Foreclosure and bankruptcy: where does it all end?

As Yogi Berra used to say, "it ain't over 'til it's over." Although not talking about mortgage foreclosure sales, his words carry a message both for foreclosing lenders and purchaser at foreclosure sales. It has taken a U.S. Supreme Court decision (BFP vs. RTC, U.S. Supreme Court, May 23, 1994), with the court split 5 to 4, to decide when a mortgage foreclosure sale is over.

The Court answered the question whether foreclosure sales could be set aside by a bankruptcy court if the proceeds were less than an amount which a bankruptcy judge felt was close to fair market value. It held the bankruptcy court may not, thus sustaining the validity of foreclosure sales where state law was followed.

The decision is significant in light of the inexorable march of bankruptcy powers over hundreds of years of developed real property law. The integrity of a foreclosure sale will be upheld, unless intervening factors are proven by the bankrupt, the trustee in bankruptcy and/or determined by the judge to prejudice the bankrupt by wilful acts or negligence of the mortgagee. The finality of the sale offers the "bright line" of certainty to all participating in real estate foreclosures. Upholding the expanded authority of the bankruptcy court would have created further havoc to the real estate market.

The issue arises in cases where the mortgagor files bankruptcy after a foreclosure sale takes place. The federal Bankruptcy Act gives the bankruptcy court the power to set aside certain transfers made by the bankrupt, and put the property back into his estate, where the transfers are made for less than "reasonably equivalent value." In other words, if the bankrupt, the trustee in bankruptcy or a creditor was able to convince a bankruptcy judge that the bid accepted by the mortgagee was too low, such sale may be undone. Such eventuality may leave the mortgagee without collateral and a bidder without property. The majority of the Court says that "reasonably equivalent value" does not mean "fair market value", and the dissenters agree. The only question remaining is, what is "reasonably equivalent value?"

A line of cases, going back to 1980, suggest 70 percent or more of fair market value constitutes the requisite "reasonably equivalent value." The validity of these cases, however, was put in doubt, although not extinguished, by the 1984 Amendments to the Bankruptcy Act. The Supreme Court majority opinion states that valid title to real property in the hands of purchasers at foreclosure sales cannot depend upon a subjective test, which it suggested the bankruptcy court's discretion may create. Clearly, if no one was sure what they were buying (if they were in fact buying anything at all), no one would bid as much (or bid at all) at any foreclosure sale.

Justice Antonin Scalia, writing for the majority, quotes a phrase from a case decided more than eighty years ago: "the general welfare of society is involved in security of titles to real estate." The majority discerningly distinguishes between fraudulent conveyances, voluntarily made by a debtor for insufficient value (or for no value) to defeat creditors, and involuntary transfers like mortgage foreclosures, where the debtor has no control over the price paid or who pays it. Therefore, without fraud, duress or overreaching by the mortgagee or his agents, the sale will be upheld and the security of the title maintained.

The dissenter suggest that a bankruptcy judge, with the benefit of hindsight, has the facts and expertise necessary to decide whether the sale is valid, an expertise which they say the U.S Supreme Court does not have. The dissent argues that the Bankruptcy Code means what it says. If the price is not right, the sale is invalid. However, given the fact that the bankruptcy judge is not present at the sale, the judge has little practical way of knowing whether the price is appropriate; neither does the bidder, foreclosing mortgagee, referee conducting the sale, or anyone else.

The dissenters state that the number of challenges to foreclosure sales, on grounds of less than reasonably equivalent value, is very small. However, the majority did not consider this to be sufficient reason to overturn their principle.

Above the silver lining of certainty, however, the cloud remains. The majority opinion does not rule out setting aside other foreclosure sales besides mortgage foreclosures, such as sales arising from tax foreclosures or foreclosures not involving real property (like co-operative apartment foreclosures), based on failure of such sales to release reasonably equivalent value. It may be that Congressional action will be necessary to settle these matters. In the meantime, one can be sure that, as far as present bankruptcy law goes, a mortgage foreclosure sale is a valid sale.