Zev Shechtman, Esq.
Danning, Gill, Diamond & Kollitz, LLP
www.dgdk.com
As a general rule, trustees do not sell underwater properties. If the property is fully encumbered by liens, there is no equity available to benefit the bankruptcy estate, and thus the trustee should not liquidate the property.[1] Like many good rules, this one has its exceptions. If selling the property will benefit the estate, and the lien holder consents to the sale, the property may be sold under 11 U.S.C. § 363. Enter the “carveout.” A carveout agreement, in this context, is one by which a lien holder subordinates its secured claim, thereby making it possible for the trustee to liquidate the asset.[2]
One prime example of this kind of carveout involves a secured claim holder whose lien is secured by overencumbered real property. Outside of bankruptcy, or if granted relief from the automatic stay pursuant to 11 U.S.C. § 362, such lien holder would seek to foreclose on the property. Instead of seeking relief from the automatic stay to then proceed with foreclosure under nonbankruptcy law, the lien holder negotiates a carveout agreement with the trustee thereby allowing the trustee to sell the property under 11 U.S.C. § 363, amounting to a shortsale of the property. The specific terms can be negotiated, but whether they involve payment of a sum certain to the estate or payment in full of administrative expenses with a dividend to unsecured creditors, the basic concept is that funds that would otherwise need to be paid to the secured creditor will instead be paid to the estate by virtue of the carveout agreement.
A challenge to such an arrangement may arise when the debtor claims an exemption in the proceeds of the sale. State exemption laws, incorporated in the Bankruptcy Code by 11 U.S.C. § 522, exempt from property of the estate certain property, including equity in real property, subject to dollar limitations.[3] Several courts have opined on whether the debtor’s exemption applies to funds generated from a lien holder’s carveout for the sale of property. The apparent majority of cases have ruled that the debtor’s exemption does not attach to such proceeds which inure to the estate by virtue of the secured lender’s carveout.[4] The secured lender, it is reasoned, can distribute the proceeds subject to its lien as it deems fit, including by transferring such carveout funds to the bankruptcy estate. In re Wilson, a Central District of California Bankruptcy Court case, appears to be an outlier, ruling that it makes no difference that the funds collected by the trustee amount to a “tip” from the secured lender—the proceeds of the sale constitute property subject to the debtor’s homestead exemption.[5] However, in light of the weight of cases contrary to Wilson, carveouts are sure to remain a fixture in bankruptcy estate liquidations, whether they are of the debtor’s homestead or of investment properties that would not be subject to the debtor’s exemption.
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[1] In re KVN Corp., Inc., 514 B.R. 1, 5 (B.A.P. 9th Cir. 2014) (“It is universally recognized… that the sale of a fully encumbered asset is generally prohibited.”)
[2] Carveouts are also common in the context of cash collateral and debtor in possession financing in chapter 11 cases. See generally Richard B. Levin, Almost All You Ever Wanted to Know About Carveout, 76 Am. Bankr. L.J. 445 (2002).
[3] In California, the applicable statute is Code of Civil Procedure § 704.730, and the dollar limit ranges from $75,000-$175,000 depending on age, whether the debtor is single or lives in the property with her family and disability, among other factors.
[4] See, In re Diener, No. 11-83085-MHM, 2015 WL 4086154 (Bankr. N.D. Ga. July 1, 2015) (collecting cases, and finding Law v. Siegel, 135 S.Ct. 1188 (2014) inapposite); see also In re Bunn-Rodemann, 491 B.R. 132 (Bankr. E.D. Cal. 2013).
[5] See, In re Wilson, 494 B.R. 502 (Bankr. C.D. Cal. 2013).
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