkc.edu/exchweb/bin/redir.asp?URL=http://www.umkc.edu/dirt

Comment 4:  Although stated as an opinion of the Pennsylvania Supreme Court, the heading indicates that the opinion is by the "Middle District" of that court, so perhaps this is a small panel, and there may be a further appeal.


5. Gold v. Interstate Financial Corporation (In re Schmiel) 2005 WL 110466 (1/20/05)

BANKRUPTCY; PREFERENCES; REFINANCING:  Rate and term refinance a preference in bankruptcy in Michigan, but not a preference elsewhere.

Interstate refinanced a Wells Fargo loan for the Schmeils. The mortgage was submitted for recording on the day of disbursement, but the Register of Deeds did not "record" the mortgage for three months. The borrowers filed bankrutpcy within 90 days after the recording of the mortgage. The Bankruptcy Court held that there were two transactions - the payoff of the Wells Fargo mortgage, and the granting of the Interstate mortgage. The Trustee in bankruptcy sought to overturn the recording of the mortgage, claiming that this was a preference. The lender claimed that the "earmark"doctrine protected Interstate. Under this doctrine, the borrower never has control over the funds from the refinance transaction, and the new mortgage merely substitutes one creditor for another - the borrower's estate is not diminished.

The Bankruptcy Court agreed with the Trustee, and interpreted the "earmark" doctrine narrowly. The Court held that the doctrine protects Wells Fargo from having to return the proceeds, but it does not protect Interstate:

This Court agrees with the Messamore court's finding that there are two "separate and distinct" transfers at issue in the context of refinancing and granting a new mortgage. Even if the funds paid to Wells Fargo were "earmarked" for Wells Fargo, that does not insulate Interstate from the Trustee's action to avoid the transfer of a mortgage lien to it. The earmarking doctrine simply does not apply to this transfer. There were no funds transferred to Interstate that could be earmarked. The granting of the security interest was not done by a third party, but by the Debtors. The granting of the security interest to Interstate diminished the bankruptcy estate by encumbering the Truwood property and there is a loss to creditors because the non-exempt equity in that property was no longer available for the Trustee to administer for the benefit of creditors. The wire transfer of funds from Interstate to Wells Fargo in paying off the original mortgage is a "separate and distinct transfer," which is not the subject of this adversary proceeding.

The Court concludes that Interstate wrongly invokes the earmarking doctrine. This analysis is consistent with the analysis employed in Bohlen. That court recognized that the beneficiary of the earmarking doctrine is the old creditor, for whom the funds were earmarked, not the debtor, or the new creditor who provided such funds. Bohlen, 859 F.2d. at 565. Whether the policy of protecting the old creditor for whose benefit the funds are earmarked is a prudent policy is not to say. The salient point is that the doctrine, if applicable at all in this case, would operate to protect Wells Fargo, the recipient of the earmarked funds, not Interstate, the creditor who loaned the funds and who received a transfer (i.e., the mortgage) that was not earmarked for it by some third party.  In the final analysis, Interstate asks the Court to rescue it from an untimely perfection of its mortgage by application of the earmarking doctrine to it even though it did not receive any earmarked funds. That is an expansion of the earmarking doctrine. Interstate received no transfer of any interest in property that was earmarked for it. To accept its argument would undermine the requirement to timely perfect its mortgage and would improperly expand the ten day safe harbor that § 547(e)(2)(A) provides to those secured creditors who perfect within ten days after the time that the transfer takes effect between the transferor and the transferee. The ten day safe harbor provision simply would have no meaning if a secured creditor could perfect its interest at any time after the ten days and then depend upon the earmarking doctrine to somehow avoid the operation of the statute when its mortgage was later perfected.  Comment: The Reporter expects this decision to be reversed if appealed. First, the .Bankruptcy Court wrongly assumed that the mortgage was not perfected when it was submitted to the register of deed. Recording occurs when the mortgage is submitted to the register of deeds, not when the register of deeds gets around to indexing the document. In Central Ceiling and Partition, Inc. v. Dept. of Commerce, 683 N.W. 2d 142 (Mich. 2004) the Michigan Supreme Court recognized that a document is deemed recorded when presented for recording. The fact that the register of deeds does not perform its statutory duty does not diminish the perfection of the mortgage. Hence, the Interstate mortgage was "recorded" prior to the preference period.

Second, the split transaction analysis used by the Court is a subterfuge for overturning the "earmark" doctrine. In another recent bankrutpcy case,  Shapiro v. Homecomings Financial Network, Inc. (In re Davis) 318 B.R. 119 (Bkrtcy. E.D. Mich. 12/13/04) (the DIRT DD for 1/7/05), one of the borrowers (the husband) declared bankruptcy within 90 days after refinancing his home mortgage. The bankruptcy trustee could not seize and sell the property owned by husband and wife to satisfy the debts of the husband alone. Hence, the Trustee tried the novel idea to seize Homecomings' loan and sell it to an investor because the Homecomings note was a "preference" under Section 547(b) of the Bankruptcy Code.

The Bankruptcy Court disagreed. The loan proceeds were "earmarked" to pay off the prior lender and, therefore, the loan proceeds were never owned by the husband. If the husband never received the money, the note to Homecomings never reduced the husband's estate, and there was nothing to avoid. The court stated:

"Section 547(b) requires that there be "an interest of the debtor in property". When a third party lends money to a debtor for the specific purpose of paying off a designated creditor, that money is not "an interest of the Debtor in property" and, therefore, is not property of the estate. Accordingly, the transfer of that money cannot be a preferential transfer. Grubb v. General Contract Purchase Corp., 94 F.2d 70, 72 (2d Cir. 1938); Mandross v. Peoples Banking Company (In re Hartley), 825 F.2d 1067, 1070 (6th Cir. 1987); In re Bohlen Ltd., 859 F.2d 561 (8th Cir. 1988). In this case, Homecomings Financial Network loaned money to the Debtor for the specific purpose of paying off the Creve Coeur mortgage, and all of the proceeds did, in fact, go to Creve Coeur. The Debtor received no funds. Therefore, to the extent that the money was used to pay off that mortgage, that money never became property of the estate.  This rule, which was later to be termed the "earmarking doctrine", was originally set forth in Grubb v. General Contract Purchase Corp., 94 F.2d 70 (2d Cir. 1938). In Grubb, the debtor owed the defendant $25,000. The debtor borrowed money from a third party to pay the defendant. The third party made a check out to the defendant, paying him directly. After the debtor went bankrupt, the trustee challenged the payment as a preferential transfer, voidable under section 60 of the former Bankruptcy Act. The Grubb court, in a decision written by Judge Learned Hand, held that the payment was not preferential because the funds did not belong to the debtor because the debtor never controlled the money and the money never became a part of the debtor's assets. Id., at 72. The transaction merely substituted one creditor for another without loss to the estate. See also, In re Bohlen Ltd., 859 F.2d 561 (8th Cir. 1988) (the three requirements that a transaction must meet in order to qualify for the earmarking doctrine are: (1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt; (2) performance of that agreement according to its terms; and (3) the transaction viewed as a whole (including transfer in of new funds and the transfer out of the old creditor) does not result in any diminution of the estate.)"  The Court stated that any cash out received by the borrower could be a preference, but in this case the borrower did not receive any cash from the refinancing.

The court also held that selling the loan to another investor and using the funds to pay off the creditors was inconsistent with the purposes of the Bankruptcy Code. The stipulated order in this case would obligate the non-bankrupt spouse (also a borrower) to pay Homecomings on the loan, even though the bankrupt borrower would no longer be liable on the debt. The Court stated:

"The Court is unsure whether the promissory note to Homecomings Financial Network would still be in effect, thus still binding the Debtor's non-filing spouse to Homecomings Financial Network for the amount loaned. The language of the stipulated Order Resolving Trustee's Objections to Debtor's Amended Exemptions appears to obligate the Debtor under the mortgage regardless of the Trustee's actions. If the Debtor is so obligated, then the non-filing spouse would be liable on the note to Homecoming Financial Network, the property remains encumbered by the original mortgage, and the Debtor and his non-filing spouse could be obligated on additional mortgages. If the language in the stipulated Order Resolving Trustee's Objections to Debtor's Amended Exemptions does not bind the Debtor on the mortgage to Homecomings Financial Network then, after the Debtor receives his discharge, the Debtor would only be liable on the new mortgage but the Debtor's non-filing spouse would be liable on the entire amount owing to Homecomings Financial Network as well as on the new mortgage. These scenarios appear to penalize the Homecomings Financial Network, the Debtor and the Debtor's spouse in ways that do nothing to promote the policies behind §547(b), those being to provide equality of treatment to creditors and to deter a race to the courthouse. Neither of these policies are served in this case by allowing the Trustee to sell the mortgage and note, when the Trustee admits that it cannot sell the real estate. While there might be facts which would justify the court authorizing the sale of the mortgage independently of the sale of the real estate, this case does present such a scenario. Without authority for the Trustee's position, this court finds no reason to step into this quagmire."

This issue is likely to arise again as trustees continue to try creative ways to enlarge a bankrupt borrower's estate.

The Reporter for this case was Howard Lax of Michigan, writing in the Mortgage Banking Newsletter


6. Melendrez v D & I Inv., Inc. (2005) 127 CA4th 1238, 26 CR3d 413

Experienced investor in foreclosed properties, who purchased foreclosed property at significantly below market value, was bona fide purchaser for value.

After the Melendrezes defaulted on their home mortgage payments and foreclosure proceedings were initiated, the Melendrezes entered into a forbearance agreement with their lender. When they missed a payment under the agreement, a trustee sale was noticed and held. The property was sold to a real estate broker, an experienced purchaser of properties at foreclosure sales, for $197,100; the fair market value of the home was between $317,000 and $380,000. The Melendrezes sued the trustee, lender, and buyer to set aside the trustee sale and cancel the trustee deed, alleging that the trustee sale was invalid for violation of the repayment agreement and the lender’s internal policies. Ruling in favor of the defendants, the trial court found that the trustee sale was valid and that the buyer was a bona fide purchaser for value (BFP), and ruled in favor of the defendants.

The court of appeal affirmed. The Melendrezes argued that under the ruling in Estate of Yates (1994) 25 CA4th 511, 32 CR2d 53, the buyer was not a BFP because he (1) was experienced in foreclosure sales and (2) purchased the subject property at less than market value. The court noted the conclusive presumption created by CC §2924 in favor of a BFP and the equitable rationale of protecting those who have invested value in reliance on an honest belief in the validity of the foreclosure proceedings.

The court distinguished Yates as involving a faulty notice of the sale and other indicators to the buyer of irregularities in the sale, and reiterated the trial court’s finding that the buyer in this matter was a BFP because he gave up something of value in exchange for the title to the Melendrezes’ home and had no notice or knowledge of any defect in the proceedings. Furthermore, nothing inherently precludes an experienced foreclosure speculator who pays less than market value from being a BFP, absent a showing of fraud on the buyer’s part.

COMMENT: I can’t blame Miller & Starr for asserting that “a speculator who frequently purchases at foreclosure sales who pays substantially less than the value of the property at a foreclosure sale is not a bona fide purchaser” (4 Miller & Starr, California Real Estate 10:210 (3d ed 2000)) based on their reading of Estate of Yates (1994) 25 CA3d 511, 32 CR2d 53. That really is what Estate of Yates said. I might have made a more cautious statement about it, such as “one court has characterized an experienced speculator who purchased at a foreclosure sale for substantially less than the value of the property as not a bona fide purchaser (BFP), and other courts may be inclined to do the same”—but I, too, read Estate of Yates that way. In any event, the court was certainly not inclined to follow any such interpretation, and has made it clear that there is no blanket rule on this issue. It is now probably closer to reality to say that an experienced foreclosure buyer may or may not be treated as a BFP, depending, in part, on how much its bid was, how much of an increase over the lender’s opening bid it was, and how close it came to market value—plus a lot of other things.

More important, I think, is the court’s holding that even if one is a BFP, the conclusive presumption of the recitals provides only limited help. Under CC §2924, the only recitals in the trustee deed that are conclusive regard mailing, publishing, and delivering copies of notices of default and sale. Although it is not uncommon (or illegal, as far as I can tell) to see trustee deeds that recite more proprieties than that, additional recitals do not come under the umbrella of statutory protection.

Some attacks on foreclosure sales may be based on improper notice, but many others are grounded in claims such as the one presented here, i.e., violation of a promise to wait longer. In those cases, it doesn’t help to be a BFP rather than any other bidder (or even the lender). If the claimed irregularity is covered by a recital to the contrary, there may be a presumption against the irregularity. However, the presumption is not conclusive, and therefore probably will play no role in the litigation. If the irregularity is not within any recital, then it becomes a question of ordinary burden of proof.

This is not an area where lenders, trustees, or buyers can hope to protect themselves or significantly improve their positions via better drafting. On this one, comfort can come only from the legislature.

Reported by Roger Bernhardt  (From CEB California Real Property Law Reporter)


7. Moldo v Charnock (In re Charnock) (BAP 9th Cir Dec. 15, 2004) 318 BR 720

Plain meaning of 11 USC §522(f)(2) requires avoidance of creditor’s judicial lien, even though that lien is senior to consensual lien.

Moldo was appointed state court receiver in the dissolution proceedings of debtor Paula Charnock. In 1996, Moldo recorded an abstract of judgment, covering $56,072 in fees and costs incurred in the administration of the receivership estate. Charnock owned a residence that she refinanced in 2002, paying Moldo $28,000 from the proceeds of the loan; a deed of trust was recorded at that time evidencing the lender’s lien. A year later, Charnock filed for Chapter 7 bankruptcy protection and moved to avoid Moldo’s judicial lien under 11 USC §522(f)(2). The sum of the balance of the refinancing loan plus the amount of Charnock’s homestead exemption exceeded the stipulated value of the property. The bankruptcy court granted Charnock’s motion to avoid the lien.

The appellate panel affirmed. As the court noted, Congress chose among conflicting policies and ultimately favored consensual lienholders over judicial lienholders. The clear legislative intent of the changes to the bankruptcy statute was to override case law holding that a judicial lien could not be avoided if it was senior to a nonavoidable mortgage lien, and the total of all mortgages against the property exceeded the value of the property. Congress deliberately determined that judgment lien creditors would be treated differently from consensual lien creditors. The Bankruptcy Code provision is intended to preempt state law lien priorities that would apply outside bankruptcy; the policy favoring preservation of the homestead exemption does not create a windfall for, or confer a benefit not intended by Congress on, the debtor in a consumer bankruptcy proceeding.

COMMENT: This case involved a judgment lien of about $70,000, a deed of trust of $370,000, and a debtor’s homestead protection of $75,000, against a property valued at only $435,000. The lien, the deed of trust, and the homestead totaled $515,000, or $90,000 more than the worth of the property; at least one of those interests had to suffer.

There is no easy resolution of this issue. The judgment lien is superior to the deed of trust but inferior to the homestead, while the deed of trust is inferior to the judgment lien but superior to the homestead, and the homestead is superior to the judgment lien but inferior to the deed of trust. Everybody is superior to one party and subordinate to another party. It is classic lien circuity!

While this is a hard issue for state courts to resolve (see Bratcher v Buckner (2001) 90 CA4th 1177, 109 CR2d 534, cited in Charnock), it is apparently a slam dunk for bankruptcy courts, since the plain meaning of §522 of the Bankruptcy Code is that the judicial lien may be avoided as impairing the homestead exemption even though the impairment happens only because of the deed of trust, which came after the judicial lien. Put another way: If the debtor had filed bankruptcy before putting a deed of trust on her property, the judicial lien would have been allowed, since at that stage it did not impair her statutory homestead exemption. But if the debtor later encumbers her liened property with a deed of trust, leaving her with less than $75,000 of equity in the property, then to the extent her homestead has been impaired, the prior judicial lien can be avoided.

So, the judicial lien creditor in this situation is the real loser. But who is the winner? The BAP was a little less willing to call that result (it was not before the panel on this appeal), but the judges made their sentiments clear: The winner should be the bankrupt debtor rather than the beneficiary of the deed of trust. The deed of trust is to stay as far below the judgment lien as it always was; the amount avoided enhances the homestead protection instead.

Thus, assuming the property was encumbered by a judgment lien of $70,000 and worth $435,000 when the deed of trust was put on, there was only $365,000 of remaining value to secure the $370,000 deed of trust; it was undersecured by $5000. Avoiding the $70,000 judgment lien could add the missing $5000 to the beneficiary’s security, or it could, as suggested here, add $70,000 to the debtor’s homestead exemption and nothing to the deed of trust. That latter result is not surprising, because that’s what bankruptcy is supposed to be about: protecting debtors even at the expense of their creditors.

It is too bad that the deed of trust beneficiary did not also appeal. Its loan was apparently a refinance, meaning that there was a good chance it could have claimed subrogation rights for the old loan it paid off, which loan probably was superior to the judgment lien. That would have generated a whole different set of calculations.

Reported by Roger Bernhardt (from CEB California Real Property Law Reporter)


8. Mortgage Electronic Registration Systems v. Odita, 822 N.E. 2d 821 (2004).

MORTGAGES; PRIORITY; DEFECTIVE EXECUTION:. Defectively executed mortgage was not entitled to priority over subsequent, properly recorded mortgage.

Eric Odita was the president and owner of Tempest Properties and Management Corporation, the owner of certain real property in Columbus, Ohio.  Odita granted first and second mortgages on the subject property to Labyrinth Mortgage and Investment Company in August of 1998, both of which were also recorded in August of 1998.

Odita signed the second mortgage in his individual capacity, not in his capacity as president of Tempest.  Upon discovering this mistake, the mortgageee rerecorded in September of 1998.  The rerecorded mortgage was executed by Odita in his representative capacity, but his signature was not properly notarized.

The plaintiff Mortgage Electronic Registration Systems (“MERS”) is the holder of this rerecorded second mortgage.  In October of 1999, First National Security Corporation filed a foreclosure action against Odita and the junior mortgagees, and obtained a judgment in June of 2000.  The property was subsequently conveyed to Robinson, and another mortgage was put in place in November of 2000.

In October of 2002, MERS filed a claim for monies, foreclosure, and other equitable relief against Odita and the other mortgagees, which was later amended to add Tempest and others.

The trial court held that MERS was entitled to summary judgment based upon both defendants’ actual knowledge of the MERS mortgage and upon equitable subrogation.  Defendant-appellants argued that (1) the defectively executed mortgage was not entitled to record; (2) mortgage lien priority in Ohio is determined by looking to the first properly executed and recorded mortgage; and (3) the trial court erred in allowing reformation of the defectively executed mortgage where plaintiff-appellees never plead reformation nor any facts relative to mistake in accordance with Ohio Civil Rule 9(b).

The appeals court, citing Citizens National Bank v. Denison, 133 N.E. 2d 329 (1956), held that the recording of a defectively executed mortgage does not establish lien priority over subsequently recorded properly executed mortgages, and that there is no need to read into Citizens Bank (as the trial court did) an exception to that rule in cases of actual rather than constructive notice.  The court also held that reformation was inapposite in this case, because the purpose of reformation is to change an instrument so that it expresses the actual intent of the parties as to the contents of an instrument, not to validate an invalid instrument.  Delfino v. Paul Davies Chevrolet, Inc., 209 N.E. 2d 194 (1965).  The lower court’s award of summary judgment was reversed and the cause remanded.

Comment 1: Note that, for mortgages, Ohio maintains a “pure race” system.  Thus, although the later recorded mortgagee had actual knowledge of the prior mortgage, it still had priority over the prior mortgage is the prior mortgage had not been properly recorded.

Comment 2: I asked Dale Whitman, co-reporter of the Restatement of Mortgages and co-author of a leading mortgage treatise, to comment on this one.  Here are Dale’s comments:

When I first read this opinion (which was several weeks ago), I was initially outraged by it, since it seemed to disregard notice issues entirely.  But then I remembered something that caused me to calm down: Ohio has a pure "race" recording statute for mortgages (though not for other types of conveyances).  In other words, in Ohio an unrecorded mortgage is ineffective against any subsequent purchaser, whether the subsequent purchaser paid  value, or had notice of the mortgage, or not.  Notice is  simply irrelevant.  This is obviously contrary to the way the issue of recordation is treated in most states, and for most types of conveyances in Ohio, but it is the law.

I don't know that it's such a bad law, either.  We do waste a lot of time litigating issues of constructive and inquiry notice in most states, and the beauty of a pure "race" statute is that it completely eliminates that inquiry.  Either the mortgage is recorded or it's not.  If it's not, it's void as against any subsequent taker of any interest in the property.  The recording statute in Ohio is quite clear on this point.

On the other hand, do I agree with the notion that a defectively acknowledged mortgage should be treated as unrecorded?  That's by far the majority view, but in this case, the fact that the acknowledgement was defective was subject to debate.  What apparently happened (the court is not crystal clear on the facts) is that the notary used the wrong form of acknowledgement when Odita acknowledged the second version of the mortgage -- they used a corporate acknowledgement form when Odita had signed the mortgage individually, and not as an officer of the corporation.  (It seems to me that he should have signed as a officer of the corporation, since title to the land was held by the corporation, but the court doesn't seem to think that this error, if it was an error, is relevant.)

If my understanding of the facts is correct, then it is true that the acknowledgement was technically defective (since it didn't agree with form of the signature), but it was a sort of chicken-feed defect,.  After all, Odita did sign the mortgage and did appear before the notary.  There is not the slightest suggestion of fraud or forgery.  I would have preferred the court to hold that, despite the technical defect, the mortgage was sufficiently acknowledged to be validly recorded.  Otherwise, the penalty on the mortgagee for allowing a minor error to occur is rather Draconian.

Comment 3: Then I asked Roger Bernhardt to comment.  Roger is the dean of mortgage commentators in California.  Here are Roger’s thoughts:

I like race statutes, and so does the UCC, which provides a nice source of authority to answer questions like these.

If Ohio's recording act really is pure race for mortgages, then MERS should win if its mortgage was recorded, and it should lose if it wasn't. What the other parties knew wouldn't matter (and shouldn't matter, since that only invites perjury).

Was this mortgage recorded? It was 1) delivered to the right office, as many statutes require, and 2) it got placed in the records and 3) was properly noted in the right index, as a lot of other statutes require, but 4) the notarial seal wasn't the way some other statutes require. It depends on how you define “recording.”

How you define recording ought to depend on what your system's goals are. A race system should protect B as first to record even when he knows that nonrecording A took first, so should the same be true where A did record first, but did so defectively?  I think its meaningless formalism to say A did not record if he is in the records, and I say so for race purposes, and even though notice is not a part of the statute.

Race statutes contain an implicit notice component.  The real policy reason for letting first recording A win in a race state is  that by being in the records for B to see, B can avoid harm by searching and then declining to proceed when he does see A. Conversely, If B cannot see A in the records, A should be deemed to have not recorded. And conconversely, if A is there enough to be seen (like an adverse possessor being open & notorious), then A should be deemed to have recorded, even if there is something slightly wrong in the way he did it, if B can see it.

That is an objective test that doesn't depend on anybody's testimony.  If a standard search of the records should turn up the mortgage, then it should be deemed recorded.

Article 9, which is about as tough as you can get in favor of a pure system, says a minor error does not ruin a filing unless it makes the financing statement seriously misleading, and that that depends on the office's search logic.  Under any search logic, a notarial seal is what a searcher sees last, so its absence ipso facto cannot be seriously misleading. Searchers ought to be able to stop their search (even though the news is bad), without having to go on to study the notary stamp after they read the document, and filers shouldn't have to go back to their prior recordings to double check that each detail was done right.


9. NAB Asset Venture III, L.P. v. Brokton Credit Union, 815 N.E. 2d 606  (Mass. App. 2004)

MORTGAGES; PRIORITY; SUBORDINATION: First lienholder's agreement to subordinate its interest to a junior lienholder is not an agreement to  subordinate to future advances subsequently made pursuant to a future  advance clause in the junior lien.

In the 1960's Borrowers gave a mortgage to  BCU securing a $10,000  indebtedness.  In 1980, Borrowers gave a second mortgage to MBTC  securing  $180,000 note and certain obligations under a guarantee of  another mortgage loan.

In 1984, Borrowers desired to increase their mortgage indebtendness to  BCU, and apparently MBTC had an interest in cooperating by subordinating  the MBTC mortgage to a new BCU mortgage.  MBTC subordinated its 1980  mortgage to BCU's 1984 mortgage.

The 1984 BCU mortgage secured a note for $66,000 and "all other direct  and contingent liabilities of the Mortgagor hereof to [BCU] whether now  existing or hereafter contracted."  The court describes this clause as a  "dragnet" clause.  Although, two decades later, an MBTC loan officer  testified in deposition that it was not MBTC's intention to subordinate  to the "dragnet" clause, it produced nothing in writing documenting that  claim.  (The case was decided on summary judgment, so we have no record  to speak of).

Later, another lender, Shawmut, also took a mortgage from Borrowers, and  thereafter, in 1989, Borrowers also gave an additional mortgage to BCU,  securing a revolving credit agreement, and Shawmut subordinated to that.  (Such cooperative lenders!!!)

Guess, what?  Borrower eventually defaulted, MBTC foreclosed, obtained  title at the sale, and then sought declaratory relief that its lien was  subordinate only to the face amount of the $66,000 note secured by the  1984 BCU mortgage, and not to advances made by BCU thereafter.

The court agreed - on summary judgment no less.   The court began by saying that Massachusetts law generally favors the  borrower's position on dragnet loans, refusing to grant secured status  to subsequent advances unless those advances are "generally related" to  the original debt or the intent of the debtor otherwise is clear  that  these advances are secured by the original mortgage.  This is consistent  with common law in many jurisdictions.

Here, however, the question before the court was not the protection of  the debtor from overreaching by the lender, but a priority dispute  between two lenders.  The court acknowledged that, as against other  lenders, advances made pursuant to a "dragnet" or "future advances"  clause are generally held validly secured with priority  when they occur  before  the attachment of the other lenders' liens.  But where a lender  or another party obtains an interest in the security before  the making  of an advance by the original "dragnet" lender, Massachusetts courts are  more circumspect, apparently even where it is clear that the borrower  intends that the earlier mortgage will secure the new advance.

The court says that the future advances clause will not provide priority  to the original lender as to advances made after another party has  obtained an interest in the property.  The subsequent interest will  "prime" the lien for the later additional advances.   Interestingly, the  court does not say whether the rule is true both for optional advances  made by the first lender and "obligatory" advances - those made pursuant  to a binding commitment to lend (such as lines of credit or many  construction loans.)  The distinction is not significant here, since the  new loan made by BCU in 1989 appears to have been "optional."

The general common law rule (now disputed by the Restatement of  Mortgages) is that optional advances do not enjoy the original priority  of the future advance mortgage as against known subsequently arising  interests attaching prior to the optional advance, but that "obligatory"  advances do enjoy that original priority.  The editor suspects that the  Massachusetts is just acknowledging that rule here, although it doesn't  mention the "optional/obligatory" distinction.

But the application of the traditional common law rule to the instant  case is still a little problematic, because MBTC's lien was not  "subsequently arising," but rather arose prior to the original future  advances clause and became a junior priority interest pursuant to a  subordination agreement.

The court, however, concluded that the narrow reach typically given to  future advance clauses as against junior interests mandated that the  intent of any attempt to subordinate by a future advance loan be read  very narrowly.  Unless the parties clearly indicate their intent that  the subordination is valid as to the "dragnet" feature of the prime  loan, the court will not infer an intent to subordinate.

Comment: The purpose of the "optional/obligatory" distinction usually is  said to be to preserve the "mortgageability" and transferability of the  property for the debtor by preventing the original dragnet lender from  tying up the property with a monopoly on the security value in the  property

But is that purpose served by protecting MBTC here?  Note that any other  lender, buyer, lessee, or dogcatcher was free to obtain an interest in  the property that would prime the lien of any advances made by BCU.  There really was no concern that the Borrowers' property was tied up in  any significant way by honoring the priority of the BCU lien.

MBTC and BCU were commercial parties engaged in complex and technical  arrangements.  They deserved to have their agreements given the meaning  expressed by their language.  There is no supervening policy here that  should outweigh commercial predictability.  The logical meaning of its  subordination to the BCU mortgage was that MBTC was subordinating to all  the rights of that mortgage.  Unless contemporaneous documentation or  similar evidence indicated that the parties placed a different meaning  on the subordination agreement to which they openly agreed, what benefit  is served by denying to BCU its legitimate expectation that future  advances it made primed the MBTC lien?

The case is wrongly decided.  We're not dealing with widows and orphans here.  If MBTC had a different intent than that expressed in the subordination agreement, it should have had the burden of clarifying  that intent.


10. Sensenich et al. v. Molleur (In re Chase), 2005 WL 1880784 (8/2/05)

BANKRUPTCY; FRAUDULENT CONVEYANCE; STRICT FORECLOSURE: A strict  foreclosure will be analyzed like a deed in lieu of foreclosure to  determine whether reasonably equivalent value has been received by the  debtor in exchange for the cancellation of the debt, and a court will  review all the facts an circumstances in determining whether such value  existed.

The Bankruptcy Court had previously determined as a matter of law that  compliance with the Vermont strict foreclosure process does not create a  presumption of "reasonably equivalent value" and that a transfer  effectuated under the strict foreclosure process may be avoided in the  absence of "reasonably equivalent value"  Sensenich, et al. v. Molleur  (In re Chase), 2005 WL 189711, January 27, 2005).   In that case, the  Bankruptcy Court determined that the property had a value of $151,200 on  the transfer date, while the outstanding debt was $110,927.64 (In re  Chase, 2005 WL 280436,  February 3, 2005).

In the most recent skirmish in the dispute, the Bankruptcy Court ruled  finally that the debtor did not receive "reasonably equivalent value"  when the property was transferred to the lender through strict  foreclosure and that transfer therefore constituted a fraudulent  conveyance.  The decision hies back to case law that once was at the forefront of every real estate lawyer's thinking, but has now passed  into dusty memory.

In 1994 (yes, 1994) the Supreme Court decided in B.F.P. v. Resolution  Trust Corp., 511 U.S. 531, that the price obtained at a regularly  conducted foreclosure sale complying with state law was conclusively  presumed to provide "reasonably equivalent value" for bankruptcy law  purposes.  This decision appeared to put to rest a seething dispute in  the lower courts on the question, which had generally been referred to  as "the Durrett issue, name for the case that seemed to be at the center  of the dispute, Durrett v. Washington Nat. Ins. Co., 621 F.2d 201  (1980). (Can these cases possibly be so long ago?)  Durrett had held  that fraudulent conveyance analysis did apply to foreclosure sales, and  touched off a storm of application and interpretation.  What emerged as  the "Durrett benchmark" rule was that "reasonably equivalent value"  meant 70% of the fair market value as determined by the court.  But  other courts demurred, concluding that courts should look at all the  facts and circumstance s.  Foremost in this group was In re Bundles, 856  F.2d 825 (7th Cir. 1988).  Another demurring court found that Durrett  was simply wrong when applied to a regularly conducted foreclosure  auction and that such auctions ought to be treated as producing a  "reasonably equivalent value."  In re Madrid, 21 B.R. 424 (9th Cir. BAP.  1982), (aff,d on other grounds 725 F.2d 1197 (9th Cir.)

Ultimately, as noted the Supreme Court apparently put all this  controversy to rest, but the Court, in the B.F.P. case noted that it was  reaching no conclusion as to circumstances in which a public sale had  not been used to sell the property.

Taking its cue from this exception in B.F.P., the court used  a  bifurcated approach to resolve how the Vermont strict foreclosure  process fit within the fraudulent conveyance statutes. It noted that  Connecticut was the only other state using strict foreclosure, and that  bankruptcy courts in that state had split on whether strict foreclosures  could be presumed to return reasonably equivalent value.  This court  opted to conclude that there was no such presumption, and further  rejected the notion that a "benchmark" ratio test ought to be used.  Instead, it embraced the Bundles notion that all facts and circumstances  ought to be studied.  Reviewing, therefore, all the facts in this case,  th e court concluded that the transfer arising out of the strict  judicial foreclosure process was fraudulent.

The Trustee was entitled to either avoid the transfer under 11 USC  Section 548, or under Vermont law.  As an alternative to the order  avoiding the transfer authorized by federal statute,   the Trustee under  Vermont law could obtain a money judgment for the difference between the  debt and the value of the property(see 9 VSA Section 2292). That's what  the Trustee sought here.   The Court held the transfer to be fraudulent  and awarded the Trustee a judgment against the Defendant in the amount  of $40,272.36.

Comment 1: Of course, what makes the case interesting is that the U.S.  Supreme Court had already eliminated the Durrett analysis with respect  to most state law foreclosures in the famous case of In re BFP. , where,  basically (and not without controversy) the Court ruled that a  foreclosure auction carried out in accordance with state law was deemed  to return to the debtor "reasonably equivalent value."  Of course, where  there is no auction, there is less reason to conclude that the process  provides the necessary safeguards to protect value.

Comment 2: On the other hand, Vermont practitioners might well be able  to demonstrate how the strict foreclosure process, in practice, is  hedged about with sufficient procedural limitations that it is rare, if  ever, that any forfeiture of value is suffered.  Without looking, the  editor suspects that the courts involved in a strict foreclosure have  discretion to order a foreclosure by sale where there is in fact danger  that excess value will be lost.   Even in a judicial foreclosure  process, there is going to be some slippage, and arguably judicial  supervision of a strict foreclosure sale provides just about the same  level of protection that a debtor might get in a judicially supervised  auction, and probably more that the debtor might get in a private power  of sale auction.

Comment 3: As the case here applies as well to deeds in lieu of  foreclosure, and abandons the 70% rule in favor of a Bundles test,  practitioners need to take this case into account in evaluating the deed  in lieu option.


11. Sherwood Partners, Inc. v Lycos, Inc. (9th Cir 2005) 394 F3d 1198

 

Bankruptcy Code preempts California statute empowering debtor-selected assignee to void preferential transfers that could not be voided by unsecured creditor.

Thinklink Corp. contracted to pay Lycos $17 million to exclusively promote Thinklink’s service on Lycos websites for a two-year period. When Thinklink defaulted on a payment, Lycos continued to display links to Thinklink’s messaging service. The parties renegotiated their contract, with Thinklink promising to pay $1 million plus stock for a truncated exclusive promotion period of 90 days. Thinklink paid the $1 million but never delivered the stock. Two months later, Thinklink made a voluntary general assignment to Sherwood Partners for the benefit of creditors. Sherwood shut Thinklink’s business operations down and sued Lycos in state court under CCP §1800, alleging that the $1 million was a preferential transfer that Sherwood was entitled to recover. Lycos removed the matter to federal court and moved to dismiss on grounds that the Bankruptcy Code preempted §1800. The district court denied Lycos’s motion to dismiss and granted Sherwood’s motion for summary judgment.

The Ninth Circuit reversed. The court explained that the resolution of the case depended on whether the power to invalidate preferential transfers under §1800 (1) is incorporated into or (2) can coexist with the Bankruptcy Code. The court rejected Sherwood’s argument that the assignee’s special avoidance powers are incorporated into the Code by 11 USC §544(d), which allows unsecured creditors to void preferential transfers. The court pointed out that Sherwood’s role is to represent present creditors—it is not itself a creditor—and ruled that Congress did not intend the term “creditor” to apply to assignees. In determining that §1800 cannot peaceably coexist with the Bankruptcy Code, the court found that §1800 purports to perform one of the Code’s major goals—equitable distribution of a debtor’s assets among competing creditors—but does so by means of a system under state, not federal, control. Unlike the bankruptcy trustee, who is affiliated with the federal court, a state assignee like Sherwood is actually selected by the debtor, giving rise to the potential for conflicts of interest. The court concluded that because funds recovered under §1800 cannot later be recovered under the Bankruptcy Code, Sherwood’s authority under §1800 to invalidate preferential transfers is inconsistent with the bankruptcy system and is therefore preempted.

COMMENT: I decided I needed bankruptcy guidance on this case, so I turned to Jim Stillman to learn more. Mr. Stillman is a shareholder at Ellman Burke Hoffman & Johnson, in San Francisco, where he specializes in bankruptcy and work-out matters. He is a member of the American Bankruptcy Institute and was elected to the American College of Real Estate Lawyers in 1993. Roger Bernhardt

RB: Jim, do you think this decision marks the death of assignments for the benefit of creditors?

JS: Yes and no: Its explicit holding does not appear to do that, because these “general assignments” involve more than merely undoing preferences. On the other hand, the rationale for the majority opinion is so overbroad as to suggest otherwise.

RB: It sounds like you think the court went further than it had to.

JS: According to the opinion, the Bankruptcy Code preempts CCP §1800 (which gives an assignee selected by the debtor the power to void preferential transfers that could not be voided by an unsecured creditor) because §1800 may impermissibly “sharpen or blunt” the incentives of parties to file bankruptcy, and Congress did not mean for bankruptcy incentives to be disrupted by state law. If that is the logic underlying bankruptcy law preemption, then we should do away not only with general assignments, but also with much of state law that resolves competing commercial claims, thereby sharpening or tempering—at the level of incentive or motive—the desire of such claimants to file bankruptcy.

RB: How have general assignees been able to survive as rivals to bankruptcy trustees for so long?

JS: Prior to the Bankruptcy Reform Act of 1978, general assignees found that the opaque and quixotic nature of bankruptcy practice enabled them to offer their services as a cheaper and more certain or controllable alternative. The Reform Act made significant changes to bankruptcy law and practice, one of them being that existing management could continue to operate businesses in Chapter 11. This change alone made bankruptcy a far more palatable option and broke up the small, exclusive bankruptcy bar that had run the show for the previous hundred years.

Use of the general assignment survived the enactment of the modern Bankruptcy Code because of certain perceived benefits for a company facing liquidation:

The troubled company selects the assignee (as opposed to having a Chapter 7 trustee appointed from the panel), with the likelihood that a privately selected assignee will be more suited to the particular company in liquidation and/or considerably less expensive to employ.

The procedure allows for a claims bar date, so that the liabilities against the company can be determined and cut off.

A sale of the company’s assets can be accomplished without unsecured creditor consent.

The proceeds of the sale are distributed pro rata.

A general assignment is not an alternative to a Chapter 11 reorganization. The statutory scheme for general assignments includes none of the powers of recomposition of claims and reorganization of interests set forth in 11 USC §1129. A general assignee can sue, as a representative of creditors, to recover fraudulent transfers (as can any individual creditor) and can also sue to recover preferences.

RB: But I thought preferences were lawful under state law.

JS: They are. Civil Code §3432 says: “A debtor may pay one creditor in preference to another, or may give to one creditor security for the payment of his demand in preference to another.” So a distressed company or individual may freely choose to pay back some creditors and not others. Such payments usually are not considered fraudulent transfers—about which an unpaid, “unpreferred” creditor could complain—because the antecedent debt satisfied by the payment can constitute fair consideration. See CC §3439.04. Under 11 USC §547(b) and §1800, the preference may be recovered, generally during a reach-back period of three months, with a nine-month extension for insider preferences.

RB: Were you surprised at the outcome of the case?

JS: Yes. The Bankruptcy Code refers to the existence of general assignments and makes provision for them—primarily, that the assignee under a general assignment arising more than 120 days before the commencement of a bankruptcy case need not turn over property to the trustee. The dissent cited considerable federal case law and legislative history showing congressional approval of general assignments. But the majority said that by giving assignees greater avoidance powers than individual creditors, our general assignment laws “trench too close upon the exercise of the federal bankruptcy power.” 394 F3d at 1205. The majority explained:

If an assignee recovers preferences, it may become impossible for a bankruptcy trustee to do so; and the existence of such a state law alternative will affect incentives for using federal bankruptcy law.

But I wonder about saying that states are preempted from giving any persons bankruptcy-type powers. All the powers vested in a bankruptcy trustee are important; a bankruptcy trustee is vested with all the powers necessary to operate a distressed business. Does that mean that Congress intended no one else to do so? State courts appoint receivers to operate partnerships and corporations in dissolution, and they are empowered to schedule claims and make payments pro rata where the stock of the corporation is insufficient to make payment in full. In state practice, receivers are typically immune from being sued without leave of court being first obtained, much as the automatic stay of 11 USC §362(a) protects the bankruptcy trustee. Sherwood Partners’ reasoning thus could apply to receivers as well as assignees. Might all state-law creditor enforcement remedies of every stripe, including attachment and foreclosure, be preempted on the basis that bankruptcy is an alternate forum for the satisfaction of creditor claims?

RB: Might some of the motivation for this holding be premised on a distrust of assignees?

JS: Certainly, some insolvent companies have hoped that their assignees would direct less attention to the recovery of preferences (and fraudulent transfers) from insiders—for example, fat “management retention” salaries or dividends that, in retrospect, look improvident or ill-timed—and less attention to avoidance in general. Preference recovery is a nasty business on any front; from the preferee’s point of view, the avoidance is grossly unfair and a remedy that does not respond to immoral or wrongful conduct. But that still leaves open the question whether the exclusive powers of Congress to establish “uniform laws on the subject of Bankruptcies” (US Const art I, §8) should preempt a state-law creditor remedy because the remedy may be wielded unfairly. The purpose of the Bankruptcies Clause is not to police fair treatment of claims under state law. See, e.g., Butner v U.S. (1970) 440 US 48, 59 L Ed 2d 136, 99 S Ct 914 (bankruptcy law defers to state law for definition of claims).

RB: So how do you think the line should be drawn?

JS: What the majority struggled with in Sherwood Partners is the difficulty of identifying, from the host of state-law debtor/creditor statutes, those key operations that belong intrinsically and exclusively to the uniform practice of bankruptcy. A discharge is such an operation; both the majority and dissent acknowledged that no state law may provide for it. But many other legal operations are not—e.g., barring of future claims after adequate notice (even though it is a procedure every bit as important to bankruptcy as the avoidance of preferences); winding up of a corporation; pay-out to claimants of equal rank pro rata from a common fund; and, I submit, avoidance of offending transfers, since some states allow individual creditors to recover preferences while others, such as California, do not.

If there is a key bankruptcy operation embedded in California’s general assignment scheme, I think it is the appointment by the debtor of a representative imbued by statute with a power to attack creditors who would, in the absence of such appointment, otherwise be immune. Identifying extraordinary representation—i.e., the installation by the debtor of a representative with extraordinary powers—as the key bankruptcy operation embedded in our general assignment law would avoid the need for discussing motive, statutory incentives, potential for unfairness as applied, or the academic overlapping of powers. A more clearly defined search for key bankruptcy operations would have drawn the court into the important current debate over whether certain core bankruptcy law principles govern application of the Bankruptcy Code—for example, in the case of solvent debtors. “Extraordinary representation” may be inextricably identified with such core principles, and the question deserves disciplined analysis.

Reported by Roger Bernhardt (From CEB Real Property Law Reporter)