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8th Cir. BAP Rules No Bankruptcy Jurisdiction Over Third-Party Challenge to Validity of Mortgage

The U.S. Bankruptcy Appellate Panel for the Eighth Circuit recently applied the “conceivable effect” test in holding that a bankruptcy court lacked jurisdiction over a state law fraud claim raised by a third party regarding the validity of a lender’s lien, and therefore, declined to consider the issue on appeal.

In so ruling, the Panel ruled that the state law fraud claim did not invoke “arising under” or “arising in” jurisdiction of the bankruptcy court because the state law fraud claim was not created or determined by the Bankruptcy Code, and could exist outside of bankruptcy.

A copy of the opinion in Michael McDougall v. Ag Country Farm Credit Service is available at:  Link to Opinion.

The debtors were farmers and ranchers who purchased 880 acres of land in North Dakota under a contract for deed.  The debtors lived on 160 acres of the parcel (“home parcel”) which was later sold to the defendant ranchers.

The debtors borrowed nearly $400,000 from the lender to pay their operating expenses under eight separate loans, two of which were secured.  In March 2016, the lender approved short-term loan extensions for the debtors in exchange for them providing a security interest in additional real estate.

The debtors executed eight promissory notes and loan modification agreements, as well as a mortgage to secure payment of the notes.  Although the legal description of the mortgage included the home parcel, the ranchers owned the home parcel at the time the mortgage was executed. On April 5, 2016, the ranchers conveyed the home parcel back to the debtors because they believed it would help them qualify for an operating loan. The mortgage was recorded the same day.

However, once the debtors discovered the lender would not loan any more funds, they conveyed the home parcel back to the ranchers on April 7, 2016. At that time, the home parcel was already encumbered by the lender’s mortgage.

The debtors later filed a voluntary petition for relief under chapter 12 of the Bankruptcy Code and an adversary proceeding naming the ranchers and lender as defendants. In their answer, the ranchers asked the bankruptcy court to invalidate the lender’s lien on the home parcel based on a state law fraud claim.

The bankruptcy court entered judgment in the adversary proceeding for the lender and against the debtors.  In doing so, it examined North Dakota law with reference to the transfer of the home parcel to the debtors and the grant of the mortgage to the lender, and stated that the debtors did not meet their burden of showing actual fraud.  As a result, the lender was found to have a valid and enforceable mortgage lien against the home parcel.

The bankruptcy case was later converted to chapter 7. Thereafter, the bankruptcy court denied a motion to reconsider the judgment in the adversary proceeding. The debtors, ranchers, and the chapter 7 trustee appealed the judgment in the adversary proceeding and the denial of the motion to reconsider.

Initially, the Panel granted the lender’s motion to dismiss the debtors’ appeal based on lack of standing and the trustee’s appeal because it was untimely. However, the lender’s request to dismiss the ranchers’ appeal was denied.

On appeal, the ranchers challenged the bankruptcy court’s judgment against the debtors in favor of the lender by arguing state law fraud and sought a determination as to whether the lender held a valid lien on the home parcel.

The panel first explained that the ranchers failed to assert a cross-claim or counterclaim in the adversary proceeding regarding the validity of the lender’s lien on the home parcel, and therefore, it would not consider a matter that was not properly brought before the bankruptcy court.

Nevertheless, to the extent the ranchers did assert a claim regarding the validity of the lien below, the Panel found that the bankruptcy court had no jurisdiction over the dispute between the ranchers and lender. The Panel noted that bankruptcy courts have “original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11.” See 28 U.S.C. § 1334(b); 28 U.S.C. § 157(a). The Panel then explained that the Eighth Circuit uses the “conceivable effect” test to determine the existence of “related to” jurisdiction for non-core proceedings.

Under this test, courts consider whether the outcome of the civil proceeding would conceivably have any effect on the estate being administered in the bankruptcy.  In other words, “[a]n action is related to bankruptcy if the outcome could alter the debtor’s rights, liabilities, options, or freedom of action … and which in any way impacts upon the handling and administration of the bankruptcy estate.” Dogpatch Props., Inc. v. Dogpatch U.S.A., Inc. (In re Dogpatch U.S.A., Inc.), 810 F.2d 782, 786 (8th Cir. 1987) (quoting Pacor, Inc. v. Higgins, 743 F.2d 984, 994 (3d Cir. 1984), overruled on other grounds by Things Remembered, Inc. v. Petrarca, 516 U.S. 124, 129 (1995)).

The Panel further explained that “related to” jurisdiction is broad but has limits, and therefore, “bankruptcy courts have no jurisdiction over proceedings that have no effect on the estate of the debtor.” Celotex Corp. v. Edwards, 514 U.S. 300, 308 n.6 (1995)).

Applying the “conceivable effect” test, the Panel determined that the ranchers’ claim involved a state law fraud dispute between the lender and ranchers, both non-debtors, concerning property that was not part of the bankruptcy estate. Indeed, the transfer of the home parcel to the ranchers was completed prior to the filing of the debtors’ petition. Thus, the outcome of the dispute would not have an effect on the bankruptcy estate.

Further, the panel noted that when questioned on the issue of jurisdiction at oral argument, the parties were unable to satisfactorily explain how the outcome of the dispute between the ranchers and lender could have a conceivable effect on the bankruptcy estate.

Thus, the Panel found that it could not consider the merits of the ranchers’ and lender’s dispute because the bankruptcy court would not have had jurisdiction.  Accordingly, the Panel remanded the case to the bankruptcy court with instructions to dismiss the ranchers’ claim regarding the validity of the lender’s lien against the home parcel.

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Stuart Miles is based in Maurice Wutscher's Chicago office and practices in the firm's Consumer Credit Litigation and Commercial Litigation groups. Before joining Maurice Wutscher, Stuart served as an Assistant Corporation Counsel with the City of Chicago’s Department of Law, where he earned the Chicago Landmark Award for Preservation Excellency from the City of Chicago Office of the Mayor and a Problem Solving Award from the Chicago Police Department. As a member of the City’s Drug and Gang House Enforcement division, he successfully conducted hundreds of trials and evidentiary hearings, including concerning criminal activity at residential buildings and at various nightclubs. He has also worked as a criminal defense and civil rights attorney. Stuart holds a Bachelor of the Arts degree in Political Science from the University of North Carolina – Chapel Hill. He earned his Juris Doctorate graduating cum laude from The John Marshall Law School in Chicago. While in law school, Stuart completed a judicial externship in the Mortgage Foreclosure Section of the Circuit Court of Cook County.

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