In Nealy v. Ivy Holdings (In re Nealy), 623 B.R. 278 (Bankr. D.N.J. 2021), the U.S. Bankruptcy Court for the District of New Jersey found that a Chapter 13 debtor lacked authority to bring an action to avoid the transfer of her family’s real property in a prepetition foreclosure sale. Because the debtor’s objective was solely to recover title to the property in order to preserve her homestead exemption, and because the relief the debtor sought was not limited to the value of her exemption, the Nealy court held that the debtor could not pursue her requested relief.

Background

On Dec. 23, 2019, Fertima C. Nealy filed for bankruptcy protection pursuant to Chapter 13 of the U.S. Bankruptcy Code. Before her bankruptcy filing, Nealy purportedly owned a partial interest in real property passed down from her grandparents. However, because certain real estate taxes assessed against the property remained unpaid, the property was eventually sold through foreclosure proceedings, and title to the property was ultimately transferred to Ivy Holdings, LLC, the assignee of the tax sale certificate covering the property in question.

A Debtor’s Section 522(h) Power to Bring Avoidance Actions

If a bankruptcy trustee fails to act, Section 522(h) of the Bankruptcy Code allows a debtor to avoid a transfer of property—but only “to the extent that the debtor could have exempted such property”—where such transfer is otherwise avoidable by the trustee under Chapter 5 of the Bankruptcy Code. The debtor’s ability to avoid such a transfer is further limited by the provisions of Bankruptcy Code section 522(g)(1), which requires that: the transfer sought to be avoided was not a voluntary transfer on the part of the debtor; and the debtor did not attempt to conceal the existence of the property.

Sections 522(b) and 522(d) of the Bankruptcy Code allow debtors to exempt, from property of their estates, their interest in property that they use as a residence. This exemption is capped at a dollar amount specified in the Bankruptcy Code, and the cap is adjusted each year for inflation. This is the debtors’ so-called “homestead exemption.”

The foregoing provisions of the Bankruptcy Code, taken together, give debtors the power to bring and pursue avoidance actions to recover real property that might be exempted under the homestead exemption in cases where the bankruptcy trustee declines to act.

Shortly after her bankruptcy filing, Nealy commenced an adversary proceeding against Ivy Holdings seeking to avoid the tax foreclosure sale as an alleged fraudulent transfer and/or preferential transfer. Nealy then filed a summary judgment motion in which she sought to avoid the transfer and to regain title to the property. Ivy Holdings opposed the summary judgment motion.

The bankruptcy court requested that the parties submit supplemental briefing to address two issues: Nealy’s standing to pursue an avoidance action in light of the limitations set forth in Section 522(h) of the Bankruptcy Code, and In re Majestic Star Casino, 716 F.3d 736 (3d Cir. 2013), a case in which the U.S. Court of Appeals for the Third Circuit questioned the propriety of a debtor bringing an avoidance action that, if successful, would offer no benefit to creditors.

The Court’s Analysis

In Nealy, the court held that the debtor was not entitled to the relief she sought in her summary judgment motion. In so holding, the court began with the Third Circuit court’s dicta in Majestic, wherein the court stated that “a debtor is not entitled to benefit from any avoidance … and courts have limited a debtor’s exercise of avoidance powers to circumstances in which such actions would in fact benefit the creditors, not the debtors themselves.”

The Nealy court also looked to In re Allonhill, 14-10663 (KG), 2019 WL 1868610 (Bankr. D. Del. Apr. 25, 2019). The Allonhill court cited the language in Section 550(a) of the Bankruptcy Code stating that transfers may be recovered only “for the benefit of the estate” and held that the debtor could not recover on its avoidance actions to the extent that such recovery would exceed the amount of outstanding creditor claims. To hold otherwise, the Allonhill court concluded, would result in a windfall to the debtor’s equity holders precluded by Section 550 and Third Circuit case law.

The Nealy court found Majestic and Allonhill to be persuasive authority for the rule that a debtor may only seek to recover transferred property if doing so would benefit the debtor’s estate. Applying this rule, the court determined that Nealy’s summary judgment motion sought to undo the foreclosure sale and have title to the property returned to her to preserve her exemption with respect to her interest in the property. Rather than save her family property, which Nealy would still have to sell in order to fund and propose any confirmable Chapter 13 plan, the court concluded that Nealy’s primary objective in the adversary proceeding was to prevent losing the value of her exemption through the prior foreclosure.

The Nealy court also emphasized that debtors do not have an unfettered, independent right to exercise a trustee’s avoidance powers. Rather, Section 522(h) provides debtors with a tool they may use for their own benefit only when statutory prerequisites are satisfied. Thus, to proceed under Section 522(h), Nealy had to tailor the relief she requested so as to comport with the limitations set forth in Sections 522(h) and (g)(1). In other words, she could only recover the value of any valid exemptions to which she might be entitled. Her motion, however, requested that title to the entire property re-vest in her.

The court concluded that to allow Nealy to pursue a total avoidance of the foreclosure sale and to have title to the property transferred to her would not further goals of the Bankruptcy Code and would exceed the purpose and limitations of Sections 522(h) and (g)(1). Therefore, the court denied Nealy’s summary judgment motion.

Conclusion

The division of rights and powers between a debtor and a bankruptcy trustee is less clear in the Chapter 13 scenario than it is in the Chapter 7 scenario. The decision in Nealy confirms that a Chapter 13 debtor’s authority to bring an avoidance action must derive from a specific provision of the Bankruptcy Code, and the debtor’s relief sought in that action must be narrowly tailored to comply with the prerequisites of such statutory provision. Further, the Nealy court’s analysis adds to growing Third Circuit case law limiting a debtor’s standing to bring avoidance actions to those that are for the benefit of the debtors’ creditors and not just for the debtor’s own benefit. Thus, debtors, including those who have filed for Chapter 13 protection, should be mindful when pursuing any avoidance action: not only of the statutory limitations on the relief they are seeking, but also of how the bankruptcy court may scrutinize both the debtors’ purpose in bringing such an action and the impact that a successful action would have on the debtors’ bankruptcy estates.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Elisa Hyder, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.