UNITED STATES BANKRUPTCY COURT FOR
EASTERN DISTRICT OF KENTUCKY
COVINGTON DIVISION

IN RE:

KENNETH R. HODGE

GLENDA J. HODGE

DEBTORS CASE NO. 04-20357

MICHAEL L. BAKER, Trustee in Bankruptcy PLAINTIFF

VS. ADV. NO. 04-2034

KENNETH R. HODGE

GLENDA J. HODGE

FIFTH THIRD BANK NORTHERN KENTUCKY, INC.

HUNTINGTON NATIONAL BANK

LEGAL RECOVERIES, INC. DEFENDANTS

MEMORANDUM OPINION

I. Introduction

Michael L. Baker (the "Trustee"), the trustee for the estate of Kenneth R. Hodge and Glenda J. Hodge (the "Debtors"), is before the court on the Motion for Summary Judgment that he filed in the above-styled adversary proceeding on August 20, 2004 as amended on September 17, 2004, and the Debtors are before the court on the Motion for Order Avoiding Lien on Exempt Property that they filed in their above-styled Chapter 7 case on August 20, 2004. Having considered the motions, the memorandum and supplemental memorandum in support of the Trustee's motion, the responses and supplemental response to the motions, and the arguments of counsel, the court will sustain the Trustee's motion in part and overrule the Debtors' motion for the reasons set forth below.

II. Factual and Procedural Background

The court finds that there are no genuine issues as to any of the following material facts. On June 11, 1999 Fifth Third Bank of Northern Kentucky, Inc. ("Fifth Third") recorded a mortgage on the Debtors' residence (the "Property") but, on February 7, 2001, it erroneously released the mortgage of record. On April 25, 2003 Legal Recoveries, Inc. ("Legal Recoveries") recorded a judgment lien with respect to each Debtor and, on January 8, 2004 Huntington National Bank ("Huntington") recorded a judgment lien with respect to each Debtor.

On February 19, 2004 the debtors filed a voluntary petition for relief under Chapter 7 of the Bankruptcy Code. Their schedules value the Property at $71,000. The Debtors did not originally claim an exemption in the Property, but they amended their Schedule C on June 22 and 25, 2004, to claim the exemption. Fifth Third has filed a proof of claim in the amount of $67,680.32. Legal Recoveries has filed a proof of claim in the amount of $10,742.79, asserting that the claim is secured by a judgment lien. Huntington has filed a proof of claim in the amount of $11,825.82, but the claim is filed as an unsecured claim.

On May 18, 2004 the Trustee filed a complaint seeking [Count I] to avoid Fifth Third's mortgage and preserve it for the benefit of the estate, [Count II] to avoid Huntington's judgment lien as a preference and preserve it for the benefit of the estate, [Count III] for a determination that the judgment liens of Legal Recoveries are subordinate to the estate and to the Debtors' exemptions, [Count IV] for a determination that the Debtors' interests are subordinate to the estate, and [Count V] for authority to sell the property free and clear of the mortgage, judgment liens, and exemptions. Process was served by mail the following day. Fifth Third and Legal Recoveries filed answers, but the Debtors and Huntington did not.

As indicated above, on August 20, 2004 the Trustee filed a motion for summary judgment in the adversary proceeding and the Debtors filed, in their Chapter 7 case, a motion to avoid the judgment liens of Legal Recoveries as impairing their exemption. On August 24, 2004 the court entered an order requiring any party opposing the Trustee's motion to file a written response by September 3, 2004 and scheduling a hearing on the motion for September 8, 2004. Fifth Third, the Debtors, and Legal Recoveries timely filed responses, but Huntington did not. The hearing was conducted as scheduled and only the Trustee and the Debtors were represented.

The court then afforded the Trustee through September 17, 2004 within which to supplement his brief and afforded the defendants through September 24, 2004 within which to supplement their responses. The Trustee timely filed a supplemental memorandum, which acknowledged that the liens of Legal Recoveries are superior to Fifth Third's mortgage and, therefore, to the Trustee's rights as successor to the mortgage. The Debtors filed a timely supplemental response to the Trustee's motion. Neither Fifth Third, Legal Recoveries, nor Huntington filed a supplemental response.

III. Discussion

A. Mortgage Avoidance and Preservation of Avoided Transfer

The Trustee seeks to avoid Fifth Third's mortgage pursuant to  544(a) of the Bankruptcy Code, which provides:

The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by--

(1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists;

(2) a creditor that extends credit to the debtor at the time of the commencement of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or not such a creditor exists; or

(3) a bona fide purchase of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.

Under Kentucky law, a release of a mortgage of record "shall have the effect to reinstate the title in the mortgagor or grantor or person entitled thereto." K.R.S. 382.360(1).

The Kentucky Supreme Court has held that "a mortgagee who mistakenly releases a mortgage is entitled to have that mortgage reinstated with its old priority rights so long as the later claimants did not rely to their detriment on the release in acquiring their new rights." Citizens State Bank v. United States, 932 F.2d 490, 494 (6th Cir. 1991) (citing Louisville Joint Stock Land Bank v. Bank of Pembroke, 9 S.W.2d 113, 115 (Ky. 1928); Farmers & Drovers' Ins. Co. v. German Ins. Co., 79 Ky. 598, 602 (1881)). However, the Sixth Circuit has held that a "mere equitable right to have [a] mortgage reinstated" does not rise to the level of a present security interest, for the purposes of the federal tax lien statutes. Id. at 494-95. Rather, under KRS Section 382.260(1), a mistaken release of a mortgage "dissolved any remaining interest [the mortgagee] had in the property." Id. at 494. Thus, a competing claimant will prevail over an unrecorded, equitable mortgage so long as the claimant did not have notice that the release was erroneous, from the face of the release or other-wise, whether or not the competing claimant relied on the release. Id.

Accordingly, under Kentucky law, Fifth Third retained no interest in the Property following the recordation of the release, so  544(a) does not authorize the Trustee to avoid such an interest. However, the statute also provides that a trustee has the rights of a creditor that becomes a judicial lien creditor or bona fide purchaser without knowledge as of the commencement of the case. Under Kentucky law, a judicial lien creditor or bona fide purchaser would prevail over Fifth Third as of the commencement of the Debtors' Chapter 7 case, and  544(a) confers those rights on the Trustee. However, such rights would, under state law, be subject to the rights of other judicial lien creditors and bona fide purchasers that arose and were perfected prior to the commencement of the case. Thus, unless avoidable for some other reason, the Trustee's rights by virtue of  544(a) are subordinate to the judicial lien rights of Legal Recoveries and Huntington.

The Trustee originally contended that 551 of the Bankruptcy Code alters this outcome. That statute provides that "[a]ny transfer avoided under section 522, 544, 545, 547, 548, 549, or 724(a) of this title, or any lien void under section 506(d) of this title, is preserved for the benefit of the estate but only with respect to property of the estate." As explained above, while 544 gives the Trustee has the rights of a judicial lien creditor and bona fide purchaser as of the commencement of the case, there is no transfer to avoid because, under Kentucky law, no interest is retained by Fifth Third. Moreover, 551 does not confer on a trustee any greater rights than were held by the secured creditor prior to the avoidance. E.g., Barnett Bank of S. Fla., N.A. v. Weitzner (In re Kavolchyck), 164 B.R. 1018, 1024 (S.D. Fla. 1994); Connelly v. Marine Midland Bank, N.A., 61 B.R. 748, 750 (W.D.N.Y. 1986); Walker v. Elam (In re Fowler), 201 B.R. 771, 781 (Bankr. E.D. Tenn. 1996); Tenn. Mach. Co. v. Appalachian Energy Indus., Inc. (In re Appalachian Energy Indus., Inc.), 25 B.R. 515, 517 (Bankr. M.D. Tenn. 1982). Thus, these and other cases hold that, when a trustee avoids an unperfected security interest, he or she steps into the shoes of the creditor and so holds an unperfected security interest, which is subordinate to later perfected security interests. Accordingly, even if the court considered Fifth Third's possible equitable right to reinstate the mortgage to be an interest in the Property that the Trustee may avoid under  544 so that 551 applied, the bankruptcy estate would succeed to a released mortgage that would be subordinate to intervening judicial lien creditors.

The court is aware of cases from other jurisdictions reaching a contrary conclusion, i.e., holding that a bankruptcy trustee may avoid a mistakenly released mortgage and preserve it for the estate so that junior lienholders do not benefit from the avoidance. First Am. Nat'l Bank v. Miller (In re Miller), 286 B.R. 334, 343-44 (Bankr. E.D. Tenn. 1999); Terlecky v. Am. Cmty. Bank (In re Godwin), 217 B.R. 540, 543 (Bankr. S.D. Ohio 1997); In re Price, 97 B.R. 264, 266 (Bankr. E.D. N.C. 1989). In Godwin, the court interpreted an Ohio statute as providing that a mistakenly released mortgage may be "given full effect . . . according to the true, manifest intention of the parties thereto." Godwin, 217 B.R. at 543 (citing Ohio Rev. Code 2719.01). There is no such statute in Kentucky; rather, the only pertinent state statute is KRS Section 382,360, providing that a released mortgage "shall have the effect to reinstate the title in the mortgagor." Price relied on the mortgagee's equitable right to reinstate the mortgage under North Carolina law but, under Kentucky law as explained by the Sixth Circuit in Citizens State Bank, a mortgagee retains no interest in property following an erroneous release of a mortgage. The court in Miller held that "the trustee steps into the shoes of [the mortgagee] and holds a first priority lien on the debtors' residence in the stead of [the mortgagee]," without addressing whether, under applicable Tennessee law, the released mortgage was, in fact, a "first priority lien."

The court is also aware that a New York bankruptcy court, applying Kentucky law, has held that the mortgagee does retain an interest - an equitable mortgage - in property following an accidental release and that the release itself constitutes a "transfer" that is avoidable under 547 or 544(a)(3). Big Yank Corp. v. Bank One, Lexington, N.A. (In re Water Valley Finishing, Inc.), 170 B.R. 831, 834 (Bankr. S.D.N.Y. 1994). However, there was no intervening lien creditor in that case and, in any event, the decision is inconsistent with the Sixth Circuit's opinion in Citizens State Bank. Also inapposite are Thacker v. United Companies Lending Corp., 256 B.R. 724 (W.D. Ky. 2000), which held that an unrecorded, equitable mortgage may be avoided under 544(a)(3), and In re Mosley, 55 B.R. 341 (Bankr. W.D. Ky. 1985), which held that an erroneously released mortgage is analogous to an unperfected security interest and may thus be avoided under  544(a)(3). Again, there was no intervening lien creditor in either of those cases and, in any event, under KRS Section 382.360(1) and the Sixth Circuit's interpretation of it, while an unrecorded mortgage gives rise to an equitable lien, the release of a mortgage "dissolve[s] any remaining interest [the mortgagee] had in the property." Citizens State Bank, 932 F.2d at 494.

For the foregoing reasons, the court concludes that Fifth Third does not hold any interest in the Property and, therefore, that the Trustee need not - indeed, cannot - avoid such an interest. Accordingly, as the Trustee now acknowledges, unless the liens are avoidable for other reasons, the judicial liens of Legal Recoveries constitute first liens on the Property and the judicial liens of Huntington constitute second liens on the Property.

B. Avoidance of Huntington's Judicial Liens

The Trustee seeks to avoid Huntington's judicial liens as preferences under 547 of the Bankruptcy Code. Huntington has filed neither an answer to the complaint initiating this adversary proceeding nor a response to the Trustee's Motion for Summary Judgment, and it did not appear at the hearing on the motion. Moreover, Huntington appears to acknowledge the avoidability of its liens in that it filed a proof of claim not asserting that its claim is secured. Accordingly, the court will enter judgment avoiding Huntington's judicial liens. Fed. R. Bankr. P. 7055, 7056; Fed. R. Civ. P. 55(b)(2), 56(c). Huntington's liens will be preserved for the benefit of the estate. 11 U.S.C. 551.

C. Avoidance of Judicial Liens of Legal Recoveries

The Debtors seek to avoid the judicial liens of Legal Recoveries under 522(f)(1)(A) of the Bankruptcy Code, which permits the avoidance of a judicial lien (other than a lien for certain domestic relations obligations) that impairs a debtor's exemption. In determining whether a judicial lien impairs an exemption, the court is required to add the amounts of the lien sought to be avoided, all other liens on the property, and the exemption; if the total exceeds the value of the property, the judicial lien may be avoided to the extent of the excess. 11 U.S.C. 522(f)(2)(A), (B). Here, Legal Recoveries asserts liens in the amount of $10,742.79, Huntington's liens preserved for the benefit of the estate are in the amount of $11,825.82, and the amount of the Debtors' homestead exemption is $10,000.00, K.R.S.  427.060; In re Bush, 196 B.R. 378, 379 (Bankr. W.D. Ky. 1995). These sums total $32,568.61, which appears to be far below the value of the Property.

Accordingly, the judicial liens of Legal Recoveries do not impair the Debtors' exemption, as there should be sufficient proceeds from the sale of the Property to pay the exemption and to satisfy those liens and the liens of the Trustee as successor to Huntington. The court will, therefore, enter an order overruling the Debtors' motion.

D. Sale of Property

No party in interest has expressed opposition to the Trustee's request for authority to sell the Property free and clear of Fifth Third's mortgage, the judicial liens, and the Debtors' exemptions. The court will grant such authority, provided that the judicial liens of Legal Recoveries and the Debtors' exemptions are satisfied at closing or transferred to the proceeds of the sale. 11 U.S.C. 363(b)(1), (f). In summary, the Trustee will be authorized to sell the Property, with the proceeds to be distributed as follows: first, to Legal Recoveries in satisfaction of its judicial liens; second, to the Debtors' bankruptcy estate in satisfaction of Huntington's avoided judicial liens; third, to the Debtors in satisfaction of their homestead exemption; and fourth, to the estate as successor to the Debtors' equity interest in the Property.

IV. Conclusion

For the foregoing reasons, the court will enter a separate order and judgment in this adversary proceeding dismissing Counts I, III, and IV of the Complaint and granting the Trustee judgment on Counts II and V of the Complaint. The court will also enter a separate order in the Debtors' Chapter 7 case overruling their motion to avoid the liens of Legal Recoveries.

Copies to:

Michael L. Baker, Trustee

Richard A. Sadoff, Esq.

Dennis R. Williams, Esq.

Daniel E. Hitchcock, Esq.

Huntington National Bank,

c/o Weltman, Weinberg & Reis Co., L.P.A.