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Use of Strong-Arm Power Not Barred by Rooker-Feldman Doctrine

The Rooker-Feldman doctrine did not prevent a bankruptcy court from considering whether a Chapter 13 debtor could use the Bankruptcy Code’s strong-arm power to avoid an unperfected lien on property for which a state court had authorized the lender to foreclose, the U.S Court of Appeals for the Sixth Circuit has decided. The claim was not barred because the bankruptcy court could rule in favor of the debtor without invalidating the state court foreclosure judgment.

The debtor and her husband took out a loan that was secured by a mortgage on their home. The lender did not immediately record the mortgage so the lien was not perfected when the debtor and her husband filed a Chapter 7 bankruptcy case a year later. Neither the debtor nor the Chapter 7 trustee was aware that the mortgage was not perfected and subject to avoidance under the Code’s strong-arm provision, Sec. 544(a). However, the lender recorded the mortgage while the case was pending and during the time in which the automatic stay was in effect.

The debtor and her husband eventually obtained a discharge in the Chapter 7 case. A decade later, the new owner of the mortgage sought to foreclose on the debtor’s home in state court. The lender obtained a judgment, and the state court ordered a foreclosure sale.

The debtor filed a Chapter 13 bankruptcy before the sale could take place. The debtor then filed an adversary proceeding to avoid the lien based on one of two alternate bases. First, stepping into the shoes of a bona fide purchaser, she sought to avoid the mortgage using the Code’s strong-arm power on the ground that the lien was never properly perfected. Although the mortgage was recorded during the debtor’s prior Chapter 7 case, the lender never obtained relief from the automatic stay and therefore the lien was arguably void.

In the alternative, the debtor argued that the lien never attached to the home in the first place. According to the debtor’s reading of the underlying mortgage agreement, the lien would attach to the property only after it was recorded. Because the lender failed to record the mortgage before the debtor’s first bankruptcy case, the lien did not attach to the home and the underlying obligation was discharged in the first bankruptcy case.

The bankruptcy court did not address the debtor’s strong-arm power argument, instead the court adopted the debtor’s reading of the mortgage agreement and determined that the lender did not have a valid lien in the property. The lower court rejected the lender’s argument that Rooker-Feldman prevented the bankruptcy court from ruling on the validity of the lien.

The bankruptcy court applied the Sixth Circuit rule from Hamilton v. Herr (In re Hamilton), 540 F.3d 367 (6th Cir. 2008) and held that the state court was wrong in entering a foreclosure judgment because the mortgage debt had been discharged in the debtor’s earlier bankruptcy. The Hamilton rule provides that, notwithstanding the Rooker-Feldman doctrine, a state court judgment is void if it is entered against a debtor as to debts that have been discharged.

The Bankruptcy Appellate Panel reversed. The BAP determined that the lien attached when the parties signed the underlying agreement. The lien was valid, and the bankruptcy court did have subject matter jurisdiction to review the state court’s foreclosure judgment. The BAP did not address the debtor’s strong-arm power argument.

The Sixth Circuit affirmed the BAP’s ruling that the bankruptcy court did not have jurisdiction under Rooker-Feldman to consider the validity of the lien. The test to determine whether a claim is barred by Rooker-Feldman, the appellate court noted, is whether the source of the claimant’s injury is the state court decision. The source of the debtor’s injury was the state court’s finding of a valid lien and its entry of a foreclosure order. For the debtor to prevail, the bankruptcy court would have to vacate the state court’s finding of a valid lien and subsequent foreclosure order.

In addition, the Hamilton exception to the Rooker-Feldman doctrine did not apply. Hamilton only protected debtors in state court proceedings from being held personally liable on discharged debts. The lender in this case obtained an in rem judgment to foreclose its lien on the debtor’s property. The judgment did not affect the debtor’s personal liability on the underlying loan.

Although the bankruptcy court did not have jurisdiction to consider the validity of the lien, the debtor’s claim that the unperfected lien could be avoided using the Code’s strong-arm power was not barred by Rooker-Feldman. The state court only determined the validity of the lien, it did not address perfection, which was not required for the lender to foreclose (the lien could be valid between the lender and the debtor even it remained unperfected). Consequently, resolution of the debtor’s strong-arm claim did not require the bankruptcy court to review or overturn the state court’s determination of a valid lien.

Isaacs v. DBI-ASG Coinvestor Fund, III, LLC (In re Isaacs), No. 17-5815, 2018 U.S. App. LEXIS 19803 (July 18, 2018)