Should the Widow Win? Part 2

Go here for Part 1 of this discussion (from nearly three months ago!).

Recapping the facts of In re Turnage, 

Widow of ne'er-do-well late husband files Chapter 7 bankruptcy with one asset--her home--valued at $180,000 subject to the following liens: a $52,000 mortgage, a $113,143 tax lien in favor of the IRS, and a $47,942 lien in favor of the Deportment of Taxation of North Carolina. Our widow is left with negative "equity" of nearly $34,000. In other words, the property is underwater, financially speaking. 

North Carolina law also affords our impoverished widow a homestead exemption of $55,000. Regrettably for her, however, the same law subordinates the homestead exemption to mortgages and tax liens.

How would bankruptcy help our widow? In the first place, it discharges her legal obligation to pay all three debts. This is important because her only significant income is from Social Security.

But what of her home?

Both federal and state law prohibit the relevant tax authorities from foreclosing on a homestead. In other words, their liens for unpaid taxes simply remain in place until the widow seeks to sell.  At that point they must be paid so a buyer will get clear title. The widow's death would lead to the same result. In short, she gets to live in the home as long as she wants/can and the liens are toothless until she or her estate sells the property. A win for the widow and delayed gratification for the tax authorities.

Enter the bankruptcy trustee. (Recall that the widow chose to file under Chapter 7 of the Bankruptcy Code, for better and for worse.) He asked the Bankruptcy Court for permission to sell the house and turn over the proceeds to the tax authorities. But why would he waste his time and go the the trouble (and expense) of doing this? After all, bankruptcy trustees are paid on a commission basis and generally don't get a cut from the sale of property whose value is more than swallowed by a lien.

In this case, however, the tax authorities agreed to take less than what was owed to them, thus freeing enough of the proceeds to pay the fees and expenses of the trustee. (And even a few dollars left over for unsecured creditors. Of course, the tax authorities also would have had the largest unsecured claims so they would get most of what's left over. C'est la guerre.)

Pretty slick. Or so it seemed.

Part 1 explained why I was unimpressed with the opinion of the United States Federal District Court judge barring this maneuver and leaving the widow in her home. The opinion of Bankruptcy Judge (linked above) is much more cogent. I don't have the inclination to articulate her reasoning because I want to make some observations on a path that was not followed, one that could have changed the result and let the bankruptcy trustee proceed with the sale.

Thirty years ago the United States Court of Appeals for the First Circuit (basically, the federal appellate court for the New England states) issued its opinion in In re SPM Manufacturing Corp. 984 F.2d 1305 (1st. Cir. 1993). The court in SPM permitted a result that in many respects is what the bankruptcy trustee was seeking in this case. The court permitted the secured creditor to "gift" a share from the sale of its collateral to general unsecured creditors even though other creditors held claims that had priority over unsecured claims. Essentially, the secured creditor was entitled to do what it pleased with the proceeds of its collateral.*

There was, however, one potentially significant legal difference between the situation in SPM and our case: the secured creditor in SPM had obtained relief from the automatic stay. In other words, the proceeds were the creditor's, not part of the bankruptcy estate. Still, the proceeds were distributed by the bankruptcy trustee under the aegis of the bankruptcy court. Not important, according the the appellate court.

I'm not sure whether the court in SPM would have reached a different result had the secured creditor not obtained relief from the stay. It went on to observe in dicta that a senior creditor could have purchased the non-priority unsecured claims to whom the trustee made the distributions in SPM and achieved the same result. An end-around the end-around.

There is a second difference between the facts of SPM and our widow's case: the widow has an exemption; she isn't asserting a priority claim. Treating the widow's exemption differently than that of a typical priority creditor makes sense as a matter of policy. Her position is, however, undercut by both federal and North Carolina law that subordinate a homestead exemption to tax liens.

I believe the bankruptcy trustee would have been unwise to appeal this case to the Fourth Circuit given the sympathies for the widow. I would like, however, to find out whether the Fourth Circuit would follow the precedent of SPM. This was not the case to make that effort.

* N.B. Most courts have held that out-of-priority-order gifting is not permitted in Chapter 11 cases because of the "absolute priority rule." Distributions in Chapter 7 cases are not subject to this rule.