Possible Change on the Horizon for Foreclosure Law


The current financial crisis ushered in by the collapse of the sub-prime mortgage market has shaken the foundations of our financial markets, exposed numerous Ponzi schemes, most infamously that of Bernard Madoff, and resulted in a tremendous increase in home foreclosures and bankruptcies.  In many of the current bankruptcy cases the line between a fraudulent conveyance and a legitimate transfer can make a difference of millions of dollars for the legitimate creditors.   In the realm of real estate, this situation has placed on the courts the burden of deciding which is more important: fair and equitable distribution of assets among creditors, or the historical distinctions between fraudulent conveyance law and foreclosure law.  

In the late 1980’s and early 1990’s a trend emerged whereby Bankruptcy courts began to allow homeowners who had become insolvent to avoid sales of foreclosed properties that occurred as early as 1 year before the debtor declared bankruptcy.  See Glaves, The Controversy Over Section 548 of the Bankruptcy Code in the Mortgage Arena: Making the Case for a Federal Statute Reforming the Foreclosure Process, 23 J. Marshall L. Rev. 683 (1990); Ehrlich, Avoidance of Foreclosure Sales as Fraudulent Conveyances: Accommodating State and Federal Objectives, 71 Va.L.Rev. 933 (1985).  The courts declared these transfers as fraudulent transfers under the meaning of 11 U.S.C. § 548(a)(2), which states that voluntary or involuntary transfers by insolvent debtors for ‘less than reasonably equivalent value,’ made within one year prior to bankruptcy, are presumptively fraudulent and avoidable by the trustee.  Ehrlich at 934.  Considering the emphasis Federal bankruptcy policy places on, “attaining a maximum …distribution [of debtors assets] to the general creditors of the debtor,” the argument for this application of the law followed that, “due to the fact that the typical foreclosure sale yielded far less than the fair market value of the property being sold,” the purchaser at the sale subsequently received a, “windfall at the expense of the mortgagor’s unsecured or under-secured creditors.”  Id. at 933-34.

 Therefore, “[a]pplying section 548 to foreclosure sales can provide relief for the mortgagor and his creditors …by giving the bankruptcy trustee the opportunity to resell the property at a price which presumably will more closely reflect the property’s true market value.”  Graves at 686.

Opponents argued that this application undermines the state-mandated foreclosure sale system.  Id.  From a state policy perspective, mortagees must, “have an expeditious and final forum to realize the value of mortgaged collateral, and potential bidders at the sale must be assured that their newly acquired title is irrevocable.”  Ehrlich at 933.  For this reason, many states operate under the “near-universal principle that a non-judicial foreclosure sale will not be overturned, nor will confirmation of a judicial foreclosure be denied, because of ‘mere inadequacy in the price received.”  Id.  Further, “applying § 548 in this context destabilizes the certainty of titles transferred at foreclosure sales, and thus is likely to exacerbate the underlying problem of inadequate foreclosure sale prices.”  Graves at 686.  As one commentator has acknowledged, this creates an “inevitable tension between state and federal policies,” which govern the finality of such transfers.   Ehrlich at 933.  

In, BFP v. Resolution Trust Corp, the Supreme Court attempted to relieve this tension when it ruled that the phrase “reasonably equivalent value” would not be read to mean that inadequacy of the sales price is a basis for setting aside a sale absent some deviation from proper procedure.   BFP v. Resolution Trust Corp., 511 U.S. 531 (1994).    This ruling however did not deal with the claim that the procedures by which many states conduct these sales create a distinction between foreclosed properties and regular real estate.  See Graves.  Dissenters claim that because of the different markets created by this system there will consistently be a problem with windfall profits gained at the expense of the legitimate creditors who have an interest in the bankrupt debtor’s assets.  Id. 

Recent events, such as the court trending toward an “objective” good-faith standard when deciding whether a transferee can be exempted from a § 548 avoidance, may represent a broadening of the courts understanding of the principles guiding fraudulent conveyance law.  Cases like Tacoma, In re M & L Business Machine Co., and Bayou, show a propensity to view the line between the principles guiding fraudulent conveyance law and those guiding preference law as non-existent.  (Tacoma Assoc. of Credit Men v. Lester 433 P.2d 901 (Wash. 1967); Jobin v. McKay (In re M & L Bus. Mach. Co.) 84 F.3d 1330, 1335 (10th Cir. 1996); In re Bayou Group, LLC, 396 B.R. 810, 843-49 (Bankr. S.D.N.Y. 2008)).  Traditionally,  the guiding principle of fraudulent conveyance law had been to ensure that a debtor’s assets were not squandered or transferred to non-creditors without allowing that “some creditor” get paid.  Lutterbein, “Fraud and Deceit Abound” but do the Bankruptcy Courts Really Believe Everyone is Crooked: The Bayou Decision and the Narrowing of “Good Faith,” 18 Am. Bankr. Inst. L. Rev. 405 (2010).  “The basic object of fraudulent conveyance laws is to see that the debtor uses his limited assets to satisfy some of his creditors…“it does not seek to ensure that all creditors are guaranteed payments or paid equally.”  Boston Trading Group Inc. v. Burnazos, 835 F.2d 1504, 1509, 1512 (1st Cir. 1988); Lutterbein at 422.  Preference law on the other hand had as its guiding light the equity of creditors.  Lutterbein at 422.  There is an argument to be made that more and more the courts are trending to treat conveyances that place creditors in an unequal position, due simply to bankruptcy filing dates, as fraudulent.  This is an interesting development and I am excited to watch which way the courts will lean in deciding the future of fraudulent conveyance law.