Saturday, August 11, 2012

FYI: 3rd Cir Holds BK Debtors Had No Homestead Exemption In Connection w/ Defective Mortgage

The U.S. Court of Appeals for the Third Circuit recently held that:  (1) the Chapter 7 bankruptcy debtors in the case did not have an equity interest to claim as a homestead exemption, where defective first-lien mortgage was void only as to junior lien holders and subsequent purchasers, but not as against the debtors themselves, and the total value of mortgage liens exceeded the value of the claimed homestead exemption; and  (2) the bankruptcy trustee's objection to the debtors' claimed homestead exemption was not subject to the 30-day deadline under Bankruptcy Rule 4003(b), where the objection was not based on the description of the exempted property, Bankruptcy Code provisions governing the claimed exemption, or the amount listed as the value of the claimed homestead exemption.
A copy of the opinion is available at:
Appellants-debtors ("Debtors") obtained a loan ("First Mortgage") from a bank that was secured by a mortgage on their residence and which was not properly executed under New Jersey law.  Debtors also obtained a second mortgage loan on the same property.   Several years later, Debtors filed for Chapter 7 bankruptcy protection.  In their filings, Debtors claimed exemptions in Schedule C for the full value of their home under Bankruptcy Code Section 522(d) based on the presumed equity in their property and the allegedly defective First Mortgage, which Debtors argued was not secured by their home.
Before the expiration of the 30-day period for filing objections to exemptions, Debtors notified the trustee ("Trustee") that the First Mortgage had not been properly acknowledged when it was executed and was thus defective.  Trustee then moved to avoid the First Mortgage lien and to preserve the value of the avoided mortgage for the benefit of the bankruptcy estate. 
The Bankruptcy Court allowed Trustee to sell Debtors' residence free and clear of all liens.  The net proceeds from the sale amounted to about $200,000.  After the second mortgage and other fees and expenses had been paid, the Trustee was left with almost $42,000, a substantial part of which Debtors claimed for themselves.
Following the sale of the home and after the 30-day deadline for objections, Trustee moved to value the homeowner's exemption at zero.  Trustee objected to Debtors' claimed exemptions, asserting, first, that Debtors had no equity in their home to which their claimed homestead exemption could attach and, second, that Debtors' claim to the homestead exemption was subordinate to the Trustee's rights to the sales proceeds, because the First Mortgage was still valid as to Debtors.
Debtors cross-moved for an order requiring the Trustee to pay the claimed homestead exemption from the sale proceeds, contending that Trustee's valuation motion was time barred by both Bankruptcy Rule 4003(b) and a decision of the U.S. the Supreme Court.  See Taylor v. Freeland & Kronz, 503 U.S. 638 (1992)(ruling that even if a claimed exemption is without legal justification, it will stand if the trustee fails to object within 30 days).  Debtors further asserted that they were entitled to the homestead exemption because the First Mortgage was void as of the date of their bankruptcy filing, rather than voidable by Trustee later in the bankruptcy.
Rejecting Debtors' argument that the First Mortgage was void as against them, the bankruptcy court ruled in favor of Trustee and valued Debtors' homestead exemption at zero.  The bankruptcy court also denied Debtors' cross-motion to compel payment of their exemptions, ruling that, by claiming the exemption under section 522(d) instead of section 522(g), Debtors had failed to provide sufficient notice of their intent to claim an exemption in the proceeds of the sale of their home.
The District Court reversed, ruling that Trustee had adequate notice of the claimed exemption through the schedules taken as a whole and that under Taylor, the Trustee's motion was barred because he failed to object within the 30-day deadline under Bankruptcy Rule 4003. 
Trustee appealed to the Third Circuit, which vacated the district court's order and remanded in light of the U.S. Supreme Court's decision in Schwab v. Reilly, ___  U.S. ___, 130 S. Ct. 2652 (2010).  On remand, the district court affirmed the previous Bankruptcy Court order and ruled that the Trustee had no obligation to object to Debtors' exemption.  Debtors appealed.  The Third Circuit affirmed.
As you may recall, Bankruptcy Rule 4003(b) provides that "a party in interest may file an objection to the list of property claimed as exempt only within 30 days after . . . any amendment to the list or supplemental schedules is filed."  Fed. R. Bankr. P. 4003(b).
In addition, section 522 of the Bankruptcy Code generally allows debtors to protect certain property from creditors where that property is exempt under federal bankruptcy law or under the laws of the debtor's home state.   See 11 U.S.C. § 522(b).  In certain limited circumstances, moreover, Section 522 also specifically permits debtors to claim exemptions in property that the trustee recovers.  See 11 U.S.C. § 522(g)(providing authority for debtors to claim exemptions in the proceeds of a sale following trustee's avoidance action).  Finally, Section 522 provides in part "[u]nless a party in interest objects, the property claimed as exempt . . . is exempt."  11 U.S.C. § 522(l).
Noting that Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), was no longer controlling and, further, that Debtors claimed their exemptions under section 522(d) rather than under section 522(g), the Third Circuit ruled that the Trustee had no duty to object within 30 days under the facts in this case.  In so doing, the Third Circuit agreed with the lower court that the asset Debtors' claimed as exempt under section 522(d) was separate and distinct from the proceeds from the sale of the residence.
The Third Circuit further concluded that the defective First Mortgage was still valid as to Debtors, but not as to subsequent bona fide purchasers or junior lienholders.  See, e.g., In re Buchholz, 224 B.R. 13 (Bankr. N.J. 1998)(ruling that an improperly recorded mortgage was unsecured as of the date of bankruptcy filing, but that the debtor was still obligated to pay it under New Jersey law). 
Moreover, noting that the value of the first and second mortgages combined exceeded the value of the claimed exemptions, the Third Circuit concluded there was no equity in the property to claim as exempt as of the date of the bankruptcy filing and that Debtors were not entitled to benefit from Trustee's avoidance of the defective First Mortgage.  See, e.g., In re cybergenics Corp., 26 F.3d 237, 244-47 (3d Cir. 2000)(noting that debtors may exercise avoidance powers only where such exercise would benefit creditors, not debtors themselves).
Importantly, the court also noted that, under the Supreme Court's opinion in Schwab, Bankruptcy Rule 4003(b)'s 30-day time limit applied only to objections based on three elements of a claimed Schedule C exemption:  (1) the description of the exempted property; (2) the Code provisions governing the claimed exemption; and (3) the amount listed as the value of the claimed exemption.
The Third Circuit thus concluded that where, as here, the objection is based on "other elements" not found on the face of Schedule C, such as Debtors' market value estimation or the estate's right to retain any value above a claimed exemption, Trustee was not bound by the 30-day time limit.
Accordingly, the court ruled that Trustee's objection was timely and valid, as Debtors failed to provide sufficient notice through their Schedule C disclosure that they intended to exempt the property's full value.

Ralph T. Wutscher
McGinnis Wutscher LLP
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