In a unique opinion out of the District of Massachusetts (resurfacing the problematic issue of bankruptcy debtor’s strong-arm powers), the bankruptcy court in In re Neiva, 2024 WL 544049 determined that a bankruptcy debtor has the ability to unwind a valid pre-petition foreclosure sale, by utilizing avoidance powers of §544(a)(3) of the Bankruptcy Code. The bankruptcy court – describing a “well-settled” law of the Commonwealth – agreed with the bank/defendant’s assertion that a mortgagor’s equity of redemption extinguishes upon the execution of a memorandum of sale at the auction. As such, it was uncontroverted that the property at issue in this case was not part of the debtor’s bankruptcy estate at the time of filing.

Notwithstanding the fact that the debtor had lost his right to redemption in the property, the bankruptcy court examined the debtor’s ability to undo (“avoid”) the foreclosure sale given the application of §544(a)(3). In making its determination, the court referenced prior Massachusetts precedent (In re Mularski,  565 B.R. 203 (Bankr. D. Mass. 2017)), which held that (1) the foreclosure of the debtor’s equity redemption was a transfer of property of the debtor, (2) that such transfer was not evidenced by a recording at the Registry as required to be effective against third parties under Massachusetts law, and (3) the transfer is therefore avoidable by a trustee in bankruptcy pursuant to §544(a)(3). Emphasis added. Neiva at 7.

In order to effectuate standing for a debtor to utilize avoidance powers (as opposed to a bankruptcy trustee), the court found that – when read together – §522(g)(1) and §522(h) permits a Chapter 13 debtor to bring an avoidance action if (1) the trustee could have brought such an action; (2) the trustee did not bring the action; (3) the transfer was involuntary; and (4) the debtor could have exempted such property had the trustee avoided the transfer. Finding the requisite standing for the debtor, the court then examined the impact of the “gavel rule” when matched against a debtor’s avoidance powers. As stated, supra, the court acknowledged that “sold at foreclosure sale” – memorialized via a signed memorandum of sale – does indeed extinguish a mortgagor’s right of redemption. However, notwithstanding the completion of that foreclosure sale, through §522(h) and §544(a)(3), the debtor is now empowered to undo that transfer.

Finally, the court declared that the ruling neither violates general statutory construction nor undermines public policy, stating that the statutory scheme of §522(h) is unquestionably designed to allow debtors to avoid certain prepetition transfers and avail themselves of exemptions in that property provided by the Bankruptcy Code. Notably, the court also stressed that a creditor could protect itself by immediately recording the foreclosure documents, as such an act would protect against bona fide purchasers, creditors, or trustees. While other jurisdictions – namely the Fifth Circuit – have arrived at different conclusions under the same circumstances, mortgage creditors (despite completing a sale consistent with state law) should be weary of bankruptcy avoidance power, and act quickly to record sale documents to “avoid” the avoidance.

For any questions regarding this legal alert, please reach out to Jeffrey Fraser at [email protected]