SECTION 551 OF THE BANKRUPTCY CODE: … SECTION 551 OF THE BANKRUPTCY CODE: AVOIDING THE PERILS OF THE USELESS AVOIDANCE OF LIENS Lawrence E. Pecan* I. INTRODUCTION 92 …

91

SECTION 551 OF THE BANKRUPTCY CODE:

AVOIDING THE PERILS OF THE USELESS

AVOIDANCE OF LIENS

Lawrence E. Pecan

*

I. INTRODUCTION .................................................................................... 92 II. PURPOSE OF § 551 ............................................................................... 93 III. APPLICABILITY OF § 551 ..................................................................... 94

A. Exempt Property ........................................................................ 94 B. Strong-Arm Powers ................................................................... 95 C. Penalties and Statutory Liens .................................................... 95 D. Fraudulent, Preferential, and Postpetition Transfers ............... 96 E. Disallowed Secured Claims ....................................................... 96 F. Only With Respect to Property of the Estate ............................. 97

1. Property Transferred Prepetition ....................................... 97 2. Exemptions .......................................................................... 99

IV. WHAT DOES A LIEN PRESERVED UNDER § 551 ACTUALLY DO? ..... 101 A. Stepping Into the Shoes of the Avoided Creditor ..................... 101 B. Selling the Property ................................................................. 103

V. WHAT DOES A LIEN PRESERVED UNDER § 551 NOT DO? ................ 105 A. Enhancing a Deficient Lien ..................................................... 105 B. Money Judgments Under § 550 ............................................... 106

VI. CONCLUSION ..................................................................................... 108

* Lawrence E. Pecan is an associate at Meland, Russin & Budwick, P.A., regularly practices in

bankruptcy courts throughout Florida and the United States, and concentrates his practice on the

representation of debtors and creditors in Chapter 11 proceedings and trustees in Chapter 7 proceedings.

J.D., magna cum laude, Oklahoma City University; B.A., University of Florida.

92 BUSINESS & BANKRUPTCY LAW JOURNAL [Vol. 2:1

I. INTRODUCTION

Any transfer avoided under section 522, 544, 545, 547, 548, 549, or 724(a)

of this title, or any lien void under section 506(d) of this title, is preserved

for the benefit of the estate but only with respect to property of the estate.1

As a Chapter 7 trustee, you are faced with the following situation: an

individual debtor and her spouse owe a joint debt on a promissory note to

the debtor’s parents on which they make regular payments. Just months

before the filing, the debtor and her spouse record a mortgage on their

exempt homestead in favor of the parents to secure the debt, thereby

elevating the parents from unsecured creditors to oversecured creditors and

allowing them to receive preference payments with impunity because they

are oversecured.

Adept trustee that you are, you sue to avoid the lien and its payments

under a preference theory. You easily win and get a money judgment for

the payments. However, you recall once reading that avoided liens are

preserved under title 11.2 After verifying that liens are indeed preserved

under § 551, you wonder if that means you can now foreclose on the debt

and possibly realize the entire amount of the lien for the benefit of the

unsecured creditors.3 That is, you wonder if, by avoiding the lien, you can

realize a portion of the debtor’s exempt asset for the estate.

With bankruptcy filings down across the country, panel trustees must

work even harder to generate income from the few cases they have.4 With

that in mind, a motivated trustee may be incentivized to look at sources of

recovery that differ from the norm. One such possibility is to look to

recovery of liens under a variety of strong-arm, fraudulent transfer, and

preference theories.5

The problem is that § 551, a one-sentence statute with far-reaching

implications, leads to more questions than answers.6 Courts have struggled

with how to apply the statute in a variety of different fact patterns that

Congress never contemplated when it enacted the statute to combat a very

narrow possibility.7 As courts have struggled with interpreting the statute,

some bankruptcy trustees have had their efforts to realize the benefit of

1. 11 U.S.C. § 551 (2014), Pub. L. No. 95-598, 92 Stat. 2602 (Nov. 6, 1978).

2. See id.

3. See id.

4. See Bankruptcy Filings Down 11 Percent for March 2014, UNITED STATES COURTS (April 24,

2014), http://news.uscourts.gov/bankruptcy-filings-down-11-percent-march-2014.

5. See infra Part III.

6. See 11 U.S.C. § 551.

7. See discussion infra Parts III–V.

2014] SECTION 551 OF THE BANKRUPTCY CODE 93

fraudulent transfers frustrated after incurring the expense of multiple

appeals.8

This article seeks to provide a guide to enable a trustee to determine

whether the avoidance of a lien will actually benefit the estate.

II. PURPOSE OF § 551

The purpose of § 551 is remarkably simple. “Section 551 is intended

to prevent the windfall to junior lienors that would otherwise result when a

trustee in bankruptcy successfully avoids a senior lien on property.”9 “The

section as a whole prevents junior lienors from improving their position at

the expense of the estate when a senior lien is avoided.”10

In a hypothetical

situation in which the estate owns property worth $1 million, there is a first

lien in the amount of $500,000 held by FirstBank; a second lien in the

amount of $400,000 held by SecondBank; and a third lien in the amount of

$600,000 held by ThirdBank. It follows that the first and second liens are

fully secured, whereas ThirdBank has a secured claim for $100,000 and an

unsecured claim for $500,000.11

Absent § 551, if the trustee avoided the second lien (and it

“disappeared”), the still-remaining liens of FirstBank and ThirdBank

(totaling $1.1 million) would exceed the value of the property ($1

million).12

FirstBank would be unaffected by the avoidance, but ThirdBank

would receive a windfall by improving the amount of their secured claim by

$400,000, all while the estate incurred the administrative expense to litigate

the avoidance of SecondBank’s lien.13

If the trustee were to sell the

property under 11 U.S.C. § 363(b), the unsecured creditors would still not

receive any portion of the proceeds from the sale.14

Section 551, however, changes the scenario.15

Again, assuming

SecondBank’s lien is avoided, if the second lien is preserved for the estate’s

benefit, the sale of the property for $1 million would yield $500,000 for

FirstBank, $100,000 for ThirdBank, and $400,000 for the estate.16

In short,

the estate would enjoy the benefits of having avoided SecondBank’s lien,

8. See infra Part III.

9. In re Appalachian Energy Indus., Inc., 25 B.R. 515, 516 (Bankr. M.D. Tenn. 1982).

10. S. REP. NO. 95-989, at 91 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5877; H.R. REP. NO.

95-595, at 376 (1977), reprinted in 1978 U.S.C.C.A.N. 5963.

11. See 11 U.S.C. § 506(a) (2014).

12. See id. § 551.

13. While it is beyond the scope of this article, there would be a strong case in such a situation for

a surcharge of ThirdBank’s collateral, pursuant to 11 U.S.C. § 506(c).

14. See 11 U.S.C. § 363(b).

15. See id. § 551.

16. See id.


and SecondBank and ThirdBank would receive distributions in pari passu

with other unsecured creditors on account of their unsecured claims.17

III. APPLICABILITY OF § 551

Section 551 provides that “[a]ny transfer avoided under section 522,

544, 545, 547, 548, 549, or 724(a) of this title, or any lien void under

section 506(d) of this title, is preserved for the benefit of the estate but only

with respect to property of the estate.”18

While a detailed analysis of any of

these avoidance actions would justify its own article, a brief discussion of

the various avoidance actions (as applied to the avoidance of liens) is

necessary to understand the types of liens which may be avoided and what

their potential use might be.

A. Exempt Property

An individual debtor can avoid certain liens that impair property the

debtor has claimed as exempt.19

These liens include judgment liens and

certain nonpossessory, non-purchase-money liens against household goods

and other similar personal property.20

An individual debtor may avoid these

liens to the extent that the avoidable lien, the other liens against the

property, and the amount the debtor could exempt if the property were

unencumbered exceeds the value of the property.21

As an example, a debtor owns a home worth $100,000, which is

encumbered by an $85,000 mortgage and a $30,000 judgment lien. If the

debtor claims the federal exemptions, the debtor is entitled to exempt

$22,975 in her home.22

Because the sum of the amount of the liens

($115,000) and the amount the debtor could exempt if the property were

unencumbered ($22,975) exceeds the value of the property ($100,000), the

debtor may avoid the judgment lien.23

Unlike most other statutes, however, it is the debtor—not the trustee—

who is empowered to avoid the lien.24

As set forth in Part III.F, this

underscores the limited applicability of § 551 to liens avoided under

§ 522.25

17. See id. § 726.

18. 11 U.S.C. § 551 (2014).

19. Id. § 522(f).

20. Id. § 522(f)(1).

21. Id. § 522(f)(2).

22. See id. § 522(d)(1).

23. See id. § 522(f)(2).

24. See id. § 522(f)(1).

25. See infra Part III.F.


B. Strong-Arm Powers

Section 544, known as the trustee’s “strong-arm” power, vests the

trustee with any state-law power of a hypothetical judgment lien creditor, a

hypothetical unsatisfied execution creditor, or a bona fide purchaser (when

real property is at issue).26

Because state laws typically give such

individuals superior title, free of an encumbrance of which they had no

notice, trustees often employ § 544 to avoid an unrecorded lien or

encumbrance.27

Section 551 automatically preserves the avoided lien.28

Section 544 also empowers the trustee with the state-law powers of an

unsecured creditor.29

This commonly enables the trustee to bring a cause of

action under the Uniform Fraudulent Transfer Act (UFTA), as enacted by

applicable state law.30

While trustees may choose to bring a UFTA

action—rather than an action under §§ 547 or 548 of the Bankruptcy

Code—for various reasons (often due to a longer statute of limitations), the

powers of state-law fraudulent transfer actions generally parallel those

conferred on the trustee by Chapter 11.31

C. Penalties and Statutory Liens

Section 545 allows the trustee to avoid statutory liens under certain

circumstances.32

These avoidable liens include liens that arise due to the

debtor’s insolvency, financial condition, or the entry of an order for relief.33

Additionally, the trustee may avoid any landlord’s lien or unperfected

statutory lien.34

Furthermore, § 724(a) permits a trustee to “avoid a lien that secures a

claim of a kind specified in section 726(a)(4).”35

Section 726(a)(4), in turn,

references claims for fines, penalties, forfeitures, or punitive damages.36

26. 11 U.S.C. § 544; Midlantic Nat’l Bank v. Bridge (In re Bridge), 18 F.3d 195, 199 (3d Cir.

1994).

27. See generally Chase Manhattan Bank, USA, N.A. v. Taxel (In re Deuel), 594 F.3d 1073,

1078–79 (9th Cir. 2010) (stating that the strong-arm clause protects trustees’ rights controlled by state

law).

28. Morris v. St. John Nat’l Bank (In re Haberman), 516 F.3d 1207, 1208 (10th Cir. 2008).

29. 11 U.S.C. § 544(b).

30. See Leibowitz v. Parkway Bank & Trust Co. (In re Image Worldwide, Ltd.), 139 F.3d 574, 577

(7th Cir. 1998).

31. Id.; Grochocinski v. Zeigler (In re Zeigler), 320 B.R. 362, 372 (Bankr. N.D. Ill. 2005).

32. 11 U.S.C. § 545(1).

33. Id.

34. Id. § 545(2)–(4).

35. Id. § 724(a).

36. Id. § 726(a)(4).


This means, for example, a properly recorded judgment lien for punitive

damages is avoidable by a trustee.37

Other than unperfected statutory liens, most avoidable liens under

§§ 545 or 724 are not deficient, and once avoided, the trustee is not limited

in its priority over other liens.38

This is important because the trustee does

not cure any deficiencies in a lien by preserving the lien under § 551.39

D. Fraudulent, Preferential, and Postpetition Transfers

The trustee has the power to avoid a lien granted with the intent to

hinder, delay, or defraud creditors, or a lien granted while the debtor was

insolvent for less than reasonably equivalent value.40

Similarly, the trustee

has the power to avoid transfers made shortly before bankruptcy to creditors

on account of antecedent debts, which enables creditors to receive more

than they would receive in a Chapter 7 liquidation.41

Finally, the trustee

may avoid the recording of a lien postpetition.42

For the purposes of

Chapter 5 of the Bankruptcy Code, the grant of a lien is a “transfer.”43

The range of possibilities for such actions is limitless, and these

“clawback” actions are among the most litigated in bankruptcy courts.44

However, a simple example of an avoided lien is the preferential,

fraudulent, or postpetition grant of a mortgage in favor of the debtor’s

spouse.45

In that case, the avoided mortgage is automatically preserved as

an asset for the estate under § 551.46

E. Disallowed Secured Claims

Finally, § 551 preserves the value of any lien voided by § 506(d).47

While it is still unclear whether § 506(d) operates independently or through

other code sections,48

§ 506(d) voids any lien for which the underlying

37. See Holloway v. IRS (In re Odom Antennas, Inc.), 340 F.3d 705, 708 (8th Cir. 2003) (holding

that the debtor could not avoid the lien because that power is vested in the trustee).

38. See infra Part III.C.

39. See infra Part III.C.

40. 11 U.S.C. § 548.

41. See id. § 547.

42. Id. § 549.

43. Gower v. Ford Motor Credit Co. (In re Davis), 734 F.2d 604, 605 (11th Cir. 1984); Stoebner v.

Ritchie Capital Mgmt., LLC (In re Polaroid Corp.), 472 B.R. 22, 33 (Bankr. D. Minn. 2012).

44. Jonathan S. Feldman & Jessica L. Wasserstrom, Expanding the Ability to Pursue Third-Party

Transfers, 33-FEB AM. BANKR. INST. J. 50, 50 (2014).

45. See generally Kols v. Unglaub (In re Unglaub), 332 B.R. 303 (Bankr. N.D. Ill. 2005) (avoiding

the recording of a mortgage in favor of non-debtor spouse as fraudulent).

46. See 11 U.S.C. § 551.

47. See id.

48. See Dewsnup v. Timm, 502 U.S. 410, 417–19 (1992); Palomar v. First Am. Bank, 722 F.3d

992, 994–95 (7th Cir. 2013); Talbert v. City Mort. Servs. (In re Talbert), 344 F.3d 555, 562 (6th Cir.


secured claim is disallowed (other than claims disallowed as a contingent or

unmatured interest) or secured claims disallowed solely for failure to file a

proof of claim.49

F. Only With Respect to Property of the Estate

Perhaps the first problem a trustee must consider before undertaking

the expense to avoid a lien is whether the lien encumbers property of the

estate and whether there is any benefit to avoidance if the lien does not.

This is because a lien preserved under § 551 is preserved “only with respect

to property of the estate.”50

While the statute may seem clear on its face,

the limited jurisprudence on the matter has produced divergent results.51

Courts agree that the “legislative history indicates that the ‘only with

respect to property of the estate’ language was appended to the preservation

power to prevent the trustee from asserting an avoided tax lien against after

acquired property of the debtor.”52

For example, suppose there were a federal tax lien for nondischargeable

taxes. Such a lien attaches to all property and rights to property of the

debtor, wherever located, whether acquired prepetition or postpetition. In

that case, if the estate took over the entire tax lien, the estate would be able

to chase after property that the debtor had obtained postpetition and to act

as a collection agent on behalf of the tax creditor, with respect to

collecting from postpetition assets. But that is precisely what Congress

was trying to say should not occur; instead, the estate should be limited to

dealing with preservation of the lien with respect to property of the

estate.53

1. Property Transferred Prepetition

Yet while courts agree as to this application of the statute, other

questions remain unsettled.54

In Waldschmidt v. Edgcomb Metals (In re

2003); Ryan v. Homecomings Fin. Network, 253 F.3d 778, 783 (4th Cir. 2001); Laskin v. First Nat’l

Bank of Keystone (In re Laskin), 222 B.R. 872, 876 (B.A.P. 9th Cir. 1998). But see McNeal v. GMAC

Mortg., LLC, 735 F.3d 1263, 1265–66 (11th Cir. 2012).

49. 11 U.S.C. § 506(d).

50. Id. § 551 (emphasis added).

51. Compare Waldschmidt v. Edgcomb Metals (In re Ward), 42 B.R. 946, 953 (M.D. Tenn. 1984)

(holding that the plain language of § 551 required that the lien not be enforced against the

property), with In re Greater Se. Cmty. Hosp. Found., Inc., 237 B.R. 518, 527 (Bankr. D.D.C.

1999) (considering the interactions of other sections with § 551 in holding that the lien was preserved

for the estate’s benefit).

52. In re Ward, 42 B.R. at 952; In re Greater Se. Cmty., 237 B.R. at 527; 126 CONG. REC. H11097

(daily ed. Sept. 28, 1978) (statement of Mr. Edwards).

53. In re Greater Se. Cmty., 237 B.R. at 522–23.

54. See supra note 52 and accompanying text.


Ward), the court considered a situation in which the trustee avoided a

preferential judgment lien under § 547 which had attached to property the

debtor sold after the perfection of the lien but prior to the filing.55

The trustee sought to preserve the lien and enforce it against the

purchaser.56

Because the transferred property was not property of the

estate, the court considered whether § 551 would still apply.57

The court in

In re Ward acknowledged that prior to the enactment of § 551, the Supreme

Court in First National Bank of Baltimore v. Staake58

“specifically rejected

the argument that the trustee could only preserve liens upon property of the

debtor which would pass to the trustee in bankruptcy.”59

Even though the

court consulted legislative history that showed the “property of the estate”

language was designed to prevent the trustee from enforcing the lien against

property acquired by the debtor postpetition, the court reluctantly held that

the plain language of § 551 unambiguously required the court to hold the

lien could not be enforced against the property.60

The court recognized the

result was inconsistent with general principles of collection and distribution

under the Code, but held the plain meaning of § 551 required such a

result.61

In In re Greater Southeast Community Hospital Foundation, Inc., the

court reached the opposite conclusion.62

There, the debtor-in-possession

avoided an unrecorded prepetition lien against the debtor’s receivables

pursuant to § 544.63

Prior to the petition, but subsequent to the grant of the

original lien, the debtor had assigned its interest in the receivables to a

third-party assignee.64

In a motion to use cash collateral, which included

the receivables, the debtor sought a determination that the avoided lien was

preserved and was superior to the assignee’s interest.65

While the court

deferred on the question of priority, it analyzed the statutory framework to

determine if the lien was actually preserved.66

Rather than considering § 551 in isolation, the court considered the

interaction of §§ 541, 544, 550, and 551.67

The court first noted that under

the relevant definitions in § 101 and the associated jurisprudence, the

“transfer . . . of the security interest in the debtor’s accounts receivable is to

55. In re Ward, 42 B.R. at 947.

56. Id. at 947–48.

57. Id.

58. First Nat’l Bank of Balt. v. Staake, 202 U.S. 141, 148 (1906).

59. In re Ward, 42 B.R. at 952.

60. Id. at 952–53.

61. Id.

62. In re Greater Se. Cmty. Hosp. Found., Inc., 237 B.R. 518, 527 (Bankr. D.D.C. 1999).

63. Id. at 519.

64. Id. at 520.

65. Id.

66. Id. at 520–21.

67. Id. at 521.


be treated as a ‘transfer of property of the debtor.’”68

Relying on

§ 550(a)—“to the extent that a transfer is avoided under section 544 . . . the

trustee may recover, for the benefit of the estate, the property transferred”—

the court held that “the trustee in a lien avoidance case recovers the

property that was transferred—the interest in the property conveyed to

effect the creation of a lien.”69

The court next turned to § 551.70

Under § 551, the lien is preserved for the benefit of the estate, “but only

with respect to property of the estate.” The phrase “only with respect to

property of the estate” is satisfied in this case because the property has

been recovered for the benefit of the estate. Thus, when a lien is granted,

the Bankruptcy Code treats the transaction as a transfer of property to

create the lien. Concepts akin to the title theory of mortgages come into

play; it is as though the debtor is making a conveyance of ownership of the

property to the lien creditor for the purpose of the lien creditor getting a

lien on the property. Section 550 pulls that property back into the estate.

Then § 551 preserves the lien for the benefit of the estate.71

The court concluded that § 551, when read in context with § 550, was

not only unambiguous, but unambiguously provided that the lien was

preserved for the benefit of the estate in spite of the underlying property

having been transferred.72

The answer, however, remains unclear.73

2. Exemptions

In an individual case, in addition to the scenario in which the property

secured by the avoided lien has been transferred prepetition, the same

analysis could apply equally to exemption claims; however, the matter does

not seem to have been litigated yet. Upon filing a petition for bankruptcy,

‘all legal or equitable interests of the debtor in property’ become the

property of the bankruptcy estate and will be distributed to the debtor’s

creditors. To help the debtor obtain a fresh start, the Bankruptcy Code

68. Id.

69. Id. at 522. Notably, the court held the avoidance brought the debtor’s property back into the

estate because granting the lien was, in effect, a transfer of some portion of the debtor’s interest in the

property. Id. Thus, by avoidance, the transfer brought that property back into the estate. See id.

70. Id.

71. Id. at 522–23.

72. Id. at 523.

73. See also Barber v. Princeville State Bank (In re Ostrom–Martin, Inc.), 161 B.R. 800, 808–09

(Bankr. C.D. Ill. 1993) (holding the trustee could not reach property securing a lien when the property

had been setoff prepetition by a third-party bank).


permits him to withdraw from the estate certain interests in property, such

as his car or home . . . .74

This distinction is important, because it confirms that a debtor’s exemptible

property passes to the bankruptcy estate and is only withdrawn by the

procedures set forth in the Bankruptcy Code.

Because a debtor “withdraws” property from the estate, it follows that

if a debtor exempts property subject to a lien (which is later avoided by the

trustee), the same problem arises as to whether an avoided lien is preserved

as property of the estate.75

That is, the property is no longer property of the

estate, and thus, it is possible that the avoided lien may not be preserved for

the benefit of the estate.76

In such a case, however, the Supreme Court’s ruling in Schwab v.

Reilly may assist the trustee.77

Because, at least for an exemption of a finite

amount, Schwab dictates that the property remains property of the estate,

and the debtor simply withdraws a monetary interest; therefore, the trustee

should be able to preserve an avoided lien.78

If a court does, however, allow a trustee to preserve the lien, the debtor

is unlikely to be able to exempt the lien.79

The preservation of the lien for

the benefit of the estate will result, even though the lien encumbers property

the debtor could claim as exempt.80

Under § 522(c), property exempted generally remains liable for a debt

secured by a lien. In re Granati, 271 B.R. 89, 95 (Bankr. E.D. Va. 2001)

(“[V]alid liens, even against exempt property, pass through bankruptcy

and may be enforced against the collateral . . . .”). Accordingly, § 522

treats a debtor’s interest in real property as distinct from a mortgagee’s

lien on that property. Unless the debtor specifically listed the lien as being

74. Rousey v. Jacoway, 544 U.S. 320, 325 (2005) (quoting 11 U.S.C. § 541(a)(1) (2012)).

75. Schwab v. Reilly, 560 U.S. 770, 778–89 (2010).

76. See In re Bethea, 275 B.R. 127, 131 (Bankr. D.D.C. 2002).

77. Schwab, 560 U.S. at 782. In Schwab, the Supreme Court delineated between “in-kind”

exemptions and “dollar amount” exemptions. Id. The Court held that the “provisions in § 522(d) . . .

permit debtors to exempt certain property in kind or in full regardless of value.” Id. at 784. In the

federal exemption scheme, in-kind exemptions include “professionally prescribed health aids, . . .

disability benefits, [and] unmatured life insurance contracts.” Id. Unlike in-kind exemptions, dollar-

amount exemptions are exemptions that allow the debtor to exempt some portion of the exempt

property’s value. Id. at 800, n.5. While the effect of an allowed in-kind exemption is to remove the

exempt property from the estate, for an allowed dollar-amount exemption, “title to the asset will remain

with the estate pursuant to § 541.” Id. at 792. There is no need for an evidentiary hearing as to the value

of the asset and the exemption; the trustee administers the property, “and the debtor will be guaranteed a

payment in the dollar amount of the exemption.” Id.

78. See id. at 791.

79. See In re Bethea, 275 B.R. at 131.

80. See id. at 129.


exempted, his exemption of the real property alone did not suffice to claim

an exemption of the lien (that upon avoidance by the trustee would be

property of the estate and exemptible under § 522(g) if the debtor met

certain conditions).81

IV. WHAT DOES A LIEN PRESERVED UNDER § 551 ACTUALLY DO?

If the avoidance of the lien does, in fact, lead to a lien preserved for the

benefit of the estate, the next question is what may a trustee do with such a

lien. If the trustee owns the property, the answer should be simple: the

trustee sells the property under § 363 and realizes the value for the

lienholders (including the lien owned by the estate), and the estate keeps the

proceeds in excess of the secured claims.82

But if the trustee does not own

the property (or cannot sell it), the options are more nuanced.

A. Stepping Into the Shoes of the Avoided Creditor

Curiously, much of the jurisprudence concerning what a trustee may

do with a preserved lien arises out of one Kansas bankruptcy trustee’s (J.

Michael Morris) efforts over multiple cases and appeals to find a useful

way to dispose of the preserved liens for the benefit of his estates.83

In

Morris v. Vulcan Chemical Credit Union (In re Rubia), the trustee avoided

a bank’s lien securing a car loan because it was perfected during the

preference period.84

Because the debtor made payments on the loan to the

bank postpetition, the trustee sued the bank to recover the amounts paid on

the avoided lien.85

The B.A.P. held that “the extent and value of the preserved lien in the

trustee’s hands turns on the amount of the creditor’s underlying prepetition

claim against the debtor.”86

It surmised that “by avoiding and preserving

the lien, the trustee simply steps into the secured creditor’s shoes and

succeeds to the creditor’s rights with regard to the lien.”87

Thus, the court

concluded the trustee held the rights to the lien but had no right to collect

81. Id. at 129–30.

82. See 11 U.S.C. § 363 (2014); In re Neal, 424 B.R. 235, 237 (Bankr. E.D. Mich. 2010).

83. See Morris v. St. John Nat’l Bank (In re Haberman), 516 F.3d 1207 (10th Cir. 2010); Morris v.

Vulcan Chem. Credit Union (In re Rubia), 257 B.R. 324 (B.A.P. 10th Cir. 2001).

84. In re Rubia, 257 B.R. at 327.

85. Id.

86. Id. at 328 (quoting C & C Co. v. Seattle-First Nat’l Bank (In re Coal-X Ltd. “76”), 103 B.R.

276, 280 (D. Utah 1986)) (internal quotation marks and citations omitted).

87. Id.


the underlying debt.88

In an unpublished opinion, the Tenth Circuit affirmed

“for substantially the same reasons as those stated in the BAP opinion.”89

In Morris v. St. John National Bank (In re Haberman), the same

Chapter 7 trustee sought to avoid a bank’s unperfected lien on an

automobile (which secured a note) and preserve it for the benefit of the

estate.90

Shortly after filing the complaint, the trustee filed a motion to have

the debtors make payments on the note to the trustee and to declare any

postpetition payments made on the note property of the estate.91

In essence,

the trustee argued that, by avoiding the lien, the trustee ought to receive

payments on the lien just as the bank would have.92

The court avoided the lien over the bank’s objection, despite the

bank’s argument that the lien could not be avoided because the debtor

claimed the automobile as exempt.93

The court, however, did not award the

trustee the full amount of the payments.94

After the B.A.P. affirmed, the

trustee appealed to the Tenth Circuit.95

The Tenth Circuit noted that while

“Section 551 places the estate in the shoes of the displaced lienholder in

certain respects, in others it does not. Section 551 says that only ‘liens’ in

particular, and ‘transfers’ more generally, may be taken by the trustee for

the benefit of the estate.”96

The court held that the “contractual promise to make future loan

payments to the Bank is itself neither a lien nor any other transfer of an

interest in property.”97

Finally, the court concluded that

Congress empowered the Trustee to avoid the Bank’s security interest in

the [debtor’s car], and to take for the bankruptcy estate the value of that

unperfected “transfer.” But Congress did not afford the Trustee the

additional power to assume all of the Bank’s rights and interests with

respect to the [debtor], including those that cannot fairly be described as

“transfers of property interests.”98

88. Id. at 329.

89. Morris v. Vulcan Chem. Credit Union (In re Rubia), 23 F. App’x 968, 971 (10th Cir. 2001).

90. Morris v. St. John Nat’l Bank (In re Haberman), No. 02-11974-7, 2004 WL 2035341 (Bankr.

D. Kan. Apr. 14, 2004).

91. Id. at *2.

92. Id.

93. Id. at *3–*5.

94. Id.

95. Morris v. St. John Nat’l Bank (In re Haberman), 347 B.R. 411, 413 (B.A.P. 10th Cir. 2006).

96. Morris v. St. John Nat’l Bank (In re Haberman), 516 F.3d 1207, 1210 (10th Cir. 2008).

97. Id. at 1211.

98. Id. at 1214.


While the line of cases from the Tenth Circuit answered whether a

trustee has the right to contractual payments on the debt secured by the

avoided lien,99

the question of how to enforce the lien remained open.100

B. Selling the Property

If unclear whether the trustee may foreclose, a trustee may instead

think to just sell the property of the estate in order to realize the value of the

preserved lien. In DeGiacomo v. Traverse (In re Traverse), the trustee

avoided JP Morgan Chase’s unrecorded mortgage against a debtor’s home

pursuant to § 544.101

The debtor filed a counterclaim seeking a

determination that the trustee could not sell the home without first

foreclosing.102

As is common among courts attempting to interpret § 551, the B.A.P.

appeared to show some frustration in applying the nebulous concept of

preservation.103

“There is no dispute that the trustee successfully and

lawfully avoided JP Morgan Chase’s mortgage under § 544, or that he is

able to preserve some benefit to the estate pursuant to § 551. The only

dispute is exactly what that benefit may be.”104

The debtor argued that she

99. A single court (the Bankruptcy Court for the District of Columbia) has disagreed with the

entire body of Tenth Circuit case law. See White v. Wachovia Dealer Serv., Inc. (In re Wyatt), 440 B.R.

204 (Bankr. D.C. 2010). In criticizing In re Haberman and In re Rubia, the well-reasoned opinion of

the bankruptcy court first explained Robinson v. Howard Bank (In re Kors), 819 F.2d 19, 23–24 (2d Cir.

1987), a case on which In re Haberman heavily relied.

Kors stands for the unremarkable proposition that the in rem rights of a trustee as a holder of

an avoided lien are limited to enforcing performance of the underlying obligations whose

performance the lien secures, the means of enforcement being the inherent threat of a

foreclosure sale or, if that threat does not prompt performance, an actual foreclosure sale.

The lesson of Kors pertinent here is that so long as the lien remains upon the collateral, that

lien remains enforceable pursuant to the lienor’s in rem rights for whatever amount is owed

pursuant to the in personam obligation whose payment it secures (including the right to sell

the collateral if there is a default with respect to the in rem right to performance as a

condition to the collateral not being sold). Without the lien securing performance of the

payment obligations, it would be worthless.

In re Wyatt, 440 B.R. at 218. The In re Wyatt court held that postpetition payments on the lien was

property of the estate, as proceeds under § 541(a)(6). Id. at 213. But while In re Wyatt, like In re

Haberman and In re Rubia, concerns entitlement to postpetition payments, In re Wyatt is premised on a

trustee’s ability to enforce the lien to compel payment obligations. Id. at 218. It follows that, even if the

debtor were not in default on the petition date, the trustee could foreclose to realize the value of the lien

for the estate.

100. See Morris v. Vulcan Chem. Credit Union (In re Rubia), 257 B.R. 324, 328 n.5 (B.A.P. 10th

Cir. 2001) (“The dissent correctly states that we do not explain how the estate realizes its claim against

the Ranger. This lack of explanation is not mistaken, however, inasmuch as we do not view that issue to

be before us.”).

101. DeGiacomo v. Traverse (In re Traverse), 485 B.R. 815, 816–17 (B.A.P. 1st Cir. 2013).

102. Id.

103. See id. at 820.

104. Id.


merely replaced JP Morgan Chase because the trustee could foreclose if,

and only if, she later defaulted on the note to JP Morgan Chase.105

The

trustee, however, argued that the home was property of the estate under

§ 541, and thus, the trustee could sell the property to satisfy the liens

encumbering the home (including the one preserved for the estate) and fund

the debtor’s finite exemption to the extent that there was equity above the

liens.106

Without passing on the foreclosure issue, the B.A.P. held that all of the

debtor’s rights to the property passed to the trustee upon the filing of the

petition.107

Thus, the trustee was left

in the homeowner’s shoes, with the added benefit that funds that would

otherwise be allocated to “pay off” the JP Morgan Chase mortgage would

enrich the estate. JP Morgan Chase still possessed its contractual right to

payment, now shorn of security, and would take from the estate pro rata

with other unsecured creditors. This is the meaning of avoidance and

preservation.108

Unfortunately, despite the B.A.P.’s pronouncement as to having finally

found “the meaning of avoidance and preservation,” on appeal, the First

Circuit disagreed.109

It framed the issue as “whether a trustee’s powers of

sale under § 363 justify selling a debtor’s asset where no equity remains for

the estate beyond the senior claims of secured creditors and the debtor’s

own exempt interest.”110

First, the court rejected the trustee’s argument that

irrespective of whether the value of debtor’s interest in the home was within

the statutory limits of the homestead exemption, under Schwab, the house

remained property of the estate and could be sold by the trustee.111

The

court held that the Schwab rule did not apply because, in that case, the

“asset’s value surpassed the exemption amount, creating additional equity

for the bankruptcy estate.”112

Next, the court noted (and the trustee admitted) that absent a preserved

lien, a trustee would not sell property of the estate if the liens encumbering

the property exceeded its value.113

The trustee, however, argued that the

benefit of realizing the lien’s value distinguished the Traverse property

105. Id.

106. Id.

107. Id.

108. Id. (emphasis added).

109. Id.; DeGiacomo v. Traverse (In re Traverse), 753 F.3d 19, 31 (1st Cir. 2014).

110. In re Traverse, 753 F.3d at 28.

111. Id.

112. Id. The First Circuit appeared to misinterpret Schwab. Id. That is, the distinction between

exempting the property and exempting the property’s value could only have any real meaning if the

property’s value was arguably less than the exemption amount. See id.

113. Id. at 29.


from the typical scenario because the sale would indisputably benefit

unsecured creditors.114

Seemingly ignoring the priority preservation scheme for which § 551

was drafted, the First Circuit held that

just because the preserved mortgage promises the bankruptcy estate a

benefit from the sale of Traverse’s home does not mean that the preserved

mortgage creates “equity” for the estate. Bankruptcy courts have defined

the equity that justifies a sale of property, consistently and explicitly, in

one way: the value remaining for unsecured creditors above any secured

claims and the debtor’s exemption. It is this equity for unsecured creditors

that authorizes a trustee to liquidate the property in the first place, as the

trustee should not exercise his § 363 powers for the benefit of secured

creditors alone.115

While Traverse seems to have been wrongly decided, it is the only line

of cases concerning whether a Chapter 7 trustee may sell property of the

estate solely to realize the value of a lien preserved under § 551.116

If

followed, it would only permit a trustee to enlarge the recovery he would

otherwise be able to generate through the sale of property with equity for

the estate (by satisfying the preserved lien).117

However, Traverse stands

for the proposition that if there is no equity in the property, the Chapter 7

trustee has no incentive to avoid the lien.118

V. WHAT DOES A LIEN PRESERVED UNDER § 551 NOT DO?

While it is difficult, if not impossible, to glean from the case law what

§ 551 does, courts seem to agree on what a preserved lien does not do.

A. Enhancing a Deficient Lien

A “trustee who avoids and then preserves a senior secured claim

cannot acquire greater rights in the property in question than those to which

the trustee succeeded.”119

But preservation alone does not “enhance the

status of the trustee’s lien so that if the avoided liens would have been

defeated by the junior claimants while in the hands of the lienholders, they

114. Id.

115. Id. (internal citations omitted).

116. See id. at 27–29; DeGiacomo v. Traverse (In re Traverse), 485 B.R. 815 (B.A.P. 1st Cir. 2013).

117. See id.

118. See id. at 25, 29.

119. In re DeLancey, 94 B.R. 311, 313 (Bankr. S.D.N.Y. 1988).


are also vulnerable in trustee’s.”120

A common example of this is an

improperly recorded lien avoided pursuant to 11 U.S.C. § 544.121

However,

since the preservation of the lien does not cure the lien’s defects, other

secured creditors are likely unaffected by the putative senior lien, for the

very reason for which the trustee was empowered to avoid it.122

“Section

551 therefore accomplishes nothing for the bankruptcy estate in

circumstances such as those . . . .”123

Thus, not all avoided liens are created equal. A lien avoidable for

fraudulent or preferential transfer is much more valuable than a lien avoided

because it is deficient.124

It follows that a trustee should ensure there is a

benefit to avoiding a deficient lien before pursuing the cause of action.

That is not to say that a trustee should never exercise strong-arm

powers to avoid liens. Returning to the previous scenario, in a hypothetical

situation in which the estate owns property worth $1 million, there is a first

lien in the amount of $500,000 held by FirstBank; a second lien in the

amount of $400,000 held by SecondBank; and a third lien in the amount of

$600,000 held by ThirdBank.125

In this case, the SecondBank mortgage is

unrecorded, but ThirdBank had actual knowledge before perfecting its

security interest. Applicable state law provides that a bona fide purchaser

does not take subject to an unrecorded mortgage, and a junior lienholder is

inferior to an unrecorded senior lien of which it had actual notice.126

In

such a case, the trustee, empowered with the rights of a bona fide purchaser,

may avoid SecondBank’s lien.127

More importantly, though, the trustee

continues to enjoy priority because ThirdBank had notice of the lien.128

However, the avoidance would be worthless if ThirdBank did not have

knowledge of the lien because ThirdBank’s lien would have priority over

SecondBank’s, whether or not it was avoided.129

B. Money Judgments Under § 550

“[O]rdinarily in the case of an avoided lien, the estate will be returned

to its previous position by simply avoiding the preferential lien and no

120. Connelly v. Marine Midland Bank, N.A., 61 B.R. 748, 750 (W.D.N.Y. 1986) (quoting Truman

v. United States (In re Tri-Sonic, Inc.), 1 B.R. 138, 143 (Bankr. N.D. Tex. 2014)).

121. See, e.g., Carvell v. Bank One (In re Carvell), 222 B.R. 178, 180 (B.A.P. 1st Cir. 1998).

122. See id.

123. Id.

124. See id.

125. See supra Part II.

126. See, e.g., Matosh v. Metro. Trust Co., 247 N.W. 156, 156–57 (Mich. 1933).

127. See 11 U.S.C. § 544(a)(3) (2014).

128. See, e.g., Chase Manhattan Bank, USA, N.A. v. Taxel (In re Deuel), 594 F.3d 1073, 1078 (9th

Cir. 2010).

129. See 11 U.S.C. § 544.


further recovery will be necessary . . . .”130

Because preservation of the lien

is automatic, the estate is made whole through the lien’s preservation, and a

money judgment under § 550 is impossible.131

There are, however,

“circumstances in which lien avoidance/preservation . . . could be

inadequate and a bankruptcy court could, in its discretion, order monetary

recovery of the value of the property under § 550(a) instead.”132

For example, in Tidwell v. Chrysler Credit Corporation (In re

Blackburn), the trustee avoided a lien on the debtor’s pickup truck.133

The

truck, however, had been resold to a good faith purchaser.134

Thus, the

purchaser’s interest in the vehicle was superior to that of the estate.135

While the court did not discuss § 551, the preserved lien would be of no

moment.136

The court awarded a money judgment under § 550(a).137

Similarly, in Seaver v. Mortgage Electronic Registration Systems, Inc.

(In re Schwartz), the debtor refinanced her mortgage postpetition.138

The

trustee avoided the prepetition mortgage as a preference under § 547.139

Because of the postpetition mortgages, the estate could not have been made

whole by preserving the prepetition mortgage.140

Accordingly, the court

awarded damages under § 550(a) against the prepetition mortgagee.141

“A

money judgment under Section 550(a) was the only remedy available to

restore the bankruptcy estate to the pre-preference position of the Debtor

because the Lenders no longer held the mortgages and thus could not return

them to the bankruptcy estate.”142

130. Rodriguez v. Drive Fin. Servs., (In re Trout), 609 F.3d 1106, 1111 (10th Cir. 2010). See

Schnittjer v. Linn Area Credit Union (In re Sickels), 392 B.R. 423, 427 (Bankr. N.D. Iowa 2008). See

also Eisen v. Allied Bancshares Mortg. Corp. (In re Priest), 268 B.R. 135, 139 (Bankr. N.D. Ohio 2000)

(holding that § 550 does not apply to an avoided mortgage); Hendon v. G.E. Capital Mortg. Servs., (In

re Carpenter), 266 B.R. 671, 676 (Bankr. E.D. Tenn. 2001) (“Once [avoided], the interest is preserved

for the estate’s benefit and protection by § 551 and becomes property of the estate pursuant to §

541(a)(4) . . . . Section 550 is simply not implicated . . . .”); Glanz v. RJF Int’l Corp. (In re Glanz), 205

B.R. 750, 758 (Bankr. D. Md. 1997) (“[A]voidance of the unperfected lien pursuant to § 544(a) is a

meaningful event in and of itself, and requires no further action to be taken by the debtor. There is

simply nothing to ‘recover’ under § 550(a) . . . .”).

131. See In re Trout, 609 F.3d at 1110.

132. Id. at 1111.

133. Tidwell v. Chrysler Credit Corp. (In re Blackburn), 90 B.R. 569, 572–73 (Bankr. M.D. Ga.

1987).

134. See id. at 572.

135. See id. at 573.

136. See id. at 573–74; 11 U.S.C. § 551.

137. In re Blackburn, 90 B.R. at 574.

138. Seaver v. Mortg. Elec. Registration Sys., Inc. (In re Schwartz), 383 B.R. 119, 122, 125 (B.A.P.

8th Cir. 2008).

139. Id. at 123.

140. Id.

141. Id. at 126–27.

142. Id. at 128.


VI. CONCLUSION

As one of the shorter sections in the Bankruptcy Code, § 551 seems to

be straightforward and easy to understand.143

Indeed, in many cases its

application may be so.144

Yet the concept of preserving the property right,

without necessarily preserving the underlying contract, is difficult for courts

and litigants alike to understand.145

This leads to disjointed case law and a

comical array of courts professing to simplify § 551 to some one-sentence

mantra.146

The lesson to be learned from § 551 jurisprudence is that no matter

how attractive an avoidable lien may seem to a trustee, one must proceed

with caution.147

There is great risk in expending estate resources to avoid a

lien unless it is absolutely clear the trustee may realize the value of the

lien.148

Despite its one sentence construction, there are no sure bets on

§ 551’s effect.149

143. See 11 U.S.C. § 551 (2014).

144. See id.

145. See supra Part III.F.

146. See supra Part III.F.

147. See supra discussion Parts III–V.

148. See supra discussion Part III.

149. See 11 U.S.C. § 551.

Documents

SECTION 551 OF THE BANKRUPTCY CODE: … SECTION 551 OF THE BANKRUPTCY CODE: AVOIDING THE PERILS OF THE USELESS AVOIDANCE OF LIENS Lawrence E. Pecan* I. INTRODUCTION 92 …