The U.S. Court of Appeals for the Sixth Circuit recently held that a debtor’s claim seeking to use a bankruptcy trustee’s § 544(a) strong-arm power to avoid a mortgage on the ground that it was never perfected did not require appellate review of the state court foreclosure judgment, and therefore was not barred by the Rooker-Feldman doctrine.
A copy of the opinion in In re Isaacs is available at: Link to Opinion.
In 2003, the debtor and her husband took out a home-equity loan secured by a mortgage on their home in Kentucky. The original mortgagee did not immediately record the mortgage, and while the mortgage remained unrecorded, the debtor and her husband filed a chapter 7 bankruptcy.
While the bankruptcy was pending, the mortgagee recorded the mortgage in violation of the automatic stay, although the issue was never raised. The loan was not reaffirmed, and the bankruptcy court entered a discharge order.
A decade later, the new owner of the mortgage loan sought to foreclose the debtor’s home in Kentucky state court. On Aug. 22, 2014, the state court entered an in rem judgment of foreclosure, and ordered a foreclosure sale. The foreclosure sale was scheduled for Sept. 30, 2014, but one day before the sale, the debtor filed a voluntary chapter 13 petition.
The debtor then filed an adversary complaint against the new mortgagee seeking to avoid the mortgage through the so-called “strong arm” power conferred by 11 U.S.C. § 544(a), which permits the bankruptcy trustee to “avoid transfers of the property that would be avoidable by certain hypothetical parties.”
Specifically, the debtor sought to use the strong-arm power to avoid the mortgage on the ground that it was never properly perfected because it was recorded in violation of the automatic stay, and actions taken to perfect a lien are “invalid” if they violate the automatic stay. The parties filed cross-motions for summary judgment, which were initially denied.
In a renewed motion for summary judgment, the debtor presented an “alternate argument” that the mortgage lien never attached in the first place, and thus the mortgagee had no valid lien to enforce. In support, the debtor argued that the mortgage contained conflicting language about when its lien would attach to the collateral. One section could be read to mean the mortgage lien attached when the mortgage was signed, while another section could be read to mean that the lien would not attach until it was recorded.
Based on the latter section, the debtor argued that the lien could not attach until it was recorded, and that because it was not recorded before the chapter 7 bankruptcy was filed, and because the recording during the bankruptcy was invalid, the mortgage remained unattached and the unsecured debt was discharged in 2004.
In response, the mortgagee argued that the lien attached when the debtor signed the mortgage, and that the bankruptcy court lacked jurisdiction under the Rooker-Feldman doctrine because the debtor was effectively asking the bankruptcy court to sit as an appellate court over the state court’s final foreclosure judgment.
The bankruptcy court granted summary judgment in favor of the debtor, concluding that the mortgage agreement unambiguously did not attach until it was recorded. The bankruptcy court also rejected the mortgagee’s Rooker-Feldman argument based on the Sixth Circuit decision in Hamilton v. Herr (In re Hamilton), 540 F.3d 367 (6th Cir. 2008), which recognized a narrow exception to Rooker-Feldman under which a federal bankruptcy court may determine whether a state-court decision correctly interpreted a prior bankruptcy discharge order.
The matter was appealed to the Bankruptcy Appellate Panel, which reversed. The BAP concluded that the mortgage agreement was unambiguous, but in the opposite way. That is, the BAP held that the mortgage unambiguously provided that its lien attached when the parties signed it. Thus, the BAP ruled that the state court’s judgment was not void ab initio under In re Hamilton because it correctly construed the discharge order, and therefore the BAP held that Rooker-Feldman deprived the bankruptcy court of subject matter jurisdiction.
The matter was then appealed to the Sixth Circuit.
On appeal, the Sixth Circuit first noted that “[t]o determine whether the Rooker-Feldman doctrine bars this action, we must distinguish between [the debtor’s] two different claims.”
The first claim sought “to avoid the mortgage on the ground that its lien never attached, that [the mortgagee] therefore lacks an enforceable mortgage altogether, and that the Kentucky court wrongly enforced it.” The second claim sought “to use the trustee’s § 544(a) strong-arm power to avoid the mortgage on the ground that it was never perfected, regardless of whether the Kentucky court properly acted when it did.”
The Sixth Circuit concluded that the Rooker-Feldman doctrine barred the first claim but not the second.
In so ruling, the Court noted that the first claim was barred because where “the source of the injury is the state court decision,” then Rooker-Feldman applies. As the debtor’s requested relief sought a “declaration that the . . . mortgage is unenforceable and that the court order foreclosing said mortgage, entered by the [Kentucky state court] be declared unenforceable,” the “request effectively asks the bankruptcy court to vacate the state-court judgment, and thus it clearly identifies the state-court judgment as the source of [the debtor’s] injury.” Accordingly, the Rooker-Feldman doctrine applied.
Moreover, the Sixth Circuit ruled that the In re Hamilton doctrine did not apply, because it was only created to reconcile Rooker-Feldman with the protection for debtors provided by section 524(a), but 524(a) only protects debtors from being personally liable for discharged debts.
“When a debtor forecloses on a lien, the debtor’s personal liability is not at stake, and therefore § 524(a) does not come into the picture.” Thus, Hamilton did not apply as the state court only entered an in rem judgment of foreclosure.
However, the Sixth Circuit held that the debtor’s second claim, which sought “to use the trustee’s § 544(a) strong-arm power to avoid the mortgage on the ground that it was never perfected,” was not barred by Rooker-Feldman because it did “not require federal appellate review of the state court’s judgment.”
Instead, “the bankruptcy court could hold for [the debtor] on this claim without finding any error in the state court’s judgment whatsoever,” because the state-court foreclosure judgment determined only that the mortgage debt “is secured by a certain mortgage,” which “constitutes a valid second mortgage upon the real estate.” It did not make any findings with regard to perfection.
“No Rooker-Feldman problem is presented, then, because the bankruptcy court need not review the state court’s judgment at all.”
However, “[n]either the bankruptcy court nor the BAP passed on that claim, and the parties have not focused on its merits in their briefing before this court.” Therefore, the matter was remanded for further proceedings.