Noticing the Bankruptcy Sale: the Purchased Property May Not Be as ??free and Clear of All Liens, Claims and Encumbrances??as You Think

• Publication year: 2010
• Pages: 0012
• Citation: Vol. 15 No. 5 Pg. 0012

Noticing the Bankruptcy Sale: The Purchased Property May Not be as "Free and Clear of All Liens, Claims and Encumbrances" as You Think Vol. 15 No. 5 Pg. 12 Georgia Bar Journal February, 2010

by William L. Rothschild and Allen P. Rosenfeld

Almost all bankruptcy sale orders recite that the subject property is sold "free and clear of all liens, claims and encumbrances," or words to that effect. Such orders invariably add that any interests in the property attach instead to the sale proceeds, and that any disputes over the sale proceeds will be resolved later in bankruptcy court. In other words, a typical bankruptcy sale order states that it blocks any adverse claimant whatsoever who may later appear from asserting an interest in the purchased property, and directs the claimant instead to chase the sale proceeds through the bankruptcy court. As a result, closing attorneys who are unversed in bankruptcy law may pay less attention to title reports and site inspections than they normally would, or even take no action at all when they spot an apparent title discrepancy.

Don't believe everything you read. Just ask the Atlanta couple (the Purchaser), the closing attorneys or the title insurer who recently found out the hard way. In 1999, the Purchaser bought the home of a chapter 7 debtor following the entry of a standard bankruptcy sale order.^[1] In 2004, a private lending company named Palmetto Capital Corporation (Palmetto) contacted the Purchaser with this news: (1) Palmetto held a mortgage^[2] on the property that was valid and properly noticed under Georgia law before the bankruptcy sale; (2) Palmetto neither received proper notice of the bankruptcy sale nor had actual knowledge of it; and (3) as a matter of law, a bankruptcy sale order does not bind a party who was without both legal notice and actual knowledge of the sale. Palmetto therefore asserted that its lien remained valid and prior to the Purchaser's fee simple interest, no matter what the sale order stated to the contrary.

One may wonder how a lienholder can wait so long after a sale to assert its claim. Palmetto's details appear in the endnote.^[3]Although the facts in Palmetto are not ordinary, they do follow a pattern. Many title disputes decide which innocent party will bear the loss after someone else exploits a string of low-probability events, takes the money and becomes judgment proof.

Palmetto and the Purchaser litigated for five years. Meanwhile, the note secured by Palmetto's lien accrued annual interest at 19 percent. In 2009, a decade after the bankruptcy sale, the Superior Court of Fulton County agreed with Palmetto's legal analysis. Palmetto's lack of actual knowledge of the sale was undisputed. The court held that Palmetto lacked legal notice and granted Palmetto's summary judgment motion.^[4] The Purchaser's title insurer then bought Palmetto's lien for a sum that included all outstanding principal on its secured note plus annual interest of over 17 percent. The contribution of the closing attorneys, if any, is not known.

Large commercial bankruptcy sales normally draw experienced bankruptcy counsel for all parties early in the process. By contrast, residential purchasers are more likely to negotiate sale contracts through real estate agents and to meet a lawyer only at closing. That lawyer may have only a passing knowledge of bankruptcy law and may represent the new mortgagee instead of the purchasers themselves. This article introduces bankruptcy sale law and practice to the residential closing attorney, and then offers some specific advice.

The Bankruptcy Sale in Federal Law and Practice

The typical residential sale in bankruptcy occurs in a chapter 7 (liquidation) case when the trustee appointed to the case believes that a sale would bring money into the bankruptcy estate, i.e., that sale proceeds would remain after applicable deductions for mortgages and other liens, taxes, usual nonbankruptcy fix-up and sale expenses and any exemptions available to the debtor.^[5]Otherwise, the trustee would abandon the bankruptcy estate's interest in the property, and the mortgagee would either foreclose or work out a settlement with the debtor.

When a buyer is found, the bankruptcy sale diverges from the normal nonbankruptcy sale in three ways: the sale contract will contain special language (no warranty of title); the trustee must file a motion requesting an order from the bankruptcy court approving the sale; and the motion will usually request sale authority "subject to higher and better offers."^[6] The trustee will then file the sale motion, usually with the sale contract attached, obtain a hearing date and serve notice of the motion and hearing upon creditors and other parties in interest. If granted, the sale order will be served in the same manner as the motion and hearing notice were served.

Whether the transaction involves a chapter 7 trustee and a two-bedroom ranch house or a chapter 11 debtor in possession^[7]and a 15-acre chemical plant, the three most important aspects of a bankruptcy sale are still notice, notice and notice.

Adequate Notice is Critical

Orders authorizing bankruptcy sales dispense with the need for consent, but not for notice. If adequate legal notice is given, then on a proper factual showing the bankruptcy court may exercise two extraordinary powers. First, the bankruptcy court may remove a lien from property to be sold and place the lien instead on the sale proceeds, whether or not the noticed lienholder consents or even appears at all.^[8] Second, the bankruptcy court may prevent an appeal from affecting the validity of the sale unless the appellant posts a bond to stay the closing.^[9] No incantation within the sale order itself, however, can remove an existing lien or other interest from bankruptcy estate property where proper legal notice is not given and the adverse claimant had no actual knowledge of the sale.

Bankruptcy cases are by and large in rem proceedings. They concern the ingathering, liquidation and distribution of particular pieces of real and personal property that are collectively called the "estate." Nonetheless, a bankruptcy sale order follows the same rules of res judicata as any other in personam judgment. One such rule is that a party cannot be bound to an in personam judgment without having notice and an opportunity to be heard. The reason is the Fifth Amendment's provision that "[n]o person shall be . . . deprived of . . . property, without due process of law . . . ."^[10]That rule applies to bankruptcy sales because "[t]he bankruptcy power, like the other great substantive powers of Congress, is subject to the Fifth Amendment."^[11]

Bankruptcy notice law developed in straightforward fashion. In 1848 the U.S. Supreme Court established the bankruptcy court's power to sell a property free and clear of a nonconsenting lienholder under any circumstances at all.^[12]In 1875 the Court clarified that the bankruptcy court's power to sell property free and clear is limited by the normal rules of in personam due process to the claimant, including notice and opportunity to be heard.^[13] In 1884 the Court added that an aggrieved claimant has a choice of remedies: either accept the sale and follow the proceeds; or ignore the sale order altogether and foreclose under applicable state law.^[14]

In the Palmetto case, Palmetto elected to...