In re Badea, Bankruptcy Courts must look to state law in determining whether a stay violation has occurred.

The following is a recent case update:

SUMMARY

In Badea v. Schwartzer (In re Badea),No. NV-18-1038-BTaL, 2018 WL 4441731 (9th Cir. BAP Sept. 17, 2018), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit (“BAP”) vacated the order of a bankruptcy court holding the debtor in contempt and expunging a mechanics’ lien recorded post-petition by the debtor after the chapter 7 trustee avoided the debtor’s transfer of that property and remanded the matter with instructions to the parties and the court to consider the effect of 11 U.S.C. section 546(b). To read the full unpublished decision, click here.

BACKGROUND

Pre-petition, the debtor, John Badea, owned a condominium which he transferred to his brother by quitclaim deed. After Badea filed a chapter 7 petition, his brother transferred the property to an individual that was found to be an affiliate of Badea and his brother. The chapter 7 trustee filed an adversary proceeding to avoid and recover the property as a fraudulent transfer, and thereafter obtained a default judgment voiding the transfers and recovering the property for the estate. Approximately six months after the judgment was entered, Badea recorded a mechanics’ lien in the amount of $12,000, based upon construction work Badea allegedly performed on the property for the subsequent transferee after he filed his bankruptcy petition, but before the default judgment was entered.

The chapter 7 trustee moved to expunge the mechanics’ lien as void for being an act in violation of the automatic stay and to hold Badea in contempt. Badea argued that the stay was not violated since the property was ostensibly not estate property at the time that he did the work. Alternatively, he contended that the upgrades he made were valuable and that voiding the lien would unjustly enrich the chapter 7 trustee. The bankruptcy court ruled in favor of the chapter 7 trustee and expunged the lien. The court also held Badea in contempt for violating the automatic stay, and awarded the chapter 7 trustee his attorney’s fees and costs as compensatory sanctions. The lien was expunged by the bankruptcy court solely on the basis that the filing violated the automatic stay. As such, the bankruptcy court did not reach the issue of the lien’s validity or perfection under the applicable Nevada law and Section 546(b) of the Bankruptcy Code.

Badea, appearing pro se, appealed the order to the BAP and raised two issues: (i) did the bankruptcy court apply the correct law to determine that Badea had willfully violated the automatic stay; and (ii) did the bankruptcy court abuse its discretion by awarding fees and costs to the chapter 7 trustee. The Panel decided only the first issue, finding that the bankruptcy court did not apply the correct law. Consequently, the contempt finding was erroneous, so the Panel voided the fee order and remanded for further factual deliberations.

REASONING

The Panel began with the principle that an action for damages for a violation of the automatic stay requires a finding that the act was “willful,” that is, (1) that the party had knowledge of the stay; and (2) acted intentionally to violate it. According to the Panel, the bankruptcy court had correctly found that Badea knew that the stay was in effect and that he acted intentionally in filing the lien. Moreover, the Panel noted that the bankruptcy court correctly found that at the time Badea recorded the lien, Badea was aware that the property had been recovered for the estate and that the chapter 7 trustee was the owner of record.

The Panel, however, reversed the order of contempt because the bankruptcy court had failed to take into account Nevada state law in its findings. The Panel pointed to Section 362(b)(3) of the Bankruptcy Code, which excludes “any act to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee’s rights and powers are subject to such perfection under section 546(b). . . .” Section 546(b) provides in part that the rights of a trustee “are subject to any generally applicable law that permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection.” Citing precedent, the Panel held that the post-petition perfection of a lien does not violate the automatic stay if state law provides that “upon perfection the lien is superior to other liens or encumbrances having priority in time.”

The Panel next focused on the Nevada’s mechanics’ lien statute, NRS section 108.225, which provides that a mechanics’ lien attaches at the point that the “construction of a work of improvement” has “commenced,” and takes priority over a subsequent deed of trust, regardless of when the notice of the mechanics lien is actually recorded. The Panel further noted that under Nevada law, a mechanics’ lien is perfected when the contractor records the notice of lien. The Panel determined that the Nevada’s mechanics lien statute fell within the scope of Section 546(b), because the Nevada statute allows the contractor to acquire an “inchoate lien” and that perfection causes the lien to relate back to the time of attachment. Such inchoate rights have priority over subsequent interest holders—including a chapter 7 trustee.

Applying the statutory scheme to the facts, the Panel held that Badea could only violate the stay if the lien was created at the time the property was estate property. The Panel ruled that it was unclear whether this element was satisfied where Badea had allegedly started the work (and thus created the inchoate lien) in July 2016—which was post-petition but before the chapter 7 trustee had recovered the property for the estate. As such, the property may not have been estate property at the time the lien was created—or, at a minimum, the element of Badea’s willful violation of the stay at that time had not been demonstrated. The Panel also noted that depending on when the work giving rise to the lien was performed, Badea’s recording of the lien after the property was deemed to be estate property by virtue of the trustee’s judgment may not have been the creation of the lien, but may instead have been an act to “perfect” the prior inchoate lien, which is expressly permitted under Sections 362(b) and 546(b)(1)(A).

The Panel acknowledged the bankruptcy court’s desire to address what it perceived to be wrongful behavior by the debtor in imposing a “bogus lien,” but determined that the bankruptcy court had had abused its discretion to the extent it did not identify and apply the correct law. The Panel emphasized that it was not resolving the question of the validity of the lien, noting that the motion procedure utilized by the bankruptcy court to expunge it may not have been the correct route. The Panel gave guidance that the “better course of action” would be for the chapter 7 trustee to file an adversary proceeding to challenge the lien’s validity, as is required under Rule 7001(2) of the Federal Rules of Bankruptcy Procedure.

AUTHOR’S COMMENTARY

The Badea case highlights the importance of looking to state law in determining whether a stay violation may have occurred, especially one involving the post-petition filing of a mechanics’ lien, the perfection of which relates back to the commencement of work under Nevada (and California) state law, as well as whether a fraudulent transfer is deemed void or voidable under the applicable state statute. The case also provides a word of caution against using the motion process as the vehicle for attempting to challenge the validity, priority or extent of a lien, as opposed to using an adversary proceeding as required by Rule 7001.

These materials were written by Janet Gertz of Barnes & Thornburg in San Diego (JGertz@btlaw.com). Editorial contributions were provided by Kit J. Gardner of the Law Offices of Kit J. Gardner in San Diego (kgardner@gardnerlegal.com).