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In re Price – HI. D. Ct. holds that lis pendens does not create security interest in escrowed funds.

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A district court in Hawai’i has held that the payment of a judgment in favor of an unsecured creditor was preferential because neither the filing of a lis pendens nor the creation of a consensual escrow had created a perfected lien in favor of the creditor. [In re Price, 2018 Westlaw 3213603 (D. Hawai’i.).]

FACTS: A creditor and a debtor were involved in litigation over the proceeds of a parcel of real property. The creditor recorded a lis pendens, rendering the property unmarketable. In an effort to settle the dispute, the debtor placed the funds in a private escrow, pending resolution of the case. Later, the funds were transferred into to a court-supervised account.

The creditor obtained a judgment in his favor. A year later, the clerk of the court paid some of the escrowed funds to the creditor. A few days after that payment, the debtor filed a Chapter 11 petition. He then brought a preference action against the creditor under 11 U.S.C.A. §547(b). Both the bankruptcy court and the district court ruled in favor of the debtor

REASONING: The creditor argued that the recording of the lis pendens was tantamount to the perfection of a security interest; therefore, he was already a secured creditor at the time of the payment. The court concluded that since the lis pendens was nonconsensual, it was not a security interest. The creditor next argued that the filing of the lis pendens meant that his interest in the property was “perfected” because no hypothetical purchaser of the property could have later acquired a superior interest in the property. But the court held that the lis pendens was insufficient:

Under Hawai’i law, a lis pendens is only effective to give notice of a claim to title or possession of real property . . . . Filing a lis pendens is ineffective to secure a claim for money damages against the owner of real property . . . . Because the [lis pendens] merely gave notice of [the creditor’s] claim for money damages against the owner of the Property, its filing was insufficient to perfect any security interest by [the creditor] in the Property.

The creditor next argued that the escrow itself was a transfer of the debtor’s property, long before the 90-day preference period had begun. But the court disagreed, holding that the debtor (and hence his estate) still retained a property interest in the escrowed funds.

Finally, the creditor claimed that the transfer of the funds to a court-supervised account meant that the funds were in custodia legis and were thus no longer the debtor’s property. Once again, the court disagreed, holding that the state court did not have exclusive jurisdiction over the funds since the parties retained the power to withdraw the funds by mutual agreement.

AUTHOR’S COMMENT: Since the amount in controversy is relatively small (roughly $123,000), I am not sure whether this decision will be appealed. If it is, though, it might be reversed. Most of the district court’s conclusions are correct. But I am not sure about the court’s handling of the effect of the lis pendens.

The problem is that this case involved two separate but related disputes, one over the real property and one over the cash proceeds. It may be true, under Hawaii law, that any hypothetical purchaser of the real property would take free of the lis pendens. (I doubt whether that is true, since the court stated that the filing of the lis pendens rendered the property unmarketable.)

But if one focuses on the proceeds, the money is not real property. It is personal property. And the issue of perfection as to personal property under §547 is governed not by the “hypothetical bona fide purchaser” rule of §547(e)(1)(A) but rather by the “hypothetical judicial lien creditor” rule of §547(e)(1)(B). After the filing of the lis pendens, could a judicial lienor have reached those proceeds? And even if the lis pendens were not sufficient to defeat a subsequent lienor, wouldn’t the escrow have accomplished the same result? I think that the answers to both questions depend on state law, but the court did not discuss this issue at all.

In retrospect, the unfortunate creditor should have documented his settlement with the debtor as a written obligation secured by a recorded deed of trust against the disputed real property, probably coupled with a perfected Article 9 security interest in any resulting proceeds. Leaving the obligation unsecured meant that any recovery in the litigation was vulnerable to a strategically-timed bankruptcy filing.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.

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