Foreclosure Warning: Property Possessed but Not Owned by a Debtor May Be Subject to the Automatic Stay

Home underwater

Creditors know that a bankruptcy petition automatically halts efforts to collect pre-petition debts from the debtor outside of bankruptcy. 

The "automatic stay" provides fundamental protection to debtors, mandating a full stop on collection activity.  Creditors violate the stay at their peril.  If you violate the stay, even without the intent to do so, you can be held in contempt and forced to pay damages.  So if a creditor is foreclosing on a debtor's residence, it is a full stop. 

But what if the residence is titled in the name of a limited liability company, and the debtor merely resides in the property?  An LLC is a distinct legal entity separate from its members.  The LLC is the record owner of its assets – not the members. And when an individual LLC member files for bankruptcy, LLC assets are not property of the debtor’s bankruptcy estate.  So if the LLC is not in bankruptcy, then the creditor can proceed with foreclosure, right?  Wrong.

The Second Circuit Court of Appeals (which encompasses courts in New York, Connecticut, and Vermont) recently held that a foreclosure sale under these circumstances violated the automatic stay.  Although the decision is not binding on North Carolina bankruptcy courts (which are part of the Fourth Circuit), it nevertheless should give creditors pause if they encounter this scenario.  For they can expect debtors to argue that the reasoning applies.

Eileen Fogarty held a 99% interest in an LLC that owned her primary residence.  The LLC defaulted on a secured loan, and Bayview Loan Servicing initiated a New York foreclosure action, which requires filing a complaint.  In the complaint, Bayview named the LLC and Fogarty as defendants.  Bayview obtained a judgment that empowered it to sell the property under the supervision of a court-appointed referee. 

Bayview scheduled a sale, but before it occurred, Fogarty filed for bankruptcy.  Bayview knew about the filing but proceeded with the sale on the theory that the LLC owned the property, not Fogarty, and because the LLC had not filed for bankruptcy, no automatic stay was in effect.

Fogarty sought sanctions against Bayview for willful violation of the automatic stay.  The bankruptcy court denied Fogarty's motion and agreed with Bayview.  But on appeal, the district court reversed, holding that because Fogarty was a named defendant in the foreclosure action, the sale was a willful violation of the automatic stay.  Bayview appealed to the Second Circuit.

The Second Circuit affirmed the district court, holding that the foreclosure sale violated the automatic stay on several grounds.  The Court explained that filing a bankruptcy petition is not only a stay of the commencement or continuation of a judicial, administrative, or other action against the debtor that was or could have been commenced before the bankruptcy was filed, but is also a stay of the enforcement of a judgment against the debtor or property of the estate if the judgment was obtained before the bankruptcy filing.  First, the Court held that the sale was a continuation of an "action against the debtor" because Fogarty was a defendant in the foreclosure action.  Second, the Court also found that because the judgment against Fogarty and the LLC allowing the sale was entered before Fogarty's bankruptcy filing, enforcing it after the filing violated the stay.  Finally, Fogarty's possessory interest as a tenant of the property was property of her bankruptcy estate protected by the automatic stay. 

Bayview argued that because it named Fogarty only as an interested party, not as a party liable for the LLC's default, her bankruptcy did not affect its ability to foreclose on the LLC's property.  The Court rejected this argument.  The Court held that no matter the reason for a debtor's status in an action or proceeding, if the debtor is a named party, the automatic stay applies.

This foreclosure was under New York law, which requires the creditor to commence a lawsuit by filing a complaint.  In North Carolina, foreclosure of a deed of trust under a power of sale provision does not require a lawsuit.  But state law requires the foreclosing party to send notice of the foreclosure hearing to "any person obligated to repay the indebtedness against whom the holder thereof intends to assert liability therefor."  It also is customary to send notice of a foreclosure sale to all tenants or occupants of the property.  

Creditors faced with this scenario could leave the individual debtor out of the foreclosure.  But by doing so, assuming the individual guaranteed the debt, they would waive any deficiency claim against him or her in the bankruptcy.  And they still might face a charge that the individual's tenancy is protected by the automatic stay.  The safest course of action is to pause the foreclosure and seek stay relief from the bankruptcy court. 

© 2024 Ward and Smith, P.A. For further information regarding the issues described above, please contact Lilian L. Faulconer or Lance P. Martin.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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