Handling Transactions with Sellers and
Borrowers in Bankruptcy

By: Kelsea L. S. Laun, Esq.

COVID-19 has had an alarming effect on our country and on the world. The economic impact is likely to be felt for years to come. In uncertain economic times, bankruptcy filings often rise exponentially (think back to 2010). Many turn to bankruptcy as a safety net to save their homes from foreclosure, their vehicles from repossession, or to keep their paychecks from being garnished by judgment creditors. Whatever the immediate reason a debtor has for seeking bankruptcy relief, the filing of a bankruptcy affects the entirety of the debtor’s estate – something debtors often don’t realize before filing. 

Accordingly, it is especially imperative in these trying times that we are on the lookout for active bankruptcy filings, and that we are aware of the effect the filing may have on the debtor’s proposed real estate transaction and any resulting title policy. 

How Bankruptcy Impacts Title

You may be wondering why bankruptcy is a concern to title examiners and title insurance agents at all. When an individual or entity files a bankruptcy, all property owned by the individual and all interest in the property, whether it be tangible or intangible (real property, legal claims, personal property, etc.), becomes property of the bankruptcy estate, albeit for varying lengths of time, depending on the chapter and treatment in the bankruptcy.  

To file for bankruptcy relief, an individual or entity (the debtor) files a compilation of pleadings referred to as the bankruptcy petition and schedules. Certain bankruptcies may also be filed involuntarily on behalf of the debtor, but that is a topic for another day.  In the petition, the debtor is required to disclose all its debts and assets, including any interest the debtor may have in real property. Pursuant to Section 541 of the Bankruptcy Code, the bankruptcy estate holds the assets of the debtor for the benefit of the creditors until the assets are liquidated and distributed or abandoned and given back to the debtor, if deemed to be valueless to the estate.  

It is important to note that the filing of a bankruptcy also affects co-obligors and co-owners (referred to as co-debtors) of the debtor. A co-debtor is a person who is obligated, or whose rights may be affected under the terms of the debt, but who did not file the pending bankruptcy petition. For example, if a married couple owns real property together that is encumbered by a mortgage, but only one spouse files bankruptcy, the other spouse is considered a “co-debtor” under the bankruptcy code.  As with the debtor, a co-owner may not be able to freely encumber or convey his/her interest in property that has become property of the debtor’s bankruptcy estate. 

As a general rule, property of the estate may not be conveyed or encumbered without an order from the bankruptcy court.

Frequently Asked Questions
  1. What if the property is listed as exempt in the bankruptcy petition?

Even where the property is listed as exempt in the bankruptcy schedules, underwriting counsel should be consulted for approval of the insured transaction for two reasons: 

  • Bankruptcy trustees often argue that although the debtor’s interest in the property is exempt, the property itself is still property of the estate; and
  • Any equity above the disclosed value of the property may be deemed property of the estate.
  1. What if the bankruptcy trustee abandons the property?

Under Section 554 of the Bankruptcy Code, a bankruptcy trustee may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate. Abandonment by the trustee, after a notice and hearing (due process), releases property from the estate and lifts the stay as to the property pursuant to 11 U.S.C. § 362(c)(1). Upon such abandonment by the trustee, real property could potentially be sold without a court order. However, underwriting counsel approval should be obtained before relying on an abandonment order, as there are several potential pitfalls. Here are some considerations:  

  • The property must be formally abandoned by the Chapter 7 trustee before the power of sale reverts to the debtor. Case highlighting the importance of formal abandonment: In re Edward Mejia (S.D.N.Y., November 20, 2017);
  • A Chapter 7 trustee’s “No Asset Report” is NOT necessarily an abandonment of property to the debtor;
  • Abandonment does not necessarily terminate the automatic stay arising from Section 362(a)(5), which protects “property of the debtor;”
    • Abandonment may be reversed by the trustee any time prior to closure of the bankruptcy case; and
    • If the property is being sold for a value more than what’s disclosed in the bankruptcy schedules, the equity will likely need to be paid into the bankruptcy estate for distribution to creditors.

From an underwriting perspective, it is always a best practice to require a court order authorizing the sale of the subject property and directing the distribution of proceeds. 

  1. Did my seller’s/borrower’s bankruptcy wipe out their pre-bankruptcy judgment?

Possibly. Judgment liens survive bankruptcy discharge to the extent the lien is not crammed down or avoided. For title insurance purposes, a court order specifically avoiding the lien is generally required for NATIC/Doma to insure without exception for a judgment lien in reliance on a bankruptcy discharge. Remember, the discharge alone eliminates the debtor’s obligation on the note, not the lien securing repayment, which is validly filed against the real property.  

Pending or Closed Bankruptcy

Bankruptcy is an area of the law that, like real estate law, requires a careful mind focusing on the specific facts of the transaction. If you examine title for a property and learn that the seller or borrower is in bankruptcy or has recently emerged from bankruptcy, it is important to determine whether the bankruptcy is currently pending.

If the bankruptcy is still pending, you will likely need to seek court approval for any action you intend to take regarding the property. If the bankruptcy is closed, then you’ll want to look at whether it was dismissed or discharged. If the bankruptcy has been dismissed it means that it was thrown out and most orders entered by the court are void as if the bankruptcy never happened. However, if the case was discharged then you want to carefully review the docket to see if there were any motions or orders pertinent to the subject property and your transaction.

When title and bankruptcy mix, it is important to pay close attention to the details of the bankruptcy and the details of title to the real property. Never hesitate to contact your NATIC/Doma underwriting counsel with any questions. 

Kelsea L. S. Laun is Vice President, Southeast Regional Underwriting Counsel at NATIC/Doma.

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