Should I stay or should I go? Second Circuit Rules Mortgagee Violated Automatic Stay by Seizure of Property Where Bankrupt Tenant Was Named Defendant – Landlord and Tenant – Leases

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On July 6, 2022, the Second Circuit Court of Appeals decided In Re: Eileen Fogarty, ruling that a mortgagee violated the automatic stay imposed when a tenant declared bankruptcy by proceeding with a foreclosure sale that named the same tenant as a defendant. The automatic stay provisions of the Bankruptcy Code are intended to protect debtors by prohibiting any legal action or proceeding that could dissipate the debtor’s assets or interfere with the orderly administration of the bankruptcy estate.

The mortgagor in this case, 72 Grandview LLC (the “mortgagor”), owned only residential property located in Shirley, New York (the “property”). The mortgagor borrowed a mortgage from Bayview Loan Servicing LLC (“Bayview”) and signed a note (the “Note”) secured by the property and a mortgage (the “Mortgage”) to evidence the lien on the property in favor of Bayview. . In January 2010, the mortgagor defaulted on the mortgage, and Bayview filed foreclosure a year later.

The debtor-respondent in the case, Eileen Fogarty, held a 99% interest in the mortgagor (the record does not reveal who or what entity held the other 1%). Fogarty also lived at the property. However, the note and the mortgage were signed in the mortgagor’s name by someone other than Fogarty, and Fogarty was not the guarantor of the note or the mortgage.

In its original 2011 complaint in the foreclosure action, Bayview did not name Fogarty as a defendant. In October 2014, Bayview requested that Fogarty be named a “defendant” as she was “a joint tenant in possession of a portion of the mortgaged premises”. On February 14, 2018, Fogarty was named a defendant, along with the mortgagor and the New York State Department of Taxation and Finance, in a foreclosure and sale judgment entered in state court. The foreclosure sale has been set for April 17, 2018.

Four days before the scheduled sale, Fogarty filed for voluntary bankruptcy. The day before the scheduled sale, Fogarty’s attorney contacted Bayview’s attorney and informed him that Fogarty had filed for bankruptcy, and thus the automatic stay was in effect and the continued foreclosure sale of the property would be in violation of the suspension. Bayview’s attorney responded that because the mortgagor is a separate legal entity from Fogarty, Fogarty’s bankruptcy petition did not stay any action against the mortgagor or its assets; thus, the stay did not apply to the impending foreclosure sale. Bayview then proceeded with the foreclosure sale as planned, and the property was sold to a third party.

On May 11, 2018, Fogarty filed for sanctions against Bayview in bankruptcy court, seeking actual damages, costs, attorneys’ fees, and punitive damages. She argued that the continued sale was a willful violation of the automatic stay imposed by Sections 361(a)(1) and 361(a)(2) of the Bankruptcy Code. Bayview has requested sanctions against Fogarty. The bankruptcy court denied both motions and emphasized in its written order that Fogarty could not be held personally liable for the mortgagor’s default. As a result, the bankruptcy court viewed the foreclosure action as “solely in remso Bayview did not breach the automatic stay when it proceeded with the foreclosure sale.

Fogarty appealed the bankruptcy court’s decision to the U.S. District Court for the Eastern District of New York, and the district court overturned the bankruptcy court’s order and found that Bayview violated the stay. The district court held that because Fogarty was a named defendant in the foreclosure action and the action was the basis of the sale, Bayview breached the stay when it proceeded with the sale. He also noted that the sale interfered with Fogarty’s possessory interest in the property as it “greatly lowered the hurdles” to his eviction from the property. (Fogarty was evicted from the property after the third-party buyer in the foreclosure sale successfully sought relief from the automatic stay in bankruptcy court, allowing him to continue with eviction proceedings.) Because the Fogarty’s possessing interest was part of his bankruptcy estate, the district court found that it was protected by the automatic stay. Additionally, the district court held that Fogarty was entitled to actual damages as a penalty against Bayview because Bayview, with full knowledge of Fogarty’s bankruptcy filing, deliberately and intentionally took the action that violated the suspension.

Bayview appealed and the Court of Appeals for the Second Circuit reviewed the bankruptcy court’s decision de novo. The Court upheld the district court’s order, finding that the automatic stay is violated “by the foreclosure sale of property where the debtor is a named party in the foreclosure proceeding, even if the debtor only holds a right of possession over the property”. As a result, Bayview willfully breached the stay when it completed the foreclosure sale, and Fogarty was entitled to penalties.

The Court focused its analysis on the clear text of Section 362(a) of the Bankruptcy Code. Section 362(a)(1) provides that a petition for voluntary bankruptcy acts as a stay of “the commencement or prosecution, including the issuance or use of any process, of ‘a judicial, administrative or other action or proceeding against the debtor which was or could have been brought before the commencement of the action under this Title, or to recover a claim against the debtor which arose before the commencement of the action under this title”. Section 362(a)(2) provides for a stay of “the execution, against the debtor or against the property of the estate, of a judgment obtained before the commencement of the proceedings under this title”.

The Court agreed with Fogarty that the foreclosure sale represented the continuation of an action or proceeding against the debtor. It noted that the stay applies to actions “against the debtor”, which it interprets as actions in which the debtor is a named defendant, and to recoveries of “a claim against the debtor”, which should encompass cases where the debtor is not a defendant, otherwise the wording would duplicate the first category. Because Fogarty was a named defendant in the foreclosure action, the foreclosure action was an action “against the debtor” covered by section 361(a)(1). Furthermore, the Court reached the same conclusion under section 361(a)(2). Since the foreclosure judgment against the mortgagor and Fogarty was issued on February 14, 2018, it was obtained before Fogarty’s bankruptcy proceedings began on April 13. authorized by the foreclosure judgment, which bound both Fogarty and the mortgagor as named defendants. The Court found that Fogarty remained a defendant at least during the sale, and therefore the sale violated the clear terms of Section 362(a)(2).

The Court rejected the opinion of Bayview and the bankruptcy court that the foreclosure action did not violate the stay because it was a in rem proceedings and Fogarty was named as a defendant only as an “interested party”. He noted that the text of Section 362(a) does not distinguish between in rem and in person proceeding in which the debtor is named party, and any action “against the debtor” is subject to the stay, regardless of how the debtor was named as defendant.

The Court also rejected Bayview’s argument that the foreclosure sale did not impact Fogarty’s bankruptcy estate. The Court has previously held that even where the debtor is not a named party to an action, if the action against the non-debtor “would inevitably have an adverse effect on the property of the estate of the bankrupt, then such an action should be prohibited by the automatic stay”. The stay does not apply, however, to actions brought against third parties which are only “factually capable, as opposed to legally certain” of affecting the estate. The Court did not analyze further whether the sale would have a “likely” or “certain” effect on Fogarty’s estate, relying on the fact that Fogarty was a named party in the foreclosure action, and that fact submitted the foreclosure action suspension regardless of its effects.

Thus, the Court took a clear approach, holding that if a debtor is by name a party to an action or proceeding, then the stay applies to the continuation of such action or proceeding, as well as to the execution of a prior judgment in such action or proceeding. Accordingly, since Fogarty was a named defendant in the foreclosure action, the stay applied to the foreclosure sale and Bayview breached the stay when it proceeded with the sale. The Court noted that if Bayview wanted to proceed with the sale, Bayview would have had to seek a waiver of the stay in bankruptcy court. This decision suggests that if a tenant of a building that is the subject of a foreclosure action is a named defendant in such a foreclosure action and subsequently files a bankruptcy petition, the automatic stay prohibits the foreclosure sale. Although the facts of this case involved residential property, the Court made no distinction between residential and commercial properties in its analysis, so its decision may apply equally to commercial properties and tenants. In such a case, the mortgagee would either have to remove the bankrupt tenant from the foreclosure action or appear in bankruptcy court to seek a waiver of the stay in order to proceed with a foreclosure sale.

While this case is significant and has “raised an eyebrow” or two in the banking industry, it is nothing more than a cautionary tale for practitioners and their clients on being careful when pursuing remedies. Indiscriminate designation of all tenants as listed parties in a common foreclosure title search is less than prudent, and designation of tenants in a commercial setting is less likely, since in most cases lenders wish to maintain a continuous cash flow. One caveat, though – if the loan structure includes a lease from an affiliated or in-house management office, a “head lease” structure to smooth cash flow or vacancies, an “OpCo-PropCo” structure or REIT-focused leases, they require more careful structuring, planning and exercise of remedies. While collusive involuntary bankruptcies and guarantor bankruptcy are generally specified as wrongdoing in most waiver warranties, the need to remedy the bankruptcy, both voluntary and involuntary, of an affiliated tenant is pronounced.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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