Sooner or later, every realtor will encounter a property involved in a bankruptcy case.
Or a property that could escape foreclosure and sell using bankruptcy.
Bankruptcy’s a different world when it comes to real estate. It pays to know how to deal.
Let’s walk through the principles and procedures involved when buying or selling real estate in bankruptcy.
We’ll start with a bit of background on bankruptcy.
Who’s the Debtor
First, entities file bankruptcy, not properties.
It’s glib to say the real estate is “in” bankruptcy, but what that really means is that the entity that owns the property, or an interest in the property, is a debtor in a bankruptcy proceeding.
The entity is “in” bankruptcy.
That entity could be an individual; a corporation or LLC; or a partnership. The “debtor” is the entity who is the subject of the case.
Get the lingo right: debtors are those who owe debts; creditors are those to whom debts are owed.
Usually the entity voluntarily elects bankruptcy, but it is possible for creditors to initiate an involuntary bankruptcy against a financially troubled entity.
For convenience, I’m going to assume here that the entity who is in bankruptcy is an individual and the property is a home. I’ll point out where practice changes if the owner or the property is otherwise.
Property of the Estate
Commencing a bankruptcy case creates an “estate”, similar in many ways to a probate estate. Ownership of the debtor’s assets passes to the estate upon filing the bankruptcy case.
Property can be removed from the bankruptcy estate by means of an allowed exemption, by abandonment, by revesting in the debtor, by sale to an outsider, or by closing the estate.
Property of the estate is part of the pool of assets from which claims of creditors can be paid. Entities who have debts secured by property of the estate are creditors as well, even if the debtor has no personal liability for the debt.
Control and responsibility for property of the estate lies in a case trustee in Chapter 7;
In Chapter 11 or Chapter 13, the debtor controls the property subject to approval by the court. Actions outside of the normal course of business require advance notice to creditors and an opportunity for a hearing before the bankruptcy judge.
This notice to creditors allows the affected creditor body to object if a proposed act is not at arms length or is otherwise objectionable.
The signature feature of any chapter of bankruptcy is the automatic stay. The stay is an injunction that is imposed, automatically, upon filing of a bankruptcy case.
It affects all parties and is designed to protect the debtor, the debtor’s assets, and the assets of the estate for its duration.
The stay is instantaneous: its effectiveness does not depend on having notice of the stay. It makes actions taken in violation of the stay void, and of no legal effect.
In the real estate context, that means if the bankruptcy case is filed even moments before the foreclosure sale, any “sale” that takes place in the moments afterward is ineffective to transfer title. Such a sale after the filing of a bankruptcy case is void, whether or not the creditor or auctioneer knew about the bankruptcy.
Creditors can petition the bankruptcy court to lift the stay if the creditor can prove that the property in question isn’t necessary to a reorganization or more commonly, that a secured interest in the property is adversely affected by the passage of time or non payment.
Relief from the stay is sought by motion, in the bankruptcy court after notice to the debtor, the debtor’s attorney, and any trustee serving in the case.
Powers of the Bankruptcy Court
The Bankruptcy Code enables a number of actions with respect to real property that are unknown, rare, or expensive in state law. As federal law, the Bankruptcy Code trumps contrary state law by reason of the Supremacy Clause of the U.S. Constitution.
- Sale free and clear– the court can order the sale of property free and clear of liens where the lien is disputed. Clear title to the property is conveyed to the buyer and the lien attaches to the proceeds of sale until the dispute is resolved.
- Sale of co owned property– the interests of non-debtor co owners of property can be sold on a showing that the sale of only the debtor’s interest would harm the interests of creditors. The co owners get a right of first refusal, and if they don’t exercise that right, they get their share of the proceeds, net of the costs of sale.’
- Avoidance of liens– judicial liens that invade an exemption that the debtor is otherwise entitled to can be voided or subordinated to the extent necessary to maximize the exemption claim.
- Void preferential liens – liens granted or imposed to secure pre existing debts perfected within 90 days of filing the case, or one year if the lienholder is related to the debtor, can be voided as an unfair preference.
These powers may make the sale of property feasible, where disputes or competing views prevented sale outside of bankruptcy.
That’s an overview of bankruptcy as it affects real estate. For every flat statement, there’s probably an exception or a variation, but this will get you started understanding bankruptcy.
Find more details at Bankruptcy In Brief.com.
Sales during bankruptcy
Let’s look at what a realtor needs to know when the seller is the debtor or a fiduciary for the debtor’s estate.
Professionals of the Estate
Realtors are among the professionals serving and advising the bankruptcy estate whose employment must be preapproved by the bankruptcy judge.
The Bankruptcy Code requires that the professionals of the estate be “disinterested”: that is, free of competing loyalties that might compromise their duty to the interests of creditors of the estate.
The requirement of “disinterestedness” may preclude the estate’s broker from also representing a prospective buyer of the property. Bankruptcy cases are usually assigned to a single judge from start to finish. Inquire of your contact what stance the judge in your case takes.
Courts vary as to whether the realtor listing property for a Chapter 13 debtor needs to be approved in advance.
The debtor or trustee’s lawyer usually prepares the application for approval of a real estate professional’s employment. The realtor will be charged with reviewing the identities of the creditors of the estate and any other parties in interest in the case for past business dealings or current conflicting engagements.
Full disclosure is imperative. One possible consequence of an undisclosed conflict is disallowance of any compensation. Disclose everything with enough facts for the judge to decide whether the relationship is disqualifying or not.
The listing agreement is usually submitted with the application for employment.
Pre sale fix up costs
Taking on new debt is among those actions that require court approval.
Anyone extending credit to the estate, post filing, will want to know that his claim will be paid as an expense of administration, ahead of the debts that existed when the bankruptcy was filed.
When fix up, repairs, or staging is anticipated, if the expenses are to be paid in addition to a sales commission, consider getting court approval in advance.
Know The State of Title
It’s important to determine early on whether there are issues or liens that will require use of the special powers discussed above in order to close. Excercising those powers usually takes more time than the time necessary to get a standard order approving a sales contract.
Those issues could be non debtor owners; liens that could be avoided; or disputed claims subject to sale free and clear. Motions before the bankruptcy court that address the rights of a specific creditor or interest holder require a longer interval between filing the motion and getting a hearing before the judge.
The timing of getting the necessary court orders goes to how long an escrow is necessary between getting into contract and actually closing the transaction.
I usually want 45 days between signing the sale contract and close of escrow. To do it in less time requires either special orders from the court to shorten time, or very good luck.
The listing should in my view disclose that the sale requires court approval.
Court Approval for Sale Contract
Once you are in contract, the terms of the sale can be noticed out to creditors. The creditor body is entitled to 21 days notice of the sale; that means an objection to the sale can be filed within that 21 days. Objections to sale are infrequent when the property has been exposed to the market and the sale is to a third party unrelated to any of the players.
The notice period is subject to being shortened upon application for such an order. The time to actually get an order entered may be longer if a hearing is required. Most courts routinely hear such motions only on certain days of the month. Again, if time is critical, work closely with the bankruptcy attorney involved.
Where the sale proceeds will go is a central question in a notice of proposed sale. An estimated seller’s net sheet is often how that information is presented to creditors. So, the escrow officer should make a prompt demand for payoffs so you have a net sheet when necessary.
I find it useful, as the bankruptcy attorney, to draft the proposed order approving the sale right after filing the motion for approval of the sale. The proposed form of order can be reviewed by the title insurer who will be insuring that the buyer gets what they think they are buying. Sometimes, the avoidance of liens, the interests of co owners, or the identity of the payee of the sale proceeds are issues of concern for the title company.
Assume that you will need a certified copy of any court orders approving the sale or the treatment of liens for inclusion in the public record. The bankruptcy court clerk issues certified orders upon request.
Finality of Court Orders
When the court issues orders approving a sale, or avoiding a lien, those orders are not final for 14 days from entry of the order on the court’s docket. An appeal of the order may be filed within those 14 days.
A careful title insurer will usually insist on waiting out the appeal period before closing the transaction. Make sure that all parties have built that extra time into their timelines.
No provision of the Bankruptcy Code requires that sales of estate property include an opportunity for overbid. Nonetheless, some courts and some trustees want to include a mechanism for competing bids.
Determine the ground rules in advance of the listing, so that no one is surprised by a chance to be outbid.
Sales after bankruptcy
You may encounter clients who have recently filed bankruptcy and now want to sell property that they retained after the bankruptcy. Many individuals emerge from bankruptcy still holding title to their homes because the trustee elected not to liquidate the property or because their exemptions covered all the equity in the property.
Let’s look at some of the issues that can arise when the bankruptcy is behind the seller.
Real estate continues to be property of the estate, subject to the automatic stay, until abandoned, sold, or the case is closed.
The administration of bankruptcy estate assets may extend beyond the point at which the debtor gets a discharge. So the case may be open on the court’s records, yet the debtor has their allowed exemptions and their discharge.
Sale of a home under those circumstances may require that the debtor get a court order expressly abandoning their property so that they can eliminate the cloud on title created by an open bankruptcy case.
Early involvement of your title company will tell you whether the pendency of a bankruptcy case is an impediment to title insurance.
If a court order is required, abandonments are effected by a motion addressed to the court; trustees will often stipulate to abandonment, but some courts require explicit notice to creditors. Debtor’s bankruptcy attorney should be able to help.
Early resort to a preliminary title report may turn up judgment liens from before bankruptcy that the homeowner didn’t know about or neglected to have removed.
Bankruptcy law allows the voiding of an otherwise valid judgment lien to the extent necessary to give the debtor the full benefit of the available exemptions.
Most courts are receptive to the debtor avoiding a lien impairing an exemption after the bankruptcy case is closed. The analysis is based on the value of the property, the balances of senior liens, and the lien to be avoided, as of the date of the bankruptcy filing.
The time required to reopen a bankruptcy case and move to avoid a lien is most likely six weeks or more. So the sooner the issue is identified, the sooner you are in a position to close a sale.
Another scenario involves liens were avoided in bankruptcy but the order that was entered in the bankruptcy court doesn’t appear in the public record.
Know the bankruptcy neighborhood
Bankruptcy, past or pending, shouldn’t be a bar to getting a property sold. Success needs only an understanding of how bankruptcy works and careful management of timelines and expectations as you work toward closing.