BANKRUPTCY COURT RULING MAKES FORECLOSURE AUCTIONS AVOIDABLE

Attorneys and foreclosure auction bidders are likely familiar with the so-called “Gavel Rule” pertaining to bankruptcy filings which occur shortly after a foreclosure sale auction has transpired.  The Gavel Rule provided that so long as the auction was concluded—by the fall of the proverbial gavel—before the owner filed for bankruptcy, the sale could not be undone by the bankruptcy filing.  In actuality, the owner’s equity of redemption was terminated at the signing of the memorandum of sale, an event that would follow directly after the conclusion of the auction, but nevertheless, the Gavel Rule name has stuck. 

Due to a recent ruling by the U.S. Bankruptcy Court for the District of Massachusetts, however, the Gavel Rule is no longer the law in the Commonwealth.

In the case of In re Neiva, the Court held that the foreclosure sale is “avoidable” under 11 U.S.C. 544(a)(3) up until the point that the foreclosure sale is “evidenced by a recording at the relevant registry of deeds”.  In other words, until the world is put on notice that the foreclosure sale was conducted, and concluded, by filing a document at the registry of deeds, the owner can potentially undo the sale through a timely bankruptcy filing.  Note that the Court did not state that the foreclosure deed must be recorded.  Rather, the Court stated that a recording must evidence that the sale took place, which leaves open the possibility of recording something other than the deed itself which typically would not get recorded for 30 days or more once the sale closes.

In the case of Mr. Neiva, the property he nearly lost at the foreclosure auction was worth approximately $700,000.00 but the sale price was a mere $315,000.00.  By avoiding the sale, Mr. Neiva was able to regain approximately $385,000.00 of equity which he could use to pay off the mortgage and other creditors.

The case hinged on Section 544(a)(3) of the Bankruptcy Code which allows a Bankruptcy Trustee to avoid a “transfer of a debtor’s interest in real property”—such as a pre-bankruptcy foreclosure sale—“to the extent the transfer could have been avoided by a bona fide purchaser under state law.”  Section 544(a)(3) requires that a transfer not be perfected in order to be avoidable as to a bona fide purchaser.  Perfection depends upon applicable non-bankruptcy law meaning state law. 

The Judge then turned to Massachusetts law which requires the transfer of real estate to be perfected by filing evidence of the transfer (such as a deed) with the applicable registry of deeds. 

The recording of the deed makes the transfer binding against third parties and provides notice to the world.  Since the foreclosure deed had not been recorded, the transfer (the foreclosure sale) was not perfected and therefore deemed avoidable by the Court.

The Court acknowledged that the decision reached to end the Gavel Rule was at odds with case law from bankruptcy courts in other states. However, the Court pointed out that the law in Massachusetts is what created a different outcome than the other cases from other states such as New York and Texas. 

In the case cited by the parties trying to stop the sale from being avoided, state law imposed a duty on prospective purchasers of real estate to inquire as to whether a foreclosure sale has occurred when pre-foreclosure notices appear on record with the Registry. But in Massachusetts, there is no duty to inquire.  Thus, under Massachusetts law, pre-foreclosure notices recorded at the registry would not suffice to put a bona fide purchaser on notice of a possible foreclosure sale and more importantly, the bona fide purchaser would not have to inquire further.  Consequently, the Court reasoned, the lack of a foreclosure deed, or other evidence that the foreclosure sale occurred, means that the sale was avoidable.

Remember, the sale is avoidable under bankruptcy law only if a bona fide purchaser could avoid the sale.

Therefore, due to the fact that there is no foreclosure deed on record, and due to there being no duty to inquire as to a foreclosure sale having taken place, a bona fide purchaser in the state of Massachusetts would indeed be able to avoid the sale.

In the end, the foreclosure sale was avoided and the Debtor retained his interest in the property subject to existing liens.  The real world consequence is that the Debtor did not lose his equity and could either repay his mortgagee through the Chapter 13 bankruptcy plan, or, he can seek approval to sell the property so as to pay off lienholders and pocket the remaining equity.

The bottom line: a foreclosure sale can be avoided in bankruptcy court if a foreclosure deed, or other evidence of the foreclosure sale, has not yet been recorded.  To avoid a late bankruptcy filing upending the finality of a foreclosure sale, it is advisable for the condo’s attorney to file an affidavit or other document with the Registry stating that a foreclosure sale took place at a particular date and time relative to the subject unit.

Contact Dean Lennon for questions concerning this decision, or regarding bankruptcy issues generally.