II. TRUSTEE'S AVOIDING POWERS
A. "Strong-Arm" Powers of the Trustee - § 544(a)
Pursuant to Section 544(a), a trustee or debtor-in-possession, without regard to any knowledge, is empowered to avoid any transfer of property of the debtor or any obligation of the debtor that is voidable by a hypothetical lien creditor. Mullaney v. Bank of Am., Nat'l Ass'n, 611 BR 770 (E.D.N.C. 2019); appeal dismissed, 2020 WL 50001. This is known as the "strong-arm" power of the trustee and elevates the trustee to the status of a "hypothetical lien creditor." A Chapter 11 debtor in possession may exercise the strong-arm powers conferred under Section 544. See BFC Chems., Inc. v. Smith-Douglass, Inc., 46 B.R. 1009, 1017 (E.D.N.C. 1985). Section 544(a), in conjunction with N.C. Gen. Stat. § 25-9-317, enables the trustee, as a lien creditor, to subordinate the rights of any unperfected security interest or any rights that could be defeated by a judicial lien creditor, a creditor with an unsatisfied execution or a bona fide purchaser of real property.
With respect to personal property, N.C. Gen. Stat. § 25-9-317 reflects the correlation between state law priority rules and Section 544(a) of the Bankruptcy Code. Under N.C. Gen. Stat. § 25-9-317(a)(2), an unperfected security interest is subordinate to the rights of a person who becomes a "lien creditor" before the security interest is perfected. "Lien creditor" is defined in N.C. Gen. Stat. § 25-9-102(a)(52) to include a trustee in bankruptcy. The defects that may cause a security interest to remain unperfected or to be deemed unperfected include, among others:
(1) Failure to file in the correct office;
(2) Failure to determine proper ownership of the collateral;
(3) Failure to set forth the debtor's correct name;
(4) Failure to adequately identify the collateral;
(5) Failure to properly authenticate the financing statement;
(6) Failure to tender the correct fee, resulting in delayed filing intercepted by a bankruptcy petition; and
(7) Failure to file a timely continuation statement.
If the security interest of a creditor is unperfected on the petition date, then the judicial lien creditor status of the trustee under Section 544(a)(1) (or the creditor status of the trustee under Section 544(a) (2)) will enable the trustee to avoid the security interest and take the property into the debtor's estate.
The introductory clause to Section 544(a) indicates that the exercise of the strong-arm powers can be carried out without regard to any knowledge of the trustee or any creditor. 11 U.S.C. § 544(a). It should be noted that this clause refers to actual knowledge of the trustee or other estate representative. This clause does not pertain to constructive or inquiry notice of an interest under state law which may be imputed to an estate representative. Under these circumstances, the imputed knowledge could defeat the avoidance powers. See Butler v. Deutsche Bank Trust Co. Americas (In re Rose), No. L-08-00080-8-JRL, 2009 WL 2226658 (Bankr. E.D.N.C. July 20, 2007), aff'd, 2010 WL 9904855 (Bankr. E.D.N.C. Feb. 9, 2010), aff'd, 418 F. App'x 244 (4th Cir. 2011) (holding that the trustee could not use strong-arm powers to avoid a mortgage despite discrepancy in lot number as party searching title would have found the document).
The exercise of the strong-arm avoidance power is conferred by the federal law through the Bankruptcy Code; however, state law controls the exercise of the power by determining the rights of the judicial lien creditor in North Carolina. See Mullaney v. Bank of Am., Nat'l Ass'n, 611 B.R. 790 (E.D.N.C. 2019).
1. Judicial Lien Creditor
Pursuant to Section 544(a)(1), the trustee acts a hypothetical lien creditor and has the powers of a judicial lien creditor as of the date of the bankruptcy filing. A judicial lien creditor is one who extends credit to the debtor, as of the time of the filing of the case, and who obtains a judicial lien on all the property of the debtor. When the trustee steps into the shoes of the judicial lien creditor, he or she can avoid any transaction or claim, such as an unperfected security interest, which could be avoided by a judicial lien creditor. If an unperfected security interest is avoided by the trustee, the creditor loses its lien and is reduced to the status of a general unsecured creditor.
The "strong-arm" power of the trustee under 11 U.S.C. § 544(a) generally is seen in the context of Chapter 7 and Chapter 11 cases. Section 544(a) can also materially impact a Chapter 13 case. The trustee's avoidance power under Section 544(a) extends to Chapter 13 trustees and the exercise of the avoidance power and its impact on the Chapter 13 best interest of creditor test could directly impact confirmation. See In re Alston, 355 B.R. 529 (M.D.N.C. 2006).
The extent of the trustee's rights as a judicial lien creditor is determined under applicable non-bankruptcy law. Examples of where a trustee will be looking to determine if the lien is properly perfected generally will be the failure to properly file the Uniform Commercial Code financing statement, a lapse of the financing statement, or a mistake in the description or other necessary language contained in the financing statement. Unrecorded or defective deeds of trust will also be subject to defeat by the trustee's hypothetical lien creditor's status. This portion of the strong-arm statute will create very favorable results for the trustee/debtor and more painful results for the presumed secured creditor. See PTM Technologies, Inc., Adv. Proceeding No. 10-06023 (Bankr. M.D.N.C. July 1, 2011), wherein a secured creditor with a $5,000,000 claim misspelled the debtor's name on its financing statement by indicating "PTM Tecnologies, Inc." (omitting the "h" in "Technologies"). Using Section 544(a), the Court found that the safe harbor statute (N.C. Gen. Stat. § 25-9-506(b)) did not apply and the misspelling was seriously misleading and therefore unperfected their $5,000,000 claim in the bankruptcy case.
2. Unsatisfied Execution Creditor
Pursuant to Section 544(a)(2), the trustee steps into the shoes of an unsatisfied execution creditor that extends credit to the debtor as of the time of the filing of the case and obtains an execution against the debtor that is returned unsatisfied. If a claim is not good as against this creditor, it is not good as against the trustee. Most competing liens and security interests will lose as against the status of the trustee in this category unless the lien is perfected. One of the goals of this portion of the strong-arm powers is to permit the trustee to obtain the benefits of equitable remedies available under state law. Examples include obtaining the ability for discovery of assets or marshaling which might not be available to judicial lien creditors. See H.R. Rep. No. 89-686 (1965); S. Rep. No. 89-1159 (1966), reprinted in 1966 U.S.C.C.A.N. 2032. However, it should be remembered that the trustee cannot assert the status of a hypothetical tax lien creditor using this strong-arm power. See Schlossberg v. Barney, 380 F.3d 174 (4th Cir. 2004).
3. Bona Fide Purchaser of Real Estate
In the case of a transfer of real property, the trustee is afforded the status of a bona fide purchaser of the subject real property (hereinafter "BFP") at the time of commencement of the case. If a hypothetical BFP of the subject real property would have rights superior to the rights of the debtor's transferee, the trustee can avoid the transfer to the transferee. 11 U.S.C. § 544(a)(3). However, Section 544(a)(3) specifically limits the avoidance abilities of the trustee to circumstances of a BFP of real property and does not include fixtures. See In re Story, No. 16-40102 (Bankr. W.D.N.C. 2016), J. Craig Whitley, Judge (unpublished decision 9/21/2016). The trustee, as BFP, can avoid the security interest of a secured creditor with an unrecorded or improperly recorded deed of trust on the debtor's real estate. If the deed of trust is recorded, then the secured creditor's interest is preserved in the subject real property unless the trustee's other avoidance powers prevail. Any liens on real estate that would not be valid as against a BFP will not survive against the trustee. Typical examples of liens that may be avoided under Section 544(a)(3) are unrecorded deeds, unrecorded deeds of trust, unrecorded leases in excess of three years and materialmen's liens where notices were not filed within the required time or where suit was not instituted within the required time after notice. Consistent with the other avoiding powers, the issue as to whether the transferred lien or interest in question is valid as against the trustee standing in the hypothetical status as a bona fide purchaser is going to be dependent upon the substantive law of the state governing the property in question. See Miller v. LaSalle Bank, N.A., 595 F.3d 782 (7th Cir. 2010). The trustee's action pursuant to Section 544(a)(3) may be subject to various state law defenses, including the doctrine of equitable lien and/or equitable subrogation. See Am. Gen. Fin. Serv., Inc. v. Barnes, 623 S.E.2d 617, 619-20 (N.C. App. 2006); First Union Nat'l Bank v. Lindley Lab., 510 S.E.2d 187, 188 (N.C. App. 1999). See also In re Hayes Iron & Metal, Inc., No. 13-1057 (Bankr. M.D.N.C. May 23, 2014); Rhodes v. Fla. Metal Trading, Inc., Adv. Proceeding No. 13-2058 (May 23, 2014).
These strong-arm powers mean that if a transfer is not good as against a judicial lien creditor, a BFP of real property, or a creditor with an unsatisfied writ of execution, then the transfer is avoidable by the trustee. It should be noted that in In re Project Homestead, Inc., 374 B.R. 193, the Court indicated the hypothetical bona fide purchase of real estate is not limited to the avoidance of transfers. The BFP trustee may exercise any right of the BFP, even in the absence of any transfer.
B. Successor to Actual Creditors - § 544(b)
Section 544(b)(1) provides that the...
