Debtor Not Allowed to Claim Exemption on Proceeds Created By Trustee's Carve-out Agreement

By Beau Hays

Hays, Potter & Martin, LLP

Peachtree Corners, GA

Judge Margaret Murphy of the Bankruptcy Court for the Northern District of Georgia recently handed down a victory for Trustees (and creditors) in a case involving a carve-out negotiated with secured lenders to allow for a short sale and create a fund for unsecured creditors. In re Diener,  No. 11-83085-MHM (Bankr. N.D.Ga. 7/6/15; docket #88) The Opinion can be found here.

 What Happened

Debtors filed Chapter 7 case with three security deeds on their home, totaling about $350,000.00.  As everyone acknowledged that the property was underwater, the Trustee sought to negotiate a carve-out with Wells Fargo, holder of the second- and third-priority liens on the house, offering to pay $9,000.00 in satisfaction of the second and third positions in exchange for finding a buyer and keeping the property from being foreclosed by the first mortgage holder.  A buyer was eventually found at market value; the first lien was paid off, Wells Fargo got its $9,000 and the balance was paid to the Trustee – allowing the Trustee to pay administrative expenses in the case and ultimately providing for about $6000 to go to the unsecured creditor pool.

The Ruling

The debtors objected to the distribution, asserting that under Georgia’s exemption statute, they were entitled to the first $10,000 from the sale of the house.  Had debtors prevailed, there would have been a shortfall in administrative expenses and no distribution to the unsecured creditors.  The bankruptcy court, after reviewing the available authority, agreed with the Trustee that the exemption should not apply to the funds which were received by reason of the carve-out.

Debtors argued that Law v. Siegel, 135 S.Ct. 1188 (2014) prevented the Trustee from paying any administrative expenses ahead of debtors’ claimed exemptions.  The Court, though, found that Siegel was not applicable as that case addressed a surcharge of debtor’s exemptions rather than the typical trustee expenses (trustee’s statutory fees, trustee out of pocket expenses, and fees for the trustee’s professionals) which were involved in administering the case.

Turning to the issue of giving the exemptions a priority when the proceeds are the result of a carve-out, the Court found decisions on both sides.  Supporting debtors’ position, In re Wilson, 492 B.R.502 (Bankr. C.D. Cal. 2013), found that a carve-out was a “tip” in exchange for allowing the lender to avoid foreclosure proceedings and that such a “tip” constituted §363 proceeds, which were subject to validly claimed interests, and importantly for this question, subject to the debtor’s exemption to such proceeds.  (The Court here noted that Wilson also appeared to involve property which ultimately was not underwater, which may be the crucial fact in the case.)

Favoring the Trustee’s argument was In re Baldridge, 533 Fed. Appx. 598 (6th Cir. 2014), which held that where some lienholder claims remained unsatisfied by the sale price, there was no equity in the property and therefore no interest to which exemptions could apply.  The Court also cited with favor In re Bunn-Rodemann, 491 B.R. 132 (Bankr. E.D. Cal. 2013), where the court reasoned that the carve-out arose from the trustee’s leverage to negotiate an efficient sale to maximize value rather than from the value of the property itself.  In that case, the court held that a carve-out represents a benefit to the creditors, in which case the trustee’s ability to recover costs and expenses of disposing of the property under §506(c) would apply.

With this background, the Court chose to interpret narrowly the applicable Georgia exemption statute, (O.C.G.A.  §44-13-100(a)(1)), which applies to a debtor’s “aggregate interest” in residential real property.  The Court found that because the property was wholly underwater, the Debtors did not hold any interest at the time of the filing of the case which was superior to the consensual liens.  Therefore, the Court reasoned, Debtors’ “aggregate interest” in the property was zero.  The Court held that “Debtors’ exemptions could not have attached to the Property as of the petition date, and Trustee’s carve-out represents the value added from Trustee’s efforts and powers, not value of the Property itself.” (emphasis original) 

Conclusion

As real estate prices begin to rise again, the opportunity for a trustee to negotiate a better sale price than the property will fetch at auction will only grow.  The decision by Judge Murphy provides a solid legal and logical basis for encouraging trustees to negotiate carve-outs that will result in a benefit to the unsecured creditors.  If a carve-out can create a little sliver of value where all was previously underwater, the trustee and unsecured creditors should prevail over the debtor’s claimed exemption.  The contrary position was neatly summarized and dispatched by Judge Murphy thusly:  "Debtors are asking the Court to forgive them their debts and then reward them for it – to find value where none existed previously."