Summer 2010 • Issue 37, page 24

May State Courts Confirm Receivers' Sale of Real Property Free and Clear of Liens and Encumbrances?

By Davidson, Peter & Rense, Kirk*

Q: A receiver is preparing to sell some real property in receivership “free and clear liens” with the liens attaching to the proceeds of the sale, believing this is something receivers can do. Counsel for the title company he was going to use said it would not write the policy because it had concerns about the court’s power to issue such an order; especially with respect to its jurisdiction over claimants whose rights would be affected by a sale. The title company referred to “due process” considerations, which it believes means that a court cannot change or alter anyone’s rights, including property rights, without at least providing all affected parties “due process.”

The title company said the court must have jurisdiction over a party to affect its rights and believed jurisdiction can only be obtained by serving such claimant as one would serve a summons and complaint. The title company acknowledged the rules are different under the Bankruptcy Code [Sec. 363(f) specifically authorizes such sales under certain terms and conditions]. Because the case is in state court, the title company didn’t see how a state court could alter lien holders’ rights by selling property free and clear of their liens, even if the liens attached to the proceeds. Certainly not without providing each affected person and entity with full notice. Is this right? Can receivers sell property free and clear of the liens?

A: The attorney who gave this advice apparently has forgotten there are a number of ways for a court to obtain jurisdiction and issue orders affecting parties’ rights. He is focused on personal jurisdiction. However, a court can have jurisdiction over property by taking the property under its custody and control. In such situations, the court has quasi in rem jurisdiction. That is what occurs when the court appoints a receiver for property.

The property is taken into the custody of the court (it is “in custodia legis” – which, by the way, is the motto of the Receiver’s Forum). Because the property is in the custody of the court, the court has quasi in rem jurisdiction and can deal with the property and affect everyone’s rights to the property. All lien holders should, however, be given notice of the sale motion. Title company’s counsel’s statement that the rules in bankruptcy court are different is incorrect. Indeed, the section in bankruptcy code authorizing a debtor or bankruptcy trustee to sell property free and clear of liens, with the liens attaching to the proceeds is modeled after the old equity receivership practice where courts of equity often authorized the sale of property under their control free and clear of existing liens. See Spreckles v. Spreckles Sugar Corp., 79 F.2nd 332 (2nd Cir. 1935) where the court points out the courts of equity have had the power to sell property free and clear of liens, including taxes, from the earliest times. Indeed, the Supreme Court has held that this power “must be implied from the general equity powers of the court.” Van Huffel v. Harkelrode, 284 U.S. 225 (1931); see also 65 Am. Jur. 2nd “Receiver” Section 343 [“The majority view is that a court has the inherent power to authorize the sale of property in custodia legis free and clear of liens, the liens being imposed upon the proceeds of the sale.”].

In Chapman v. Schiller, 95 Utah 514, 83 C. 2nd 249 (1938) the court indicated that some courts “following the rule in bankruptcy cases” will not order a sale free and clear of liens unless there is equity for the estate in the property. However, it notes: “The rule wherever adopted has been held to be discretionary.”

The receivership court, therefore, can sell property in receivership, free and clear of liens, with the liens attaching to the proceeds. This is how most of the “busted” condominium projects are operating. The receiver will get court authority to sell a unit free and clear of any liens, with the liens attaching to the proceeds. The court will work out later who is entitled to the proceeds based on their liens.

If there are not sufficient funds in the estate when all the condominiums are sold, it is likely the bank holding the senior lien position will foreclose, wiping out all the junior liens and obtaining all of the sale proceeds (less of course the administrative expenses owed to the receiver and his professionals). If there are sufficient proceeds to pay off the bank, then the court will have to determine who is entitled to the balance of the proceeds based on the liens that have been filed.

The court clearly, however, does have the power to sell receivership property free and clear of liens. It should be noted, and this may clear up some confusion expressed by some counsel as to how a receiver can sell property and pass title prior to a bank’s foreclosure. Receiver’s sales do not convey “legal” title; they convey “good”, equitable title. When a court orders property in its custody sold, the court confirms title in the purchaser. A court of equity acts by injunction against the owner and third parties and protects the purchaser against interference and assures the purchaser quiet title. SEC v. American Capital Investment, Inc., 98 F. 3d 1133 (9th Cir. 1996) citing Clark on Receivers Section 487.

[Editor’s note: There is a split of opinion on how broad the sweep is of a state court’s right to strip perfected lien rights from real property to sell it free and clear of such stripped liens. The argument begins with the express prohibition against states passing any law impairing the obligation of contracts – presumably including lien rights arising pursuant to contractual terms (the Federal government is not so prohibited). An article in the California Law Review [76 Calif. L. Rev. 267, 1988] sets out James Madison’s explanation for the express ban, which is found in Section 10 of Article One of the U.S. Constitution (“No state shall...pass any…Law impairing the Obligation of Contracts….). Madison said, in brief, that laws impairing the obligation of contracts are contrary to the first principles of the “social compact” and to every principal of sound legislation.

The argument goes that a state court’s equitable power to sell real property free and clear of liens does not emanate from a specific law or statute, however, but rather from the time-honored usages of equity, and the Constitutional ban against states impairing rights of contract is inapplicable. Case law generally supports this distinction, as Peter’s article states. But even so there are restrictions on any court’s equitable powers.

In Spreckles v. Speckles Sugar Corporation, 79 F.2d 332 (1935) Judge Learned Hand wrestled with the sale free and clear issue, and commented:

“We have no doubt that the power exists; the question is only as to the propriety of, and the proper conditions upon, its exercise. It is quite true, although there is perhaps no rigid rule about it, that ordinarily a court will not sell property free of liens unless it can see that there is a substantial equity to be preserved. [cites]”[i.e. sufficient equity to pay the stripped liens in full.]

The Spreckles case revolved around relative priority of federal taxes and city taxes.

The leading treatise on receiverships, Clark on Receivers, at Section 500(b) echoes this in addressing court decrees directing sales of real property free and clear of liens, concluding “The property should not be sold free and clear of liens unless it is made to appear that there is a reasonable prospect that a surplus will be left for general creditors [i.e. all liens paid in full] or, in other words, that a substantial equity is to be preserved.”

This general, but not absolute, requirement that in order for liens to be stripped from real property prior to sale it must appear that the sale proceeds will be sufficient to pay all such liens appears frequently in case law and treatise materials, and does not seem to work a hardship. All secured creditors already have ample and well-defined rights of recovery at law – i.e. through foreclosure — with respect to their collateral. Indeed, most attempts to sell free and clear of liens arise in tandem with an ongoing judicial foreclosure proceeding. The associated issue of when the court may allow a sale of real property in receivership – liens stripped or not – is quite another issue not treated here.

As Peter states, only equitable, rather than legal, title may thus be conveyed by equity, leaving it up to title insurers to determine the scope and certainty of title they will insure.]

Peter Replies:
While the Editor is correct that some state courts exercise their power to sell property free and clear of liens (with the liens attaching to the proceeds) generally only when there is equity in the property to be preserved, that is not a hard and fast rule and is discretionary with the court.

The problem with such a rule is that is allows a junior secured creditor, with no equity in the property, to, in effect, blackmail the Court, the receiver and senior secured creditors, by holding up development and sale of property in receivership.

Take the typical “busted condo” project. The bank has the first deed of trust. There might be some mechanics liens junior to the bank. The developer, a LLC or LLP with no other assets, has walked away from the project because it has determined that the value of the completed project is less than it owes to the bank.

The property is unguarded, sixty percent finished, and the construction loan has likely been exhausted. The bank has had a receiver appointed who was instructed by the court to safeguard the property, to finish construction and to sell the finished units to protect the bank’s collateral. The bank’s interest is in maximizing the value of the collateral and limiting its liability. Indeed, the bank often will advance funds, through receiver certificates, so that the property can be secured, protected and the construction finished. [Remember: receiver’s certificates are a promise by the court that the lender will be paid.]

Should a junior secured creditor, with no equity in the property, be allowed to prevent a court of equity from having its receiver finish construction, to maximize the collateral’s value, and sell the collateral for the benefit of whomever the court may later determine is entitled to the funds? Courts of equity have often said no and allowed such sales.

The Clear Channel bankruptcy decision, cited by the Editor, is not as broad as the Editor implies, should have no effect on receiverships, and has not been followed by other courts, even courts in this circuit. See, In Re Jolan, Inc., 403 B.R. 866 (Bankr. W.D. Wash. 2009) [“I conclude that Clear Channel … does not preclude a §363(b) sale free and clear for an amount less than enough to satisfy all liens …”]

The court in Jolan found that there are other legal and equitable proceedings where a sale could be allowed free and clear of junior liens, even if the sale was for less than the amount to satisfy all liens, and, therefore, a bankruptcy trustee could sell property free and clear of junior liens under 11 U.S.C. §363(b)(5).

The Clear Channel court was focused on §363(b)(3) and did not discuss subsection (b)(5). The proceedings cited by the court that will allow a sale free and clear of liens is a Washington statute, RCW 7.60.260, which allows a receiver to sell free and clear of liens, with the liens attaching to the proceeds, and a federal tax lien sale, 26 U.S.C. §6335, 6339(c) and 6342(c).

Because a federal tax lien sale can take place in California, bankruptcy trustees in California should be able to use §363(b)(5) to sell property free and clear of liens, even if there is no equity for a junior creditor in spite of the Clear Channel decision.

Too often counsel and courts look to bankruptcy cases when they are deciding receivership issues. While the remedies and procedures may often seem similar, the rights and powers of a receiver and a court of equity are not governed or controlled by what happens in a bankruptcy courts. Bankruptcy courts are bound to follow the bankruptcy code and the federal rules of bankruptcy procedure, none of which apply in receivership cases.

Receiverships, unless a specific statute applies, follow the practices of courts of equity which go back to the rein of Elizabeth in the 17th Century.

[Editor’s note:
“Blackmail” is such a harsh word. Junior lien creditors receive a bundle of rights when lending against real property, including the right to block a sale of that real property for an amount less than that required to pay their junior lien in full. Under California law the bank in first position has the ability to avoid this situation – by foreclosing on its collateral and wiping title clean of such junior liens. The fact that some lenders would rather not foreclose and take title to their collateral hardly seems a reason to strip such a valuable, bargained-for right from junior lien creditors. This ability to block a sale for an amount insufficient to pay junior liens has undoubtedly led to many junior lien creditors receiving at least some payment on their otherwise no-equity liens.

A receiver is never allowed to improve property it has been asked to seize and preserve. The receiver may take steps to “protect” such property, however. Using Peter’s example, many courts are being asked to appoint receivers to take possession of unfinished real property construction projects and, if lenders are willing to advance funds, to “protect” such projects through build-outs. The right of the lender to this interim remedy is usually contract-based (rather than equity-based): the bank’s security agreement typically covers all assets and property of the borrower and contains the right to seize and protect its collateral. Such agreements also include a right in the bank to advance funds to “protect” its collateral, often the source of build-out funds.

Selling the completed units after build-out is quite another issue, however. Legal title to the properties remains in the defendant/tapped-out builder until the bank completes its foreclosure. As Peter states, only equitable (not legal) title may be passed, and the “seller” (as defined by statute) has a ten-year liability for any construction defects pursuant to California statutes. See the Receivership News article “Impact of California’s Subdivided Lands Act and Right to Repair Law on Foreclosing Lenders” in Issue 33, Summer 2009. Whether this liability attaches to the receiver and/or the appointing court is unresolved.

Peter is certainly correct that the effect of the Clear Chanel decision is unsettled. The Jolan court’s use of a federal tax lien as an instance of “applicable nonbankruptcy law” permitting sale of property free and clear of liens is questionable, since it renders the Bankruptcy Code’s Section 363(b)(3)’s statutory qualifier moot – such a federal tax sale is possible in all jurisdictions. “It is a cardinal principle of statutory construction that a statute ought, upon the whole, to be so construed that, if it can be prevented, no clause, sentence, or word shall be superfluous, void, or insignificant.“ (internal quotation marks omitted)). All the more so where the redundant interpretation also strains common sense. 5” CFTC v. White Pine Trust Corp., 574 F.3d 1219, 1225 (9th Cir. 2009), citing to TRW Inc. v. Andrews, 534 U.S. 19, 31, 122 S. Ct. 441, 151 L. Ed. 2d 339 (2001).”

*Peter A. Davidson is a Partner of Ervin Cohen & Jessup LLP a Beverly Hills Law Firm. His practice includes representing Receivers and acting as a Receiver in State and Federal Court.