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Bankruptcy, Part 2

by Peter Griffiths, Vice President and Counsel

This is the second part of a two-part article on the effect of a bankruptcy filing on the title and closing process.

Automatic stay
The stay is one of the most important protections given to a debtor, and it is intended to provide a “breathing space” in which the debtor and creditors can come together and work out, under court supervision, the conflicting claims of each party.

The Bankruptcy Code provides for an automatic stay on the filing of a petition of bankruptcy under any chapter of the code. The stay applies to the commencement or continuation of any action or proceeding to recover a pre-petition claim against the debtor, the enforcement of any pre-petition judgments, any act to obtain possession of the estate, any action to create, perfect or enforce any pre-petition lien against the estate.

The stay comes into effect immediately on the filing of the petition for bankruptcy. Any action taken by a creditor to collect on a debt, after the filing of the petition for bankruptcy and irrespective of whether the creditor has knowledge of the bankruptcy filing, is void.  A creditor can request the court for relief from stay, which, if granted, will allow the creditor to proceed with an action against the debtor’s property, such as the foreclosure of a deed of trust, and judgment and mechanics’ liens.

Avoiding Powers
Under the Code, the trustee (and a debtor-in-possession in a Chapter 11 case) has the power to recover property for the estate, set aside certain liens and transfers, and reject or assume executory contracts and unexpired leases. The trustee must commence a separate proceeding (“adversary” proceeding) and serve a complaint on the party whose interests will be affected.

The trustee has the power to avoid a transfer by the debtor of any interest in the debtor’s property if the transfer is:

  • A preferential transfer, which is broadly defined as a transfer to or for the benefit of a creditor, relating to a prior debt owed to a creditor, if the transfer is made within 90 days of the filing for bankruptcy and while the debtor is insolvent;
  • A fraudulent transfer, which is broadly defined as a transfer made with the intention to hinder, delay, or defraud, future creditors, or a transfer made for less than reasonably equivalent value. The trustee can reach back for a period of two years under the Code, but also has the power to apply state law, which in Colorado, allows the trustee to reach back for up to four years prior to the filing for bankruptcy.

The trustee also has the power to avoid a judicial lien on property which is exempt under the Code. The debtor has the option to apply state law to determine the amount of the exemption. In Colorado, based on the homestead exemption, the debtor can claim up to $60,000 (or, in certain cases, up to $90,000) of the net equity in real property, free of the judicial lien.

Particular problems where closing and insuring transactions intersect with the operation of the Code:

Deeds in lieu of foreclosure
A “deed in lieu” generally describes the conveyance of real property by the owner/borrower to the lender in exchange for the release of property from the lien of the mortgage and possibly the release of the personal liability of the borrower from the note. Such a transaction raises bankruptcy concerns whereby, for example, it can be set aside as a preferential or fraudulent transfer.  Depending on the form of policy issued, a deed in lieu transaction may or may not be covered under the policy.

Most title insurance companies issue policies in the form approved by the American Land Title Association. Both the Owner’s Policy of Title Insurance (6-17-2006) and the Loan Policy of Title Insurance (6-17-2006) exclude coverage for the insured transaction by reason of the operation of federal bankruptcy, state insolvency, or similar creditors’ rights laws. However, the same policies provide coverage (under the “Covered Risks”) for prior transactions by reason of the same matters. However, the Residential Title Insurance Policy (6-1-87) does not contain a similar exclusion from coverage and therefore provides coverage for these matters.

Foreclosure sales
Under Colorado's foreclosure statutes, the filing for bankruptcy, including the automatic stay, will affect the continuation of the foreclosure sale, depending on the stage which the foreclosure sale process has reached.

  1. If all publications of the notice of sale have been completed, the sale is continued for as long as the automatic stay is in effect.
  2. If all publications of the notice of sale have not been completed, the sale is cancelled.
  3. If the relief from stay is granted, or the bankruptcy case dismissed, the public trustee will proceed with the foreclosure sale following all foreclosure procedures as though the foreclosure process has just been commenced.

Pending contracts for the sale of real property
If a contract for the sale of residential real property has not yet been completed, and either the seller or buyer files for bankruptcy, the Code provides that the trustee, or debtor-in-possession, may assume or reject the contract (referred to as an “executory” contract). If the debtor has filed under Chapter 7, the trustee has 60 days to assume or reject the contract. If the debtor has filed under Chapters 11 or 13, the trustee or debtor-in-possession has until the confirmation of the plan to assume or reject the contract (unless the court orders otherwise).

If the contract is assumed, the contract continues under the existing terms and conditions of the contract. The contract must be assumed in its entirety and cannot be assumed in part and rejected in part. Examples of the operation of the provisions of this section of the Code are that the buyer cannot terminate the contract and obtain a return of the earnest money until the decision to assume or reject the contract has been made by the trustee or debtor-in-possession, assuming that the seller has filed for bankruptcy.

The automatic stay will also prevent the commencement or continuation of any action to enforce the contract. For example, if the seller has filed for bankruptcy, the buyer cannot sue the seller under any alleged breach of the contract until the automatic stay has been lifted.

Sales during bankruptcy
During the bankruptcy process, the trustee or debtor may decide to sell property of the estate.
In chapter 7, 11 and 13 cases, the trustee or debtor is authorized to sell property of the estate in two ways:

  1. in the ordinary course of business, without notice or hearing; and 
  2. other than in the ordinary course of business, after notice and hearing.

A sale of property of the estate may be made, free and clear of liens, under certain conditions. In reorganization cases, under chapters 11 and 13, the approved plan may provide for the sale of the property.

The trustee or debtor may also abandon property of the estate, which revests the property in the debtor, who is free to deal with the abandoned property without any further reference to the Code. Generally property which is burdensome to the estate or of inconsequential value and benefit to the estate may be abandoned. In order to abandon property of the estate, the trustee or debtor will file a notice of intention to abandon with the court, and serve a copy of the notice on creditors who may object to the proposed abandonment.

Property of the estate may also be deemed abandoned at the closing of the case, if the debtor listed the property in the schedule of assets, but the trustee did not administer the property during the bankruptcy. Once abandoned, the debtor is free to deal with the property without the consent of the Bankruptcy Court.

For title insurance purposes, a final, non-appealable order of the court will be required in order to insure a sale under any of the above procedures.

Disclaimer: This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal or accounting advice or other expert assistance is required, the services of a competent professional should be sought.
© Copyright, 2012, by Land Title Guarantee Company