A recent Maryland bankruptcy case has been decided by the 4^th Circuit and may be helpful in sorting out the issues concerning pre-petition judgment liens. Birney v. Smith, No. 98-2479, U.S. 4th Circuit Court of Appeals, December 29, 1999 concerns the attempt by a judgment creditor to execute on a judgment on real property in Maryland. The property was originally owned by the debtor as tenants by the entireties with his wife who died after the filing of the petition in bankruptcy.

Birney and his wife owned real property located in Cecil County, Maryland as tenants by the entireties. In 1984, Smith obtained a judgment against Birney individually in state court. In Maryland, as in North Carolina, a judgment lien against individuals does not attach to entireties property held by debtors with their spouses. In May of 1995, Birney filed a voluntary Chapter 7 bankruptcy petition. Birney listed the property as exempt because it was jointly owned as tenants by the entireties by the debtor and his non-filing spouse. In June of 1995, the trustee notified the creditors that the case was a no-asset case and filed a report of no distribution in August of 1995. In October of 1995, Birney’s wife died. The trustee determined that the estate could not acquire these assets and he filed a second report of no distribution in December of 1995. In January of 1996, a discharge was issued and the case was closed without objection to the claimed exemptions or the trustee's reports.

Smith then attempted to execute on the property, claiming that he acquired a lien on the property upon Mrs. Birney's death. In April of 1996, Birney reopened the bankruptcy case seeking a determination by the court that no lien attached to the property and that Smith's claim against Birney had been discharged in the bankruptcy proceedings. The Bankruptcy Court granted Birney's motion for summary judgment, finding that Mrs. Birney's death did not void the property exemption. The District Court affirmed the Bankruptcy Court's order, finding that the property was never captured by the bankruptcy estate and therefore could not be reached by the creditor who then appealed.

The 4^th Circuit ruled that the creditor could not reach the property directly through the debtor. During the period prior to the debtor’s bankruptcy petition, the lien could not attach to the property because the spouse was still alive. During the period between the bankruptcy filing and the discharge, no lien could attach because of the automatic stay imposed by 11 U.S.C. § 362(a)(5). This section prohibits ‘any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title’. The creditor contended that his lien on the property arose by operation of law upon the death of the spouse. He argued that attachment of the lien did not fall under the § 362(a) prohibition since it did not involve an "act" to create or perfect the lien. The Circuit Court determined that this contention was incorrect under the holding of In re Avis v. Trustee, 178 F.3d 718 (4th Cir. 1999).

In Avis, the 4^th Circuit held that the attachment of a tax lien, arising by operation of law to post-petition property, is an "act" within the meaning of § 362(a). Attachment is, therefore, prohibited during the time that the automatic stay is in effect. The Court rejected a narrow interpretation of the term "act" and concluded that the attachment of a lien is itself an "act" that is prohibited by § 362(a)(5), even when the attachment occurs automatically by operation of law. Id. at 722- 23.

The automatic stay imposed by § 362(a)(5), therefore, prohibits the attachment of Smith's post-petition lien because it is still an "act". The automatic stay remained in effect until January of 1996, when Birney was granted a discharge. Smith's lien could not attach from the time Birney filed his bankruptcy petition until the time he was granted a discharge. After discharge, no lien could attach to the property because the discharge extinguished the debt upon which the lien was based, as the debtor was no longer liable for the judgment debt.

The creditor also cannot reach the property through the bankruptcy estate. He contended that upon the spouse's death, the basis for exempting the property from the bankruptcy estate lapsed, and that therefore the property should become part of the estate and made available to satisfy the claims of creditors. The court ruled that the basis for the debtor's exemption of the property was in fact extinguished upon the spouse's death citing In re Cordova, 73 F.3d 38 (4th Cir. 1996). Cordova held that an exemption for property owned as tenants by the entireties lapsed when the joint tenancy was extinguished by operation of law following a divorce that occurred post-petition. Termination of the exemption after the filing of the petition does not, by itself, bring the property into the bankruptcy estate. There must also be some applicable statutory mechanism by which the estate "captures" the post-petition property. Section 541(a) provides the only statutory basis having potential for bringing the property into the bankruptcy estate.

This section defines as part of the estate

" Any interest in property that would have been property of the estate if such interest had been an interest of the debtor on the date of the filing of the petition, and that the debtor acquires or becomes entitled to acquire within 180 days after such date --

(A) by bequest, devise, or inheritance;

(B) as a result of a property settlement agreement with the debtor's spouse, or of an interlocutory or final divorce decree; or

(C) as a beneficiary of a life insurance policy or of a death benefit plan."

In these limited circumstances, the statute allows the estate to "capture" property acquired by a debtor within 180 days after filing the bankruptcy petition. Such property becomes part of the bankruptcy estate only if the property was obtained as a result of the events contained in subsections (A) through (C). Upon Mrs. Birney's death, less than 180 days after filing his bankruptcy petition, Birney became the sole owner of the property. A tenant by the entireties does not "inherit" the co-tenant's interest in the property. The survivor continues in full ownership of the property alone. As a result, the debtor did not receive a fee simple interest in the property by "bequest, devise, or inheritance." Nor did he obtain the property in a divorce settlement or as an insurance beneficiary. As a result, the creditor could not reach the property through the estate.

This case presents an excellent opportunity to remind title examiners of the potential problem that arises from pre-petition property subject to a pre-petition judgment lien. Discharge in bankruptcy only discharges the personal obligation to pay the debt as noted above. The lien of a pre-petition judgment is not voided or discharged when the debtor retains the pre-petition property after the bankruptcy. The discharge operates to prevent the creditor from executing on the lien as long as the debtor retains the property. Once the debtor conveys the property after discharge, the creditor may execute on the lien against the new owner. This is also a problem in the lending context. Subjecting the property to a deed of trust or mortgage is not a conveyance giving rise to a right on the creditors part to execute. Foreclosure of the instrument, by the lender, terminates all legal and equitable rights of the debtor but does not cut off the lien of the prior judgment. There are, at least, two exceptions to this principle. Obviously, if the judgment has expired due to an applicable limitations period, it may not be enforced. In addition, if the debtor obtained an order of lien avoidance, after due notice, under Section 522(f) of the Bankruptcy Code, the creditor is cut off from the right to execute on the lien.

If the title examination discloses judgments of record that have attached to property owned at the time of a discharge in bankruptcy, the examiner should report the facts to the title insurer for underwriting review. It is not unusual to require re-opening of a bankruptcy proceeding in order to obtain a lien avoidance order in such cases, but these situations do not arise very often.

Note: This article is re-printed with the compliments of Asset Preservation, Inc. (API), a subsidiary of Stewart Title located in Granite Bay, California. Statewide Title Exchange Corporation (STEC) and API work together on the distribution of IRS Section 1031 information and on the more involved transactions such as reverse and improvement exchanges.

When an Exchanger elects to carry-back a Note on the relinquished property (the sale of Phase 1 property), there are basically two options for the treatment of the Note:

1. DO NOT include the Note in the exchange and pay any taxes that may be due. The Exchanger would receive the Note as the Beneficiary at the closing and pay taxes on this portion of the capital gain under the installment method (§453).
2. Include the Note in the exchange by initially showing the "Qualified Intermediary" (STEC) as the Beneficiary and possibly defer the capital gain taxes.

In option number (1), the Exchanger is electing to take the Installment method per Code Section 453. The Note is made payable to the Exchanger and is received by the Exchanger at the closing of the relinquished property. The drawback to this method is the capital gain tax could become due in one lump sum if the Note allows for prepayments or if a balloon payment is required. In option number (2), the Exchanger has four different alternatives for attempting to use the Note as part of the tax deferred exchange. In order to avoid "constructive or actual receipt" by the exchanger, STEC is named the beneficiary on the Note.

1. Use the Note Towards the Down Payment on the Replacement Property (Purchase or Phase II)

The Seller of the replacement property accepts the Note as partial payment towards the purchase price. In this scenario, the Note is assigned to the Seller by STEC and delivered to the Seller at closing.

2. Exchanger Purchases Note From the Exchange

Essentially, the Note is to be replaced with cash. To avoid constructive receipt of funds at the relinquished property closing, the Exchanger deposits cash equal to the face value of the Note directly to the closing officer. STEC assigns the Note to the Exchanger for delivery immediately after closing on the replacement property.

3. The Payer on the Note Pays Off the Note Prior to Closing on the Replacement Property

The Note is actually paid off during the exchange. This works only on short-term Notes due within the 180 day exchange period. The Payer pays off the Note directly to STEC, the holder of the note. STEC adds the payoff proceeds to the existing proceeds in the Qualified Exchange Account. When the replacement property is ready to close, all proceeds are delivered to the closing officer.

4. Selling the Note on the Secondary Market

The Exchanger finds an investor willing to purchase the Note, thereby replacing the Note with cash. The cash proceeds are added to the existing cash in the Qualified Exchange Account for purchasing the replacement property. Typically the Note will need to be sold at a discount, often anywhere from 15% - 30%. If the Note is discounted, the discounted amount MAY be considered a selling expense.

If the Exchanger chooses option (2) and then is unsuccessful with any of the four alternatives shown above, STEC will assign the Note back to the Exchanger. The Exchanger has all the tax benefits of the installment method in Code §453 as shown under option (1) available. Many Exchangers choose option (2) because it allows for several alternatives of tax deferral, without penalizing the Exchanger.

There is a new decision by the New Jersey appellate court that may be the precursor of a trend to incorporate technology into the legal process by judicial decree. While the ruling involves a domestic case, the implications for foreclosures and other real estate related litigation is obvious. It is interesting to note that the Court cited a North Carolina case to support its ruling. The Court held that where a party cannot physically locate an adverse party for service, the known existence of an e-mail address is a relevant fact to be disclosed to a trial court in support of an application for service by publication. That in conjunction with service by publication the court may require an attempt be made for "actual service" by e-mail. Modan v. Modan, SUPERIOR COURT OF NEW JERSEY, APPELLATE DIVISION, A-6286-97T5, decided January 12, 2000, was an appeal by defendant from an order denying a motion to vacate a default judgment of divorce obtained by plaintiff.

The parties were married in 1995, and separated in 1997, subsequently plaintiff brought defendant to her mother's home in New York. Plaintiff employed an attorney to work out the terms of a property settlement but defendant, nevertheless, departed for Pakistan. When negotiations failed, plaintiff filed a complaint for divorce alleging that defendant resided in New York. According to a verification filed in the matter, a copy of the complaint was sent to the mother's address by both regular and certified mail which was returned undelivered. The facts of the case made it clear that plaintiff knew of defendant's move to Pakistan though he may have been unaware of defendant's exact address there. However, copies of e-mail messages sent to him were in the record, and he was aware of an e mail address in Pakistan where defendant could be reached. The Court found that the plaintiff knew that defendant did not reside in New York and that she had not gone back to Pakistan merely for a visit. Rather, defendant went home and was waiting, according to her e-mails, for plaintiff to accept her back as his wife.

Plaintiff submitted an affidavit of diligent inquiry, pursuant to the New Jersey procedural rules, in support of a motion for an order for publication. Plaintiff stated, in the affidavit, that when defendant left their marital abode she went to live in New York. He admitted that she had called him several times from Pakistan but he did not "know whether she is still in Pakistan visiting or what . . .". An affidavit of diligent inquiry is required in New Jersey to disclose the efforts made to ascertain the defendant's whereabouts before seeking an order for publication. The Court pointed out that the plaintiff did not mention in his affidavit that he had received e-mails from defendant and that he knew of an e-mail address where defendant might be reached in Pakistan. Service by publication in New Jersey requires that, in addition to publication, a notice in the form of a summons must also be sent by mail to the defendant's residence or the place where the defendant usually receives mail if known. By reason of this requirement, the Court determined that plaintiff's affidavit of diligent inquiry and his failure to notify plaintiff by e-mail did not comply with the Rule.

The Court noted that virtually every jurisdiction requires a diligent inquiry be made as to the whereabouts of the defendant before permitting service of process by publication. The Court cited the decisions of several States for the proposition that there is no laundry list for due diligence, including North Carolina's Court of Appeals holding that determination [of due diligence] in each case is based upon the facts and circumstances thereof." Barclay's American/Mortgage Corp. v. BGCA Enterprises, 446 S.E.2d 883, 886 (N.C.App. 1994). The opinion pointed out that a plaintiff need not exhaust all conceivable means of personal service before service by publication is authorized, but need only follow up on the information that might reasonably assist in determining defendant's whereabouts. They noted that North Carolina's Court of Appeals has stated that due diligence "requires a party to use all reasonably available resources to accomplish service." Barclay’s, supra, 446 S.E.2d at 886.

In this case, since plaintiff knew of an e-mail address where defendant could be reached, a reasonable method was available for effecting actual notice to defendant in addition to the requirement of service by publication. The Court held that the trial court should have been made aware that an e-mail address was available to plaintiff in order that it could have required that an appropriate notice of the complaint be e mailed to defendant so that actual notice to defendant would likely have been effected. The Court stated that perhaps " actual notice to defendant may not have been effected, but by attempting to notify her via e-mail, plaintiff's due diligence in making complete disclosure would have satisfied both the letter and spirit of R[ule]. 4:4-5. By reason of the foregoing, we reverse the denial of defendant's motion to vacate the final judgment of divorce."

We are often asked to insure title to property acquired through judicial proceedings effected through service by publication. Due diligence in such cases is a significant concern since our courts have consistently been unwilling to divest title based upon service by publication where parties could have been located with little extra effort. Search engines on the Internet, dedicated to locating people, are easily found and are becoming very powerful. We expect a trend in appellate decisions mandating Internet research, of some kind, as part of the due diligence process.