The Sixth Circuit Bankruptcy Appellate Panel handed down a decision that seems at first to be inequitable and wrong. On closer inspection, however, the opinion looks correct and fair. It shows that a discharged debtor must invoke the proper remedy to address an unperfected lien and should do so before the lender wakes up and records the mortgage.
The facts lend themselves to a marvelous final exam question in an advanced bankruptcy seminar.
The Unrecorded Mortgage
In their chapter 7 petition in 2004, the debtors scheduled a second mortgage on their home as a secured claim. The couple received their discharges, not knowing that the lender failed to record the mortgage until three months after they filed bankruptcy. Recordation occurred about a month before the discharges were granted and thus apparently violated the automatic stay.
The debtors allegedly paid the second mortgage about two years after bankruptcy and then stopped. More than 10 years after bankruptcy, the lender initiated foreclosure in state court. The foreclosure court concluded that the second mortgage was valid and enforceable. Immediately before the foreclosure sale, the wife filed a chapter 13 petition and soon initiated an adversary proceeding to avoid the lien under Section 544(a).
Not deciding the question of lien avoidance, the bankruptcy court ruled that the lender was an unsecured creditor at the time of the first bankruptcy and that the debt had been discharged. In substance, the bankruptcy court believed that there was no valid lien because there was no debt to which the lien could attach. The bankruptcy judge therefore ruled that the foreclosure judgment violated the discharge injunction and was void.
The Two BAP Opinions
Relying on the Rooker-Feldman doctrine, the lender appealed and won, in a majority opinion for the BAP written on July 3 by Bankruptcy Judge Guy R. Humphrey of Dayton, Ohio. Believing even more strongly in the applicability of Rooker-Feldman, Bankruptcy Judge Tracey N. Wise of Lexington, Ky., concurred in the judgment.
Named for two Supreme Court decisions, the Rooker-Feldman doctrine stands for the proposition that federal courts lack subject matter jurisdiction to review judgments by state courts. More colloquially, it means that someone cannot appeal a state court judgment in federal court.
For himself and Bankruptcy Judge C. Kathryn Preston of Columbus, Ohio, Judge Humphrey dissected the ruling by the state court and, in substance, examined whether it was right or wrong. Presumably, Judge Humphrey was attempting to determine whether the state court’s judgment was void or simply wrong, because the Sixth Circuit had held that Rooker-Feldman does not bind a federal court when the state court judgment is void, as opposed to incorrect.
Judge Humphrey recited the black letter rule that liens ride through chapter 7 unaffected. Because the lien had not been avoided in the first bankruptcy, he concluded that it remained valid against the debtor, although it would not have been enforceable against third parties until it was recorded.
He also said that the discharge injunction in Section 524(a)(2) did not void the debt, it only barred actions to collect the debt as a personal liability of the debtors. Since the state court did not enter a judgment against the debtors personally, the foreclosure court therefore could enter an in rem judgment of foreclosure against the property without violating the discharge injunction.
Concluding that the state court judgment was not void, the majority reversed the bankruptcy court with directions to dismiss the adversary proceeding for lack of subject matter jurisdiction under Rooker-Feldman. In essence, the majority believed that the bankruptcy court erred in overruling the state court about the validity and enforceability of the mortgage lien. The BAP also appeared to conclude that the state court was right on the merits and the bankruptcy court was wrong.
The treatment of the automatic stay violation merits attention. Although recording the mortgage during the pendency of the automatic stay in the first bankruptcy was in violation of Section 362(a), the BAP majority said it didn’t matter because the lien had become valid against the debtors the instant they signed the mortgage long before bankruptcy. Lack of recordation, in other words, made no difference in terms of the enforceability of the mortgage against the debtors. Therefore, violation of the automatic stay evidently afforded the wife no relief in her second bankruptcy.
Concurring with the lack of subject matter jurisdiction, Judge Wise saw no occasion under Rooker-Feldman for the majority to have analyzed the merits of the state court’s in rem judgment, since the state court did not impose personal liability.
The focus of both BAP decisions was on the Sixth Circuit’s Hamilton v. Herr (In re Hamilton), 540 F.3d 367 (6th Cir. 2008), an instructive opinion on Rooker-Feldman in the bankruptcy context. In Hamilton, a state court held the debtor personally liable on a discharged debt. Rooker-Feldman did not apply, the appeals court said, because the state court judgment was void since it attempted to modify the discharge.
In the eyes of all three judges on the BAP, Hamilton was not applicable to void the state court foreclosure judgment since the state court did not hold the debtors personally liable on a discharged debt. The state court only enforced in rem rights against property.
The BAP opinion suggests that a lender can record an unperfected mortgage after discharge without violating the discharge injunction. In this case, though, the lender recorded the mortgage before discharge, thereby arguably violating the automatic stay. The opinion does not discuss whether the recording of the mortgage was void in some contexts, thus making Rooker-Feldman possibly inapplicable if the debtors or their trustee in the first bankruptcy were proceeding under another theory.
How Did an Unperfected Lien Survive Two Bankruptcies?
So, what went wrong from the debtors’ perspective? The lien of the second mortgage surely could have been avoided in the first bankruptcy. Did the debtors make a strategic or procedural mistake? Or were the debtors simply not entitled to relief in a new bankruptcy?
In bankruptcy court, the judge rested his decision on the unenforceability of the lien under state law, perhaps because there were no grounds for using avoiding powers in the second bankruptcy to avoid a lien that should have been attacked in the first bankruptcy. Although the postpetition recordation of the mortgage was an unauthorized postpetition transaction that likely could be set aside by the trustee in the first bankruptcy under Section 549(a), the debtors may not have had standing to pursue that remedy.
Arguably, the debtors could have reopened the first bankruptcy and they or the trustee could have moved to avoid the second mortgage lien under Section 544 for being unperfected at the original filing date. Since the couple needed to enjoin the foreclosure quickly, the wife may have filed the chapter 13 petition to obtain an immediate injunction since they may not have had time to reopen the prior bankruptcy and obtain an injunction before the sale. Also, they may have made a mistake by defending the foreclosure suit on the merits regarding the enforceability of the mortgage rather than reopening the first bankruptcy to avoid the lien.
However, it’s not certain they could have avoided the lien since the first bankruptcy was 10 years earlier. The violation of Section 362 during the pendency of the automatic stay might have gained more traction if the initial bankruptcy had been reopened.
Perhaps the couple should have filed the chapter 13 petition and simultaneously reopened the first bankruptcy, thus subjecting themselves to the objection that they could not have two bankruptcies pending simultaneously.
On the other hand, avoiding the mortgage in a reopened bankruptcy may have ended up benefitting only the trustee and creditors by allowing the trustee to preserve the lien for the estate, and to sell the property with no recovery for the debtors if they had already used up their exemptions.
The debtors may have been aiming for a windfall. After all, the creditors, not the debtors, would have been the beneficiaries had the trustee avoided and preserved the second mortgage in the first bankruptcy. On the other hand, the wife was in chapter 13, where anything the couple saved in debt service on the second mortgage would have gone into the calculation of payments to creditors.
Perhaps the story isn’t over. Perhaps the trustee from the first bankruptcy will awaken, set aside the postpetition recordation of the mortgage under Section 549(a), avoid the mortgage as unperfected under Section 544(a), and sell the property. Litigation in that direction will surely raise issues regarding laches.
For ABI’s discussion of a decision from June finding Rooker-Feldman inapplicable to state court judgments violating the discharge injunction, click here.