20 Real Est. L.J. 263
Real Estate Law Journal
Volume 20, Number 3
From the Courts
*263 LIEN ON ME (BANKRUPTCY, HOMESTEADS, AND THE SUPREME COURT)
The 1990-1991 docket of the U.S. Supreme Court was heavy with bankruptcy cases, several of which should be of interest to the real estate practitioner. In Farrey v. Sanderfoot, [FN1] the Court held that a debtor in Chapter 7 bankruptcy could not avoid a judicial lien on homestead property that had been awarded to secure his spouse's financial interest in the equitable distribution of assets upon divorce. On the same day, in Owen v. Owen, [FN2] the Court held that a debtor could avoid a preexisting judgment lien that impaired his homestead exemption, notwithstanding the fact that the applicable state law explicitly allowed such liens to be enforced against homestead property. [FN3]
Farrey: Till Bankruptcy Do Us Part
Farrey concerned a divorce in which the principal asset for equitable distribution was the marital home. The Wisconsin divorce court awarded possession of the property to the husband, Mr. Sanderfoot, but ordered him to compensate his former wife, Ms. Farrey, for her half share in two equal installments. The couple's joint tenancy in the property, in which each had an undivided half interest, was dissolved, and fee simple title was conferred on Mr. Sanderfoot. To secure his obligation to compensate Ms. Farrey for her half interest, however, the court gave her a lien on the property for the amount due.
Sanderfoot did not make the required payments and, possibly taking a page from those solvent *264 companies that have used bankruptcy to avoid inconvenient labor union contracts, he sought refuge in Bankruptcy Court. Shortly after the divorce became final he filed for Chapter 7 bankruptcy, listing the home as exempt property pursuanted to Wisc. Stat. § 815.20 (1989-1990), which allows a homestead exemption to the amount of $40,000, [FN4] and he sought to avoid his ex-wife's lien under 11 U.S.C. § 522(f)(1), which allows avoidance of judicial liens that impair a homestead exemption.
Farrey, needless to say, objected, and convinced the Bankruptcy Court that Sanderfoot's maneuver improperly interfered with her preexisting interest in the marital property. [FN5] Both the district court and the Seventh Circuit, however, concluded that the divorce had dissolved Ms. Farrey's prior interest in the property and that her lien attached to the debtor's newly created fee simple interest, thus permitting it to be avoided under the plain language of 11 U.S.C. § 522(f)(1). [FN6] The Supreme Court reversed, in a mostly unanimous opinion (Justice Scalia withheld support for one paragraph).
The Crucial Importance of the Estates in Land
Building on Judge Posner's dissenting opinion in the Seventh Circuit, Justice White read the language of 11 U.S.C. § 522(f) very closely. Since the parties agreed that the lien in issue was a judicial lien subject to 11 U.S.C. § 522(f)(1), that Mr. Sanderfoot was entitled to a homestead exemption, and that the lien "impaired" the exemption, the question became interpretation of the operative language of 11 U.S.C. § 522(f), which allows the debtor to "avoid the fixing of a lien on an interest in property." [FN7] The court held that the lien could be avoided only if it attached to the debtor's interest at some point after the debtor obtained the interest:
The statute does not say that the debtor may undo a lien on an interest in property. Rather, the statute expressly states that the debtor may avoid "the fixing" of a lien on the debtor's interest in the property. The gerund "fixing" refers to a temporal event. That event--the fastening of liability--presupposes an object onto which the liability can fasten. The statute defines this pre-existing object as "an interest of the debtor in property." Therefore, unless the debtor had the property interest before the lien attached to that interest, he or she cannot avoid the fixing of the lien under the terms of § 522(f)(1). [FN8]
Applied to Ms. Farrey's lien, the Court found that Mr. Sanderfoot *265 did not have a prior interest in the property to which the lien attached. In what turns out to have been a crucial concession, he had agreed with Ms. Farrey in his brief and at oral argument that the old joint tenancy was dissolved by the divorce decree, and that he was given a new fee simple title. Viewed then through the court's construction of 11 U.S.C. § 522(f), his interest in the property was created simultaneously with the fixing of the lien in Ms. Farrey's favor. Thus, he acquired his new fee simple with the lien already attached, just as if he had purchased property that was encumbered by a preexisting lien, and on this basis it could not be avoided.
This result, Justice White argued, was consistent with the "fresh start" policy embodied in the Bankruptcy Code. While Congress generally wished to have liens and other security interests survive the discharge in bankruptcy, it mitigated this approach by enumerating avoidable liens. In the case of judicial liens, Congress was particularly concerned that sophisticated creditors could abuse the system by a rush to the courthouse, converting an unsecured debt into a judicial lien before the debtor could acquire bankruptcy protection. This concern became particularly important after the 1978 revision of the Code, which eliminated the timing provisions of the old Code that had allowed the debtor to avoid liens on an exempt interest that attached within four months of the bankruptcy filing.
Lest the rule of Farrey be applied too narrowly, Justice White also offered an alternate analysis, assuming that the divorce court had not extinguished the prior interest, but had merely transferred the wife's interest to the husband, augmenting and merging with the undivided one-half that he already owned. In this case, he observed, Farrey's lien could be avoided to the extent that it attached to his prior interest, because this was an interest to which the lien could be "fixed," in the statutory term. However, in the actual case, Justice White concluded that Farrey's lien only protected the interest that she had previously owned and if this interest was transferred to Sanderfoot, it was with her lien already attached. [FN9] Thus, either way, Farrey's lien survived Sanderfoot's bankruptcy, under the newly announced rule that the lien must "fix" to an interest of the debtor after the debtor acquires that interest in order for the lien to be avoidable.
Justice Kennedy Sounds a Warning
Justices Kennedy and Souter joined in the Court's opinion but also wrote a brief concurring opinion, agreeing that the Court had reached a fair result but expressing *266 concern with the fragility of its reasoning. But for Sanderfoot's ill-advised concession about the destruction of the prior interests in the property and the creation of wholly new ones, Justice Kennedy wrote, an argument could be made under state law [FN10] that Farrey's undivided interest in the tenancy in common was merged into Sanderfoot's without the latter's ever having been extinguished, and that at least some of her lien attached to his preexisting interest, thus satisfying the rule announced by the Court. He distinguished from this situation a tenancy by the entirety, which is deemed a single interest owned by the marital entity, and which of necessity must be dissolved when the marriage does. [FN11]
Justice Kennedy's concerns seem well-placed. The Court's result is, as he observes, consistent with "fairness and common sense," [FN12] but state law could have valid reasons apart from bankruptcy considerations to treat tenancies in common as continuous when one holder's interest is merged into the other's. Nor is there unassailable logic to the Court's alternate holding (clearly dictum, in light of the debtor's concession) that the lien attaches only to that portion of what is now a fee simple that came from the creditor spouse, other than the logic that this produces a result consistent with fairness and common sense.
Thus, Justice Kennedy warns, the holding in Farrey places a premium on astute tactics when the marriage is dissolved. The creditor spouse could seek to ensure that the decree orders conveyances in a specific sequence, so that the debtor spouse's chain of title is clearly discontinuous, achieving the posture that was achieved by concession in Farrey. Less precisely, the divorce decree could be drafted to include general language indicating that the prior interests were terminated and new estates in the property created. Or, the court could condition the award of property to one spouse on the other's acceptance of voluntary termination of the prior interest and the creation of a new estate subject to the lien. (As Justice Kennedy notes, however, this latter approach could be construed as a "waiver" of the debtor's ability to avoid the lien, which might independently violate 11 U.S.C. § 522(f).)
Farrey gives the forewarned and well-lawyered a useful weapon that can frustrate the misuse of bankruptcy law to defeat the obvious goals of an equitable distribution regime in divorce law. Even for this group, however, the absence of a clear and extrinsic basis in the law of estates in land for the Farrey analysis may invite *267 bargaining between the spouses for the necessary Farrey language, bargaining that from an equitable perspective may force one spouse to give up something of value when "fairness and common sense" suggest that it ought to be his or hers as of right. And for the unwarned or poorly lawyered, disproportionately those for whom half shares of a marital home may be a major element of financial stability, Farrey is little more than a trap. Justice Kennedy is clearly correct in suggesting that the rule of Farrey should be codified by Congress if inequitable results are to be avoided. [FN13]
Companion Case Sidesteps Farrey
The fragility of the Farrey holding is underscored by the Court's treatment of a companion bankruptcy case, Owen v. Owen, [FN14] decided that same day. Owen also involved an attempt by one ex-spouse to avoid a judicial lien held by the other ex-spouse, but unlike Farrey, the spousal relationship was essentially irrelevant to the proceedings. Instead, after the marriage was dissolved, Mrs. Owen obtained a separate judgment against Mr. Owen for some $160,000 on some unspecified legal claim, which she then recorded in Sarasota County, Florida. When Mr. Owen subsequently purchased a condominium in Sarasota County, she automatically acquired a lien on the property under Florida law.
To further complicate matters, Florida law at that time limited homestead exemptions to heads of households, disabling Mr. Owen, who was single at the time as a result of the divorce, from acquiring a homestead interest in his new condo. A year later, however, Florida's homestead law was amended to bring single homeowners within its provisions. In a final twist, Florida's homestead exemption has been held inapplicable to liens that attached before the property acquired its homestead status. Mrs. Owen's lien was preexisting, of course, because she acquired it when Mr. Owen bought the property, a year before the change in Florida law enabled him to claim it as a homestead.
When Mr. Owen thereafter filed for Chapter 7 bankruptcy, he elected the Florida homestead exemption pursuant to 11 U.S.C. § 522(b)(2)(A), and he sought to avoid his ex-wife's lien on the ground that it impaired his homestead exemption and, therefore, *268 was within the protection of 11 U.S.C. § 522(f). The lower courts all rejected this argument, holding that the preexisting lien could not logically impair the state-created exemption if Florida law explicitly permits enforcement of such a lien against the homestead. "To permit avoidance of the lien, respondent urges, would not preserve the lien but would expand it." [FN15]
Writing for the entire Court except Justice Stevens, Justice Scalia reversed and held that for purposes of 11 U.S.C. § 522(f), a judicial lien impairs exempt property and can be avoided without regard to its status under state law.
To determine the application of § 522(f) [the cases] ask not whether the lien impairs an exemption to which the debtor is in fact entitled, but whether it impairs an exemption to which he would have been entitled but for the lien itself. [FN16]
Justice Scalia, who characterized this as the "hypothetical," as opposed to "actual" approach, supported his conclusion with an elaborate argument based on the interaction between Sections 522(b) and (f) of the Code. Ultimately, his argument was that because 11 U.S.C. § 522(b) limits exemptions to the "debtor's aggregate interest" in the property, and because 11 U.S.C. § 522(f) incorporates 11 U.S.C. § 522(b) by reference, the "actual" approach would by definition operate to exclude all liens from the debtor's "aggregate interest" in the exempt property, which would frustrate the federal policy of allowing the debtor to shelter from his bankrupt estate such essentials as homesteads, motor vehicles, household goods, wearing apparel, and tools of the trade.
Farrey May Be Limited to Divorces
Justice Stevens vigorously dissented, arguing that 11 U.S.C. § 522(b) was irrelevant to Owen because it deals with the bankruptcy status of exempt property vis a vis unsecured creditors, and that its incorporation into 11 U.S.C. § 522(f), which governs secured creditors, was merely for the purpose of listing the types of property that are exempt. Both he and Justice Scalia, however, recognized that there were arguments on both sides, and in that sense the decision in Owen is one of those situations where it is more important to have some rule, whatever it is, rather than to contend to the ultimate for any particular rule.
Justice Stevens, however, also points out in his dissent that the majority's disposition of the Owen question immediately throws into question its companion holding in Farrey. The majority remanded Owen for a determination of when the lien had "fixed," as required by the opinion in Farrey. In Justice Stevens' view, however, the answer to this question was clear and should have governed the outcome in Owen without necessity of *269 remand and without reaching the issues that the court instead decided.
Stevens' analysis was as follows: Under Farrey, the Court is obligated to determine whether the lien fixed after the debtor acquired an interest in the exempt property. It is conceded that Mr. Owen did not have a claim to a homestead exemption under Florida law when Mrs. Owen's lien attached, because at that time Florida law did not grant homesteads to single persons. The lien therefore did not fix on an interest he held and, under Farrey, it cannot be avoidable. Viewed this way, it is irrelevant whether Florida law may limit the homestead exemption as to prior liens, the issue the majority decides, because there was no valid homestead claim, limited or otherwise, at the time when Farrey requires analysis of the lienholder's rights.
But there is more. Even if one were to argue that Farrey only requires that the debtor hold an interest in the property, whether or not it qualified as exempt property (thus skirting the somewhat unique facts of Florida's decision to change its homestead law), Farrey requires that the debtor acquire his interest before the lien attaches. In Owen, the previously-recorded lien would seem to have attached at the instant Mr. Owen acquired title to his property in Sarasota County, which is exactly the same situation as in Farrey, where the wife's lien attached at the instant the new fee simple estate was created for her husband.
Against this reasoning, Justice Scalia for the majority observes somewhat laconically that "[u]nder Florida law the lien may have attached simultaneously with the acquisition of the property interest. If so, it could be argued that the lien did not fix 'on an interest of the debtor.' See Farrey. ..." [FN17] This ambivalence about the applicability of Farrey suggests that the rule in Farrey is less settled than one might have thought from the unanimous decision in that case. Given that Farrey is the only one of the five bankruptcy cases this term to hold against the debtor, it may suggest that the real basis of Farrey is the peculiar inequity of allowing Chapter 7 to be used to defeat a divorcing spouse's equitable interest in the property of the marriage. Whatever, the interplay of Farrey and Owen underscores Justice Kennedy's call for congressional attention to this area of bankruptcy law.
[FN1] Farrey v. Sanderfoot, 111 S. Ct. 1825 (1991).
[FN2] Owen v. Owen, 111 S. Ct. 1833 (1991).
[FN3] Three other significant bankruptcy cases were also decided this term. Johnson v. Home State Bank, 111 S. Ct. 2150 (1991), discussed briefly note 13, infra. In Grogan v. Garner, 111 S. Ct. 654 (1991), the Court held, also unanimously, that the preponderance of the evidence standard, rather than clear and convincing evidence, applies to proof of all exceptions from dischargeability of debts, including the point in issue there, nondischargeability for fraud. And in Toibb v. Radloff, 111 S. Ct. 2197 (1991), the Court (with Justice Stevens dissenting) struck down a long-standing gloss on the Bankruptcy Code by holding that an individual debtor not engaged in business could avail himself of Chapter 11 reorganization as an alternative to Chapter 13. The net force of these decisions, it will be noted, is to give the debtor the fullest possible protection under the Bankruptcy Code.
[FN4] Sanderfoot exercised his right under 11 U.S.C. § 522(b)(2)(A) to claim the state rather than the federal homestead exemption.
[FN5] In re Sanderfoot, 83 B.R. 564 (Bankr. E.D. Wis. 1988).
[FN6] Id., 92 B.R. 802 (Bankr. E.D. Wis. 1988), 899 F.2d 598 (7th Cir. 1990).
[FN7] Farrey, note 1 supra at 1828 [emphasis added].
[FN8] Id. at 1829 [emphasis supplied by the Court].
[FN9] Id. at 1831. Justice Scalia dissented without explanation from this alternate analysis.
[FN10] Justice Kennedy noted that Wisconsin law substantially followed the Uniform Marital Property Act. Id. at 1832.
[FN11] Id., citing McCormick v. MidState Bank & Trust Co., 22 B.R. 997 (W.D. Pa. 1982).
[FN13] Johnson, note 3 supra, decided several weeks after Farrey, permits a debtor to include a surviving lien in a Chapter 13 reorganization plan, even after personal liability had been discharged in a Chapter 7 proceeding. The Court held unanimously that the Code does not prohibit sequential filings under these two chapters. Johnson thus offers another strategy to debtors in a position such as Mr. Sanderfoot, but Chapter 13 proceedings are hedged by requirements of good faith and feasibility, see 111 S. Ct. at 2156, that give the creditor spouse protections that are not available in the all-or- nothing approach of Farrey.
[FN14] Farrey, note 1 supra at 1833.
[FN15] Id. at 1836 [emphasis by the Court].
[FN16] Id. at 1836-37 [emphasis by the Court].
[FN17] Id. at 1836 [emphasis added].