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STRONG ARM CLAUSE - §544(a). Policy: To avoid secret liens on real and personal property.

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Policy: To avoid secret liens on real and personal property.

Section 544(a) allows the trustee or DIP to void unperfected Article 9 security interests and unrecorded mortgages on real property by conferring on the trustee or debtor in possession the status of (1) a judicial lien or judgment creditor; or (2) a bona fide purchaser of real property.

The effect is that the trustee can avoid any security interest, lien or encumbrance that a judicial lien creditor or a bona fide purchaser would take free of under state law.

State and Federal Bankruptcy law work hand in hand to avoid the interest. State law determines the trustee’s (or DIP’s) rights, primarily the priority of the trustee’s claim, as a judicial lien creditor or BFP. Federal Bankruptcy law determines the consequence of those rights/priority; namely, that the inferior lien or transfer is avoided. 11 U.S.C. §544(a). Even if state law merely subordinates the unperfected lien or security interest, 544(a) makes it avoidable in its entirety.

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EXCEPTION TO 544(a) Avoidance

  • 11 U.S.C. §§ 362(b)(3) and 546(b) limits avoidance if applicable non-bankruptcy law provides for retroactive effect of perfection; such as for purchase money security interests.

  • 11 U.S.C. §546(a) statute of limitations, which is applicable to all avoidance power actions.

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  • McCannon v. Marston [Pg. 469]

    • In 3/73 McCannon signed a contract to buy a condominium in a hotel which was owned and operated by the Debtor. She paid a $500 deposit toward the $18,000 purchase price and took up residence in the unit in 4/75. McCannon never received record title to the unit and never recorded her contract of sale. In 11/79 Debtor filed chapter 11. As of the petition date McCannon resided and continued thereafter to reside in the unit. After bankruptcy McCannon filed a complaint seeking specific performance of the purchase contract. The trustee counterclaimed to avoid McCannon’s interest under Section 544(a)(3). Under state law McCannon had equitable but not record title to the unit.

    • Who wins? What did the court rule?

  • The phrase in 544(a) “without regard to any knowledge of the trustee or any creditor” is to clarify that the DIP may avoid an unrecorded mortgage executed by the debtor before bankruptcy because a BFP would take free of an unrecorded mortgage.

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  • [pg. 473] David, an experienced investor, from time to time has invested money for family and friends. For example, his Aunt Minnie gave him $40K to invest, Cousin Harry gave him $25K and George, his neighbor gave him $35K. With the money David bought the following:

    • 100 shares of stock for $15,000 registered in David’s name

    • Blackacre, a vacant lot, for $50,000 recorded in David’s name

    • $35,000 loan to Roe who gave David a promissory note to evidence the debt and secured that obligation with a mortgage on Whiteacre, Roe’s residence. The note was payable to David and David was the mortgagee. The mortgage was duly recorded.

      David signed documents clearly indicating that the transactions were for the benefit of Minnie, Harry and George and that they hold undivided interests in the stock, Blackacre and the promissory note proportionate to the investments made by each of them (i.e. 40%, 25% and 35%, respectively).

      If David files bankruptcy does any of the property held by David as a result of the $100K investment become property of the estate?

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  • Statutory lien defined as a “lien arising solely by force of a statute on specified circumstances or conditions but . . . does not include security interest or judicial lien” 11 U.S.C.§101(53).

  • Trustee or DIP may avoid the fixing of a statutory lien on property of the debtor to the extent that such lien –

    • First becomes effective against the debtor-

      • (A) when a title 11 case is commenced

      • (B) when an insolvency proceeding other than under title 11 concerning the debtor is commenced

      • (C) when a custodian is appointed or authorized to take possession

      • (D) when debtor becomes insolvent

      • (E) when debtor’s financial condition fails to meet a specified standard

      • (F) at a time of an execution against Debtor’s property by a creditor.

    • Is not perfected or enforceable against a BFP on the petition date

    • Is for rent; or

    • Is a lien of distress for rent. 11 U.S.C. §545

  • Policy: to avoid reordering of bankruptcy distribution scheme.

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  • Section 510(c) provides that after notice and a hearing the court may –

    • (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or a part of another allowed interest; or

    • (2) order that any lien securing such a subordinated claim be transferred to the estate.

  • Bankruptcy courts have equitably subordinated claims where certain criteria have been met. Those criteria are set forth in Matter of Mobile Steel Co.,563 F.2d 692 (5th Cir. 1977) as follows:

    • The creditor engaged in inequitable conduct

    • The misconduct resulted in injury to debtor’s creditors or conferred an unfair advantage on the claimant

    • The subordination is not inconsistent with the provisions of the Bankruptcy Act/Code.

    • “Inequitable conduct” includes: fraud, illegality, breach of fiduciary duty, under capitalization, or use of debtor as a mere instrumentality.