HAWAII – In a precedent setting move today, a bankruptcy Chapter 7 Trustee filed a Supplemental Objection under a hypothetical lien theory to the Debtor’s Motion to Compel the Trustee to Abandon the underwater property – the day before the hearing.

The Trustee’s pleading states that the lender, American Savings Bank FSB in Hawaii, had not properly perfected the mortgage at the time of the Debtor filing a petition for bankruptcy, the “Mortgage was in fact in favor of MERS as nominee for ASB at the time of the filing of the petition.”  This move essentially strangles the lender.

The Trustee states he “believes that his hypothetical lien creditor status conferred by §544 of the Bankruptcy Code is superior to and has priority over any security interest ASB may claim in the property.”

Attorneys say that even the assertion of such a theory has far reaching effects. The lender is reduced to an unsecured creditor, the Trustee or debtor-in-possession can sell the property, collect his fees and costs and distribute the windfall to the creditors.  The debtor may make out better in the long run.  In fact, the theory may be applicable to homeowners not in bankruptcy – of course, everyone should seek competent legal advice.

The hypothetical lien theory asserts that a security interest in personal property or fixtures that is not perfected (i.e. from a legal standpoint it is secret) by the time a creditor obtains a judicial lien will be subordinate to the judicial lien. If a security interest in personal property or fixtures is not perfected at the time a debtor files bankruptcy, section Bankr. Code 544(a)(1) (often known as the “strong arm clause”) permits the bankruptcy trustee (or a “debtor-in-possession” in a Chapter 11 bankruptcy proceeding) to step into the shoes of and use the subordinating power of a hypothetical creditor with a judicial lien to avoid the unperfected security interest in its entirety, even if there is no such actual creditor and even though the unperfected security interest would only be subordinated, not eliminated, under state law. Avoidance of the security interest under this section of the Bankruptcy Code has the same effect as avoidance of a security interest under the preference power.

Analogous treatment awaits the real property secured creditor whose interest has not reached the public record. Under certain state laws, the interest in real property of a holder of an unrecorded mortgage or deed of trust will be subordinate to the rights of a bona fide purchaser for value of the real property who is without knowledge of the interest of the holder of the mortgage or deed of trust. Just as section 544(a)(1) of the Bankruptcy Code puts the trustee in the shoes of a hypothetical lien creditor who has certain rights under U.C.C. 9-317(a)(2), section Bankr. Code 544(a)(3) puts the trustee (or the debtor-in-possession in a Chapter 11 proceeding) in the shoes of a hypothetical bona fide purchaser of real property.

The trustee may, therefore, avoid the unrecorded mortgage or deed of trust, for the benefit of all unsecured creditors of the debtor if, under state law, the interest of a bona fide purchaser of the real property would be superior to the rights of the holder of the mortgage or deed of trust.

In this case the Trustee was trying to force a “carve out” deal for the estate where the property would be sold and no matter what price the bank received, the Trustee would get a portion.  Prior to the 1994 Bankruptcy Code amendments, Trustees could pursue assets and unreasonably bill fees and costs that would literally eat up whatever profits were in the sale of the asset – leaving the creditors with nothing.  As of the 1994 amendments, 11 U.S.C. §330 gave the Court more oversight in determining what were reasonable and necessary expenses.  This supplemental filing is in essence a strong arm tactic to force the lender to acquiesce to a deal – but the fact that it was filed in a federal court already sets a precedence.

MERS, as nominee and mortgagee, has recently been well-defined in NY cases like Bank of New York v. Silverberg (2011) upholding Carpenter v. Longan (1872) where an assignment of the mortgage without the note is a nullity. Courts across the country have wrestled with the fact that MERS does not own the note and that under the MERS scheme the note and mortgage have been bifurcated.  MERS eventually stopped foreclosing in their name. Unless MERS took possession of the note prior to commencing foreclosure the courts were ruling they had no standing.

In any case, the bankruptcy trustee’s move was a stroke of genius that may well force more lenders to modify loans with their homeowners or face the wrath of bankruptcy court when a borrower threatens to file a petition. Otherwise, there will be a lot of extremely wealthy bankruptcy trustees and attorneys.