I hope to make one point very clear. I am not an expert on bankruptcy matters. I know just enough to spot some issues on my radar screen and call my good friend in Atlanta or Dick Hutson, both of whom can quote Title 11 of the United States Code (the "Bankruptcy Code"), chapter and verse. Over the years, however, I have collected enough tidbits of their knowledge to summarize the concerns of a title insurance underwriter when asked to insure property involved in a bankruptcy estate. The goal of this article is to provide an elementary overview of these concerns from a title insurance underwriter's perspective. In order to provide a basic understanding of some of the terminology used in the Bankruptcy Code, I refer you to the article, An Individual Seller in Bankruptcy, by Denise Bryant, which appeared in North Carolina Lawyers Weekly, January 25, 1999, and is reprinted in full at the end of this article.
Exclusion from Coverage
With respect to the potential future bankruptcy matters affecting an insured owner or their lender, a title insurer typically has no liability for two reasons. First, the loss or damage is the result of a post policy event or a risk created or assumed by the insured. Thus, the industry agrees that the ALTA 1970 Form Policy title insurance jacket was never intended to cover loss or damage associated with creditors' rights issues.
As a result of some claims whereby title insurance underwriters were forced to defend insureds in order to avoid a bad faith denial claim, however, the American Land Title Association's policy was re-written to include what is commonly known as the Creditors' Rights Exclusion. This is found in Exclusions from Coverage "number 7" on the 1992 ALTA Mortgagee Policy Form and "number 4" on the 1992 ALTA Owner's Policy Form. The exclusion in the Mortgagee Policy Form reads as follows:
Any claim, which arises out of the transaction creating the interest of the mortgagee insured by this policy, by reason of the operation of federal bankruptcy, state insolvency, or similar creditors' rights laws, that is based on:
- the transaction creating the interest of the insured mortgagee being deemed a fraudulent conveyance or fraudulent transfer; or
- the subordination of the interest of the insured mortgagee as a result of the application of the doctrine of equitable subordination; or
- the transaction creating the interest of the insured mortgagee being deemed a preferential transfer except where the preferential transfer results from the failure:
- to timely record the instrument of transfer; or
- of such recordation to impart notice to a purchaser for value or a judgment or lien creditor.
The language is substantially similar on the Owner's Policy Form.
Consequently, the underwriter has no exposure if the transaction insured is deemed a fraudulent transfer or is set aside as a preference by a trustee in a future bankruptcy. An attorney should carefully consider this exclusion and advise its client accordingly if the financial health of the seller or borrower is in question. Any transaction involving a deed in lieu of foreclosure should be closely scrutinized.
Creditors' Rights Endorsement
Similar to other endorsements addressing specific exclusions in the policy jacket, certain insureds may request an endorsement to delete the creditors' rights exclusion. With the exclusion removed by endorsement, it is even harder for an underwriter to deny that loss or damage as a result of a creditors' rights claim was not intended to be a covered risk. Accordingly, many underwriters prefer to issue the 1970 ALTA form policy that is silent as to the issue and hope that if a claim arises, they will continue to have a defense. In my opinion, the fact that one requests and/or issues an outdated/revised ALTA form policy that may no longer be filed with many state departments of insurance is just a veiled request and veiled delivery of that coverage fraught with problems.
On the other hand, and provided there is no known risk regarding creditors' rights, the title insurer is usually willing to delete this exclusion provided the transaction to be insured is (a) a bona fide arms length purchase, or (b) the refinance of existing secured debt where the loan proceeds are not also being used to send funds upstream or cross stream and that the terms of the transaction do not render the borrowing entity insolvent or in a position that could reasonably be deemed to result in insolvency.
More simply stated, the most common question posed by an underwriter is, "Where is the money going?" If the money remains an asset of the borrowing entity, the request for the endorsement to delete the creditors' rights exclusion is usually granted. Otherwise, a more detailed analysis of the financial stability of the borrower must be made and the underwriter must conclude that the entity will remain solvent after the transaction.
The title insurance underwriter will scrutinize the financials in detail and probably err on the side of caution for good reason. First, the policy provisions requiring the underwriter to pay for defense costs in a claim based on the assertion that the insured's interest was obtained in a fraudulent transfer or preferential transfer creates a great deal of exposure. Because solvency is a question of fact, it is never an issue that can be resolved on summary judgment. Moreover, in order to prove the solvency of the borrower at the time of the transaction, the defending title insurance underwriter would be required to retain expensive experts to testify. In order to testify these experts would need to spend countless hours examining the financials of the entity from the time of the transaction forward. Although the preference period under federal bankruptcy law is usually one year or less, the state-adopted version of the Uniform Fraudulent Conveyance Act typically has a four (4) year statute of limitations. Due to the filing of a bankruptcy, however, this statute of limitations may be tolled by as long as two (2) years. Therefore, the effective exposure time is six (6) years from the date of the transaction. Thus, the defense of such a claim could be a very expensive proposition.
Second, it is no longer possible to obtain an opinion from a CPA as to the solvency of an entity. The American Institute of Certified Public Accountants, Inc. (the "AICPA") has deemed it unethical to render an opinion as to the solvency of an entity. A CPA, however, may receive his hourly rate to testify as to the solvency of an entity. The AICPA reasoned that in a trial situation, the opposing side has the opportunity to ask questions and challenge the method used to conclude the entity was solvent. In other words, the AICPA recognized the risk was too great and did not want to expose its profession to liability in rendering solvency opinions.
Third, obtaining a solvency opinion from a lawyer is usually difficult and of little value. Most attorneys are too smart to give an opinion in a cold comfort fashion. Instead, he will say something to the effect of, "We understand, without independent verification, that the lender has satisfied itself on the basis of, among other things, the financial information furnished to it and its knowledge of the credit facilities available to the Company, that, among other things: (a) the Company is not insolvent and the Company will not be rendered insolvent by the transaction contemplated by the Loan Agreement; (b) after giving effect to such transactions, the Company will not be left with unreasonably small capital with which to engage in its anticipated business; and (c) the Company will not have intended to incur, or will not have believed it has incurred, debts beyond its ability to pay its debts as they mature." In the alternative, the opinion letter may spot the issues and flag them, give no opinion at all, or engage in a reasoned opinion letter, which is basically the same thing as a law review article of all the risk. It then assumes there is no undisclosed bankruptcy issue and therefore, a court should find that the transfer is not a fraudulent transfer or preference. In any event, these opinion letters are rarely addressed to the title insurance company and may not be relied upon by third parties. Moreover, the attorney must be negligent in reaching their opinion before liability follows.
Fourth, the typical solvency opinion from an investment banker assumes away all risk and the standard of care is either fraud or gross negligence. By the way, solvency opinion letters from investment bankers are extremely expensive and since the investment banker is hired by the borrowing entity and earns a large commission provided the transaction closes, one can argue the opinion will be biased.
Finally, the Departments of Insurance of New York, New Mexico, Texas and Florida prohibit coverage for the creditors' rights risk.
In summary, by deleting this exclusion, the underwriter may be insuring over loss or damage directly caused by the insured and the claim is based upon a post-policy event that uses 20/20 hindsight. Accordingly, Investors Title Insurance Company prefers to accommodate a request for the deletion of the creditors' rights exclusion by attaching to the current ALTA form policy an endorsement that carves out liability for claims caused by acts of the insured. A sample of this endorsement is included at the end of this article.
Current or Recent Bankruptcies
If the title examiner discovers that the current owner of the property is in bankruptcy, any attempt to voluntarily convey the property by the debtor, such as a sale or refinance, or any involuntary conveyance in the form of foreclosure proceedings instituted by a lender or execution of a judgement by a lien creditor is prohibited and void unless the bankruptcy court grants an order approving the sale or lifting the automatic stay as it relates to the real property in question, even if the bankruptcy court has previously entered an order abandoning the real property from the bankruptcy estate.
Once such an order granting relief from the stay has been entered, any party in interest in the bankruptcy case has ten (10) days to appeal the order. Under recent amendments to the Federal Rules of Bankruptcy Procedure, which became effective December 1, 1999, there is a new ten-day automatic stay following the entry of any bankruptcy order (1) authorizing use sale or lease of property under Section 363 (See Rule 6004(g)); (2) confirming a plan of reorganization in a Chapter 9 (municipality) or Chapter 11 case (but not a Chapter 13) (See Rule 3020(e)); (3) authorizing the trustee to assign an executory contract or unexpired lease under Section 365(f) (See Rule 6006(d)); or (4) granting a motion from release of an automatic stay made in accordance with Rule 4001(a)(1) (See Rule 4001(a)(3)), unless the court orders otherwise. Consequently, in these four situations and unless the court specifically orders otherwise, a party in interest has the full ten (10) day period in which to file an appeal and one should always wait ten (10) days from the entry of the order before conducting the sale authorized in the order so as not to violate the second "new" automatic stay. It is also important to note that the running of the ten (10) days does not run concurrently with any statutory period required by state law for foreclosures.
More specific details regarding the procedural items to review when confronted with title coming out of a bankruptcy estate, both present and past, are set forth in An Individual Seller in Bankruptcy. In summary, the title insurance underwriter wants the order authorizing the sale to specifically address all judgment creditors, deeds of trust or any liens against the property being sold out of bankruptcy by requiring that the same be paid off or specifically state that the real property is to be transferred "free and clear" of all liens with said liens being transferred to the proceeds of the sale. Additionally, the title insurance underwriter wants all the requisite time periods to have run and procedural requirements to have been followed.
Not addressed in the attached article is the effect of a Chapter 11 filing, which by statute allows the debtor to continue activities that are in the ordinary course of business. While the sale of real property is rarely considered to be in the ordinary course of business for most entities, it may be the primary purpose of conducting business for a land developer or homebuilder who has filed Chapter 11. Although it may be common knowledge that the sale of real estate is in the ordinary course of business for certain entities, most title insurance underwriters will want either a court order or the confirmed plan to specifically address the continued sales of land/houses and be clear and unambiguous as to the treatment of any and all potential lien claimants.
At a recent ALTA meeting, a concern was raised as to whether it is Constitutionally permitted for a bankruptcy court to affect the character of a lien in favor of a state, e.g., transfer it from being a lien on real property to the proceeds derived from the sale of the real property. Since this has not been addressed, most underwriters want any liens in favor of a State specifically waived or released by the State. Of course, one must confirm the party waiving or releasing the lien has the requisite authority to do so for the State.
Past Bankruptcy in a Chain of Title
Although the attached article is clear, I feel compelled to underscore that judgments and liens against real property that attached prior to the owner filing bankruptcy continue to be a lien against that property notwithstanding any discharge in bankruptcy or dismissal from bankruptcy. The discharge relates only to the debtor's personal liability and therefor those pre-bankruptcy judgments will not attach to real property the debtor acquires after being discharged.
For the protection of the debtor, certain property is exempt under state law from the claims of creditors provided the debtor has timely filed the property as exempt and the trustee has not objected to such claim within the time allotted. For title insurance purposes, the exemption that is most commonly at issue is the right of the debtor to exempt his personal residence, more commonly known as a homestead exemption. One issue surrounding a homestead exemption is whether an order by the bankruptcy court avoiding liens to the extent of the debtor's exemption avoids the lien permanently, or whether the exemption ceases if the use of a personal resident ceases or if the property is sold, so that the judgment creditor can then enforce his judgment lien. The answer depends on the applicable bankruptcy court district. In a 1987 case, In re Love (829 F.2d 11200 (1987)), the Bankruptcy Court of the Eastern District of North Carolina decided that where the court enters an order which avoids the lien of a judgment creditor "to the extent that the lien impairs the debtor's exemption in the property," such exemption in favor of the debtor is conditioned upon continued use of the property by the debtor as a residence. If ownership or use by the debtor changes, then the exemption ceases, and the judgement creditor could enforce his judgement lien.
The decision of In re Love has been expressly overruled by the Fourth Circuit Court of Appeals decision of In re Opperman (943 F.2d 441 (1991)), which held that the federal exemptions would control the state exemptions and that under the federal exemptions there is no limiting of the exemption to the duration of debtor's actual residence in the property. Accordingly, an order by the Bankruptcy Court avoiding liens to the extent of the debtor's exemption does avoid the lien permanently in North Carolina.
On the other hand, if the debtor has claimed property as exempt and he has equity in the property that exceeds any exemption to which he would be entitled under either state or federal law, the judgment creditor may file a timely objection requesting that the lien not be avoided in total, but only to the extent it impairs the debtor's exemption. The burden is on the judgment creditor to show there is excess equity. Consequently, if the judgment creditor does not file a timely objection and prove there is excess equity, the order avoiding the judgment creditor's lien will avoid it in total, notwithstanding any additional equity in the property that may accrue due to appreciation or otherwise. In re Opperman. For title examiners, it is thus important to examine the bankruptcy file to determine if a judgment creditor's lien has been avoided in total or in part.
In any event, after the debtor has been discharged from bankruptcy, subsequently incurred judgment liens do attach to the real property then owned or subsequently acquired. Finally, it is important to note that actions that otherwise would be time barred, may still be viable. Pursuant to Section 108 of the Bankruptcy Code, if the time period for commencing an action or perfecting a lien expires at a time when an automatic stay is in place or will expire less than thirty (30) days after the automatic stay has expired (typically the date the bankruptcy has been dismissed or terminated), the time for commencing said action is extended for thirty (30) days after the expiration of the automatic stay.
Recognizing these few bankruptcy related issues relevant to a title insurance underwriter will surely provide more comfort to your malpractice carrier, however, it is always best to seek specific guidance from the underwriter with whom you are dealing as to its position and/or if you have any questions.