The Trustee’s Power to Avoid a Mortgage Lien and Sell the Debtor’s House (Part One)
By John Lee

The next three blogs will be on discussing the Trustee’s power to sell a debtor’s home and the use of exemption law to protect the home. Specifically, I will be discussing three (3) cases: In re: Traverse out of the First Circuit Court of Appeals; The Fourth Circuit’s Court of Appeals decision Reeves v. Calloway; and the U.S. Supreme Court’s decision in Schwab v. Reilly.

The First Circuit Court of Appeals held in the Case In Re: Virginia A. Traverse that a Trustee could not sell the debtor’s primary residence after the trustee avoided a first mortgage when the debtor’s homestead exemption exceeded the value of of the property and the debtor was not behind on her mortgage payments.
Virginia Traverse owned a house in Massachusetts at the time she filed for bankruptcy worth approximately $223,500.00. At the time of filing she had two mortgages, but the first mortgage never recorded their deed with the State Deed Registry. Massachusetts allows for a $500,000.00 homestead exemption. The mortgages and validly claimed homestead exemption far exceeded the value of the home.
Upon her filing bankruptcy, the Trustee filed a Complaint to Avoid the unrecorded lien against the property and to preserve it for the bankruptcy estate. Traverse argued that even if the Trustee could avoid and preserve the lien for the unsecured creditors, he could not sell the house because he stood in the shoes of the secured creditor and the secured creditor did not have the right to sell the property until the debtor defaulted on the monthly installment payments.

Generally speaking the Trustee does have the power to avoid an improperly perfected lien and preserve the value of the lien for the benefit of the unsecured creditors. The reason he specifically has the right to preserve the value of the lien for the unsecured creditors is so the junior lien holders don’t reap an undue benefit from the mistake of the senior lien holder. Also, the debtor can not claim as exempt pursuant to her homestead exemption the newly found “equity” as a result of the Trustee avoiding the lien.
The debtor agreed that the Trustee could avoid the lien and that the value of the lien was to benefit the unsecured creditors not increase her homestead or benefit the formerly secured creditor. Her argument was that when the Trustee avoided the lien he stood in the shoes of the former secured creditor and since the formerly secured creditor did not have the right to sell the property until the debtor defaulted on the payments neither did the trustee. The debtor argued that the Trustee was limited to selling the secured interest, not to selling the property itself.

The Bankruptcy Court ruled in favor of the Trustee granting him the right to sell the property. The First Circuit Court of Appeals overturned and sided with the debtor stating that the Trustee could not sell the property because the debtor had not defaulted on the mortgage.
The Court of Appeals found that a Trustee can not sell property when the value of the property is less than the homestead exemption. The Court found that the Trustee has the power to avoid liens and apply the value of those liens to the bankruptcy estate for the benefit of the unsecured creditors. The court found that the Trustee did not argue that he could sell the property in the position of the formerly secured creditor because the formerly secured creditor had no right to sell because there was no default. The court found that the trustee did not argue that he could free up equity in the property by removing the lien because the debtor’s homestead exempted all equity.

The Trustee argued that the The U.S. Supreme Court Case Schwab v. Reilly holds that a debtor’s exemption is for a monetary interest in a property, not in the property itself therefore the debtor could only exempt the equity above and beyond the value of the secured liens. The Court of Appeals distinguished Traverse from Schawab v. Reilly on the grounds that Traverse’s homestead exemption far exceeded the entire value of the home therefore the property itself was exempt, not a just a monetary portion of the property. The court found that, in Massachusetts, when an exemption exceeds the value of the asset the asset itself is exempt, not just the monetary value of the exemption in the asset.

Ultimately, in Traverse the debtor is able to keep her home and the Trustee is free to sell the first mortgage interest to another creditor. Presumably, as long as she keeps paying her mortgage payments she will keep her home. The First Circuit may have ruled differently if (1) the debtor was behind on her mortgage payments; or (2) if the house were more valuable than her allowed homestead exemption.

The Traverse decision is not binding law in the Eastern District of Virginia or the Fourth Circuit. In next week’s Blog, I will discuss the Fourth Circuit ‘s Calloway decision where a Trustee was permitted to sell the debtor’s house which was also fully encumbered by perfected liens and protected by a homestead exemption. Does the Calloway decision lead to split between the Circuits, or is something else a play? Check out my Blog next week to find out.

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