Opinion
03 Civ. 1071 (TPG)
February 18, 2004
Opinion
This bankruptcy appeal arises from the sale of property belonging to the estate of the debtor, 1485 2nd Ave. Restaurant Corporation d/b/a Boxers ("Boxers"). Appellant John Pereira is trustee of the estate and made the sale in question. Appellee Ruggerite, Inc. claims that it holds a security interest in the property, and has brought an adversary proceeding in the bankruptcy court to assert that interest. Judge Gonzalez of the Bankruptcy Court granted summary judgment to Ruggerite, and the trustee appeals.
Facts
Beginning some time in the early 1990s, Ruggerite operated a restaurant at a building known as 1481-1489 Second Avenue in Manhattan. On November 8, 1994 the owner of the building formally leased the premises to Ruggerite. This lease was extended in an agreement of December 28, 1994.
Ruggerite subsequently negotiated to sell its restaurant business. A contract of sale was executed on February 12, 1999, and on March 15, 1999 Ruggerite assigned its lease to Boxers. The building owner had consented to this lease assignment on February 4, 1999.
Boxers gave Ruggerite two promissory notes for the purchase. The contract of sale stated that in the event that Boxers defaulted on payment of the balance of the purchase price, Ruggerite was entitled to recover possession of the leased premises. Additionally, Boxers executed a security agreement in favor of Ruggerite on March 15, 1999. Pursuant to this agreement, Ruggerite held possession of both the lease from the building owner and the lease assignment to Boxers. Boxers also executed a collateral lease assignment ("the lease reassignment") in favor of Ruggerite.
Neither the lease from the building owner to Ruggerite, nor the lease assignment to Boxers, nor the lease reassignment to Ruggerite, was recorded by Ruggerite or Boxers in the office of the City Register in New York County as permitted by section 291 of the New York Real Property Law.
Ruggerite did file UCC-1 financing statements with the State of New York and New York County to evidence its lien on the restaurant equipment located at the premises, which was granted by a provision of the security agreement. These filings list "1485 Second Ave. Rest. Corp." as the debtor, and Ruggerite as the secured party. The filings also indicate that they extend to cover all property indicated in the "Rider A" attachment. Rider A, which accompanies both the state and county filings, lists articles of personal property covered by the filings, "[t]ogether with all right, title and interest of Debtor in and to (i) all leases and other agreements affecting the use or occupancy of the premises described in Exhibit A." Exhibit A appears not to have been attached to the state or county filings.
On March 3, 2000 an involuntary Chapter 7 bankruptcy petition was filed against Boxers. The case was subsequently converted to a voluntary Chapter 11 bankruptcy, and then back to a Chapter 7 bankruptcy. Periera was appointed the Chapter 11 trustee, and then the Chapter 7 trustee.
On June 21, 2000 Judge Gonzalez approved the trustee's proposed sale of the Boxers restaurant. As an element of this the judge gave permission to the trustee to assume and assign the lease of the premises and the personal property located therein free and clear of all liens and encumbrances. In accordance with that order, the trustee sold the restaurant equipment and assigned the lease to a third party on or about June 28, 2000.
As will be described in more detail later, Ruggerite claims that the nature of the documentation furnished to the trustee prior to the sale gave the trustee constructive notice of Ruggerite's security interest in the Boxers lease. It was Boxers, the debtor, who was responsible for turning over to the trustee the necessary documentation regarding its property. Boxers did not have the original copies of the lease from the building owner, the assignment of the lease to Boxers, or the reassignment of the lease to Ruggerite. These were all in the possession of Ruggerite. Boxers did, however, provide the trustee with photocopies of the lease and the assignment. Boxers did not provide even a copy of the lease reassignment.
Ruggerite thereafter commenced an adversary proceeding before Judge Gonzalez asserting a security interest in the lease and the personal property located at Boxers' premises, and therefore in the proceeds of the sale of both.
A hearing was conducted by Judge Gonzalez on September 25, 2002. He rendered a decision on October 25, 2002. Judge Gonzalez stated in the decision that he did not have a transcript of the hearing, but that on the basis of his notes it was unclear whether issues regarding the validity of Ruggerite's security interest in the Boxers personal property had been settled. He did not in his opinion address the Boxers personal property. He addressed the balance of the motion concerning the validity of Ruggerite's security interest against the Boxers lease, and it is from this ruling that the present appeal is taken. Before describing the judge's decision, it is appropriate to set forth the controlling bankruptcy statute, 11 U.S.C. § 544(a)(3).
The Bankruptcy Statute
Under 11 U.S.C. §. 544(a)(3):
(a) 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 —
(3) a bona fide purchaser 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 this provision, a bankruptcy trustee has the rights and powers of a bona fide purchaser of real property from the debtor, where applicable law permits a transfer of the property to be perfected against the debtor. This bona fide purchaser status is achieved if it is obtained and perfected at the time of the commencement of the case. In determining whether the trustee becomes a bona fide purchaser, no regard is paid to any actual knowledge of the trustee or any creditor. The statute also provides that the trustee may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by a bona fide purchaser of real property, subject to the same conditions about bona fide purchaser status set forth above. In applying the statute to discern the rights and powers of a trustee, the courts make use of a fictional "hypothetical purchaser," and inquire whether such a hypothetical purchaser, standing in the shoes of the trustee, could attain bona fide purchaser status. See,e.g., In re TMH Corporation, 62 B.R. 932, 934 (Bankr. S.D.N.Y. 1986); In re Hardway Restaurant, Inc., 31 B.R. 321, 329 (Bankr. S.D.N.Y. 1983).
The Bankruptcy Court Decision
It is now necessary to return to the decision of Judge Gonzalez granting Ruggerite's motion for summary judgment. The decision examined whether the trustee, under bankruptcy law, had attained the status of a bona fide purchaser with respect to the Boxers property, and could therefore avoid the security interest held by Ruggerite.
To resolve this issue, Judge Gonzalez asked whether a hypothetical purchaser of the Boxers property would have been on constructive notice of Ruggerite's interest. Although the judge referred to the fact that Ruggerite's UCC filings referred to "the lease," he did not rely on this to any degree in his decision. Judge Gonzalez did rely on the fact that Boxers did not hold the actual lease or assignment of lease. The judge concluded that this circumstance gave rise to constructive notice of a possible prior interest in the property, and therefore to a duty of further inquiry by a hypothetical purchaser. Further inquiry would have led a hypothetical purchaser to seek out the assignor of the Boxers lease to determine whether Boxers' interest was genuine and unimpaired, and thus Ruggerite's security interest would have been uncovered. Therefore, Judge Gonzalez concluded that the trustee could not assume the status of a bona fide purchaser, and could not avoid Ruggerite's prior interest in the Boxers property.
Discussion
The parties do not dispute the facts of the case. Issues of law determined by a bankruptcy court are given de novo review by the district court on appeal. National Union Fire Insurance Co. v. Bonnanzio, 91 F.3d 296, 300 (2d Cir. 1996).
As indicated by § 544(a)(3), New York law governs the underlying property law questions in this case, to the extent not specifically contravened by that section. See In re Hilsen, 119 B.R. 435, 438 (S.D.N.Y. 1990). The New York Real Property Law provides that an unrecorded conveyance of real property, including a lease term exceeding three years, is void against "any person who subsequently purchases . . . the same real property . . . in good faith and for a valuable consideration." N.Y. Real Prop. §§ 290(1) and 291. Such a good faith purchaser is known as a bona fide purchaser. Bona fide purchaser status cannot be obtained under New York law if the purchaser has actual or constructive notice of an unrecorded prior interest in the property in question. See Chen v. Geranium Development Corp., 663 N.Y.S.2d 288, 290, 243 A.D.2d 708, 709 (N.Y.App.Div. 1997); Reynolds v. Springer Service Station, Inc., 542 N.Y.S.2d 256, 257, 151 A.D.2d 466, 467 (N.Y. A.D. 1989). Constructive notice under New York law is such knowledge as would be revealed by examination of the record, reasonable inquiry to those in actual possession, or reasonable inquiry on the basis of all circumstances. In re Kennedy Inn Associates, 221 B.R. 704, 713 (Bankr. S.D.N.Y. 1998). Since pursuant to 11 U.S.C. § 544 (a)(3), actual knowledge of the trustee is not relevant (seemingly contrary to New York law), a court asks only whether a hypothetical purchaser standing in the shoes of the trustee would have had constructive notice of any prior unrecorded interest in the bankruptcy estate.
It is apparently conceded that the lease in question was for term of more than three years.
The undisputed facts show that Ruggerite held a security interest in the lease of the premises, which was created by the lease reassignment from Boxers to Ruggerite. That this interest was never recorded renders it unperfected, but not invalid as against subsequent interests not held by bona fide purchasers. See N.Y. Real Prop. § 291.
The issue, then, is whether the trustee had constructive notice of Ruggerite's security interest, thereby preventing him from exercising the power of a bona fide purchaser and conveying the property free and clear of Ruggerite's interest.
In re TMH Corporation, 62 B.R. 932 (Bankr. S.D.N.Y. 1986), is directly on point, and was relied upon by the bankruptcy judge. There, the defendant had sold a restaurant to the plaintiff debtor, who in turn reassigned the lease to the defendant as security for the unpaid portion of the purchase price. The defendant also retained the original documents pertaining to the property, including the lease and lease assignment. The court held that, where the debtor did not possess the original lease or the original lease assignment, a hypothetical bona fide purchaser would have been required to make further inquiry in order to verify the genuineness of the debtor's interest. Because such an inquiry would have revealed defendant's security interest in the leasehold, the debtor could not attain the status of bona fide purchaser and thereby convey the property free and clear of the security interest.
In the decision below, Judge Gonzalez adopted the reasoning of the TMH court. He held that "a situation where a tenant who seeks to assign a lease is unable to produce the original of the lease would lead a reasonably prudent person to make inquiries as to this defect." Judge Gonzalez further noted that this is especially true given the reality of real estate practice in New York, where landlords discourage the recording of leases in order to keep the title record clear. Since recording is generally not available to determine the status of leases, the lease itself is the necessary evidence.
Judge Gonzalez decided the matter correctly. A hypothetical purchaser, if prudent, would request Boxers to produce the lease and the lease assignment. Boxers' failure to produce the documents would lead to further inquiry. This would lead the hypothetical purchaser to the assignor, Ruggerite, and Ruggerite's security interest would be discovered. Alternatively, if a purchaser began with inquiry to the building owner, the purchaser would discover that the owner had leased the premises to Ruggerite. This would next lead to inquiry of Ruggerite, which would uncover the security interest. The fact that Boxers provided that trustee with photocopies of the lease and the assignment does not undermine this conclusion. Possession of the original copies is what would evidence title, and anything less would raise questions.
The trustee argues that this conclusion improperly treats the lease and lease assignment as negotiable instruments, and essentially allows Ruggerite to perfect its interest in the lease by mere possession of the documents. The trustee's argument ignores the distinction between perfection of an interest on the one hand, and constructive notice of that interest on the other. Ruggerite's security interest in the Boxers lease could only have been perfected by recording that interest pursuant to New York Real Property Law § 291, an action that Ruggerite did not take. Nonetheless, a hypothetical purchaser still would be charged with constructive notice of Ruggerite's interest if reasonable inquiry based on all known facts would uncover the interest. Because Boxers could not produce the lease and lease assignment, and a reasonable hypothetical purchaser would never take possession of the Boxers restaurant without possession of those documents, such hypothetical purchaser would have been obligated to inquire as to the basis for the absence of the documents. The fact that this inquiry would have uncovered Ruggerite's interest in the lease defeats the trustee's claim to bona fide purchaser status. It should be noted that this conclusion is fully in accord with other courts that have addressed this issue. See In re Rodriguez, 261 B.R. 92, 95 (E.D.N.Y. 2001); In re Kennedy Inn, 221 B.R. at 714; In re Lasercad, 106 B.R. at 802; TMH, 62 B.R. at 936.
Contrary to appellant's assertion, Hardway, 31 B.R. at 325, is not inconsistent with this conclusion. The court in Hardway, did not discuss at any point the existence or lack thereof of original lease documents, suggesting that its reference to "copies" of such documents was of no moment.
The Court also concludes that Ruggerite's UCC filings provide an additional ground for finding that the trustee was on constructive notice of Ruggerite's interest in the lease. As noted above, Judge Gonzalez did not address this issue in his decision. However, both parties raised the issue below as well as on this appeal. Ruggerite argues that a lien search would have uncovered the UCC filings in connection with Ruggerite's. security interest in the Boxers personal property, which expressly covers "all leases and other agreements affecting the use or occupancy of the subject premises." Ruggerite argues that this constitutes actual notice of its interest in the Boxers lease. The trustee argues that the trustee was under no obligation to perform a lien search to uncover a UCC filing in connection with the sale of the Boxers lease. Even if a lien search was performed, the trustee argues, the premises corresponding to the "lease" referred to in the filings were not adequately described to provide notice to a buyer. Finally, even if the premises were adequately identified in the filing statements, the trustee argues that the next step in the search would be to examine the real estate recordings in connection with the Boxers premises, which examination would not have uncovered Ruggerite's unrecorded interest in the lease.
The Court agrees, in part, with Ruggerite. As explained above, no regard is paid to any actual knowledge of the trustee in determining whether the trustee may assume bona fide purchaser status. See 11 U.S.C. § 544(a)(3). Therefore, Ruggerite's argument that the UCC filings amounted to actual notice of its interest are irrelevant to this inquiry.
Nevertheless, the UCC filings do provide constructive notice of Ruggerite's interest to a hypothetical purchaser standing in the shoes of the trustee. Such a hypothetical purchaser of a restaurant business would certainly perform not only a search of the real property records, but also a lien search to determine the status of the equipment being sold with the premises. The lien search would uncover either the county or state UCC filings made by Ruggerite. As described above, these filings list Boxers and Ruggerite as the debtor and secured party, respectively. They also indicate that they extend to cover not only personal property but also "all right, title and interest of Debtor in and to (i) all leases and other agreements affecting the use or occupancy of the premises described in Exhibit A." Although Exhibit A appears not to be attached to either the state or county filings, this information is nonetheless sufficient to put a hypothetical purchaser on notice that Ruggerite may have a security interest in a lease pertaining to the Boxers premises. The facts contained in the UCC filings create a duty of further inquiry, which would logically lead the hypothetical purchaser to the secured party, Ruggerite, and would therefore uncover Ruggerite's interest in the lease. Contrary to the trustee's assertion, a purchaser does not satisfy the duty of inquiry merely by examining the records. Rather, evidence of defect in title creates a duty of further inquiry — i.e., beyond what the record reveals. See In re Lasercad Reprographics, Ltd., 106 B.R. 793, 802 (Bankr. S.D.N.Y.);Williamson v. Brown, 15 N.Y. 354, 362 (N.Y. 1857).
It should be noted that a search of UCC filings apparently performed on the trustee's behalf on June 7, 2000 and included in the record on appeal did not uncover Ruggerite's filings. While it is not known why this is the case, the trustee does not argue that Ruggerite's filings would not be uncovered by a hypothetical purchaser performing a proper lien search.
Thus, both Boxers' failure to produce the lease and lease assignment and the existence of Ruggerite's UCC filings gave constructive notice to the trustee of Ruggerite's interest in the Boxers property. Therefore, the trustee was unable to assume the status of a bona fide purchaser under 11 U.S.C. § 544(a)(3). Accordingly, Ruggerite asserts a valid lien against the proceeds of the trustee's sale of the Boxers lease. Summary judgment was properly granted to Ruggerite.
Conclusion
The order of Judge Gonzalez granting summary judgment to appellee Ruggerite, Inc. is affirmed.
SO ORDERED.