The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
Joining a list of competing opinions on the issue, the District Court for the Eastern District of New York (the Court) recently held that a debtor may assert a homestead exemption as provided by New York law against the proceeds from a “give-up” transaction (often referred to as a carve-out) whereby a bankruptcy trustee sought to sell an over encumbered residence. Stark v Pryor (In re Stark), 2022 WL 2316176 (E.D. N.Y. June 28, 2022).
To view the opinion, click here.
Debtor Sheryl Stark and her husband owned a residence (the Residence) encumbered by a $1.3 million mortgage. In 2012 the mortgage holder commenced a foreclosure action in New York state court; a judgment of foreclosure was entered on December 5, 2019, with a sale scheduled for February 18, 2020. Prior to the sale the Debtor filed a chapter 7 bankruptcy. She scheduled the value of the Residence at about $2.2 million, encumbered by a mortgage of over $2.5 million and stated an intent to surrender the Residence. She also claimed a homestead exemption of $170,825 under New York Civil Procedure Law § 5206.
Chapter 7 trustee Robert Pryor (the Trustee) initially filed a no asset report, then two weeks later withdrew it, stating that he believed there could be a benefit to the estate to administer an asset, the Residence. He first moved to compel the Debtor to allow access to the residence, a motion still pending when this decision was rendered, then filed a motion to sell the Residence, asserting that the mortgage lender was willing to provide a “carve-out” to the estate, which would provide funds to pay unsecured creditors, although the amount of the carve-out for creditors was unknown because of the access issue. The Debtor opposed the sale, arguing that a trustee was prohibited from selling an over encumbered asset because carve-outs were proscribed under the Bankruptcy Code and also that, even if they were permissible, her homestead exemption would attach to any available proceeds, which would mean that no benefit to the estate would occur.
The bankruptcy court ruled that carve-out deals were permissible in certain circumstances and that the homestead exemption did not apply to the carve-out funds because they were the result of the trustee’s negotiation rights, not the Debtor’s equity in the Residence. The bankruptcy court ruling approved in concept the sale and denied the homestead exemption in the carved-out funds The Debtor appealed the homestead denial order to the Court, which reversed.
After concluding that it had appellate jurisdiction because the ruling denying the homestead exemption was a final order, the Court then addressed that issue. It held that “the value of the carve-out is ultimately derived from equity in the Property as defined by New York law” and that the bankruptcy court had erred in ruling otherwise.
To reach that conclusion, the Court looked to the wording of the New York homestead exemption: it exempts “[p]roperty” consisting of “a lot of land with a dwelling thereon” that is “owned and occupied as a principal residence” up to $170,825 “in value above liens and encumbrances.” N.Y. C.P.L.R. § 5206(a). It observed that by exempting the “value” of the property “above liens and encumbrances” the statute was speaking to equity in the Residence. The Debtor asserted that even though she had no equity on the petition date, when the Trustee negotiated a carve-out, that agreement created equity measured by the reduction in the secured creditor’s claim. Disagreeing with the bankruptcy court’s determination that this “value” materialized from the Trustee’s negotiation efforts, the Court instead focused on what the creditor was getting for its carve-out, which was immediate sale and dispossession of the Debtor from the property, all of which was part of the bundle of rights that the Debtor owned by holding fee title to the Residence. It therefore concluded that “[w]hen the Trustee trades away those rights via the section 363 sale process, he is trading away the same ‘property’ referred to in the New York homestead exemption.” In essence, the Trustee was monetizing part of the value of “a lot of land with a dwelling thereon” to which the Debtor’s homestead would attach.
As a consequence, the Court held the Debtor’s homestead exemption must be paid from the carve-out in any sale.
With the recent escalation in real property value, a carve-out or short sale in bankruptcy proceedings may be rare these days. However, this issue has cycled through our economy before (i.e., the Recession of 2008 which impacted property values for several subsequent years, creating a live market for short sales) and without doubt will return, so opinions such as this could have a meaningful impact. In those recessionary times, two bankruptcy court opinions with contrary views were issued in California, In re Bunn-Rodeman, 491 B.R. 132 (Bankr. E. D. Cal, 2013), which ruled that the homestead exemption did not attach to a carve-out, and In re Wilson, 494 B.R. 502 (Bankr. C.D. Cal, 2013), which ruled that the exemption would attach. Unfortunately, neither of those rulings was tested by appeal to the BAP or a district court and those determinations became insignificant when property values rose and homes were no longer routinely over encumbered. A recent unpublished memorandum from the Ninth Circuit BAP, Marshack v. Babaee (In re Babaee), 2022 Bankr. LEXIS 1713 (9th Cir. BAP June 17, 2022), can be read to conclude that the homestead exemption would not apply to a carve-out, but the facts of that case are extreme and its weight may be limited. I make no prediction on how appellate courts in various states might address this issue in the future, as the wording of each state’s homestead exemption vary and the bundle of sticks analysis of Stark may be inapplicable to different wording. For now, this opinion may well serve to discourage carve-outs negotiations by trustees in New York, but its impact might be limited to that state.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.