Foreclosure warning: property owned but not owned by a debtor may be subject to automatic stay – Insolvency/Bankruptcy

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Creditors know that a bankruptcy petition automatically halts efforts to collect pre-petition debts from the debtor outside of bankruptcy.

The “automatic stay” provides fundamental protection to debtors, imposing a complete halt to collection activity. Creditors breach the stay at their own risk. If you violate the stay, even without intending to do so, you can be held in contempt and ordered to pay damages. So if a creditor seizes a debtor’s residence, that’s a full stop.

But what if the residence is titled in the name of a limited liability company and the debtor simply resides in the property? An LLC is a separate legal entity separate from its members. The LLC is the record owner of its assets – not the members. And when an individual member of the LLC files for bankruptcy, the assets of the LLC are not owned by the debtor’s bankruptcy assets. So if the LLC is not bankrupt, the creditor can foreclose, right? Bad.

The Second Circuit Court of Appeals (which encompasses the courts of New York, Connecticut and Vermont) recently ruled that a foreclosure sale in these circumstances violated the automatic stay. While the ruling does not bind the North Carolina bankruptcy courts (which are part of the Fourth Circuit), it should nonetheless give creditors pause if they are faced with this scenario. For they can expect debtors to argue that the reasoning applies.

Eileen Fogarty had a 99% interest in an LLC that owned her primary residence. The LLC defaulted on a secured loan and Bayview Loan Servicing filed a foreclosure action in New York, which requires a lawsuit to be filed. In the complaint, Bayview named the LLC and Fogarty as defendants. Bayview obtained a judgment authorizing it to sell the property under the supervision of a court-appointed arbitrator.

Bayview planned a sale, but before it happened, Fogarty filed for bankruptcy. Bayview was aware of the filing but proceeded with the sale on the theory that the LLC owned the property, not Fogarty, and because the LLC had not filed for bankruptcy, no automatic stay was in effect.

Fogarty sought sanctions against Bayview for willful violation of the automatic suspension. The bankruptcy court denied Fogarty’s petition and agreed with Bayview. But on appeal, the district court overruled, finding that because Fogarty was a named defendant in the foreclosure action, the sale was a willful violation of the automatic stay. Bayview appealed to the Second Circuit.

The Second Circuit upheld the district court, finding that the foreclosure sale violated the automatic stay on several grounds. The Court explained that the filing of a petition for bankruptcy is not only a stay of the commencement or continuation of any judicial, administrative or other action against the debtor which was or could have been commenced before the filing of bankruptcy, but is also a stay of the execution of a judgment against the debtor or the assets of the estate if the judgment was obtained before the bankruptcy filing. First, the Court held that the sale was a continuation of an “action against the debtor” because Fogarty was a defendant in the foreclosure action. Second, the Court also found that because the judgment against Fogarty and the LLC authorizing the sale was entered before Fogarty filed for bankruptcy, its execution after the filing violated the stay. Finally, Fogarty’s possessory interest as lessee of the property was the ownership of his bankruptcy estate protected by the automatic stay.

Bayview argued that because it named Fogarty only as an interested party, and not as a responsible party for the LLC’s default, its bankruptcy did not affect its ability to seize the LLC’s property. The Court rejected this argument. The Court held that regardless of the reason for a debtor’s status in an action or proceeding, if the debtor is a named party, the automatic stay applies.

This foreclosure was under New York law, which requires the creditor to take legal action by filing a lawsuit. In North Carolina, foreclosure of a trust deed under a power of sale provision does not require a lawsuit. But state law requires the foreclosure party to send a Notice of Foreclosure Hearing to “any person liable to pay the debt against which the holder thereof intends to assert liability.” It is also customary to send a notice of foreclosure sale to all tenants or occupants of the property.

Creditors faced with this scenario could leave the individual debtor out of foreclosure. But in doing so, assuming the person guaranteed the debt, they would waive any deficiency claim against them in the bankruptcy. And they could still face a charge that the individual’s tenancy is protected by the automatic stay. The safest course of action is to suspend the foreclosure and seek a stay from the bankruptcy court.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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