Imagine: you are a lender that has loaned substantial sums of money to an individual, secured by real property owned by the borrower. After the borrower defaults and negotiations fail, you seek and obtain the appointment of a receiver. But now litigation ensues—about the loan documents, about contract defaults, about interest rates, about foreign law. After a substantial investment of time and money, your trial date draws closer. At some point during this odyssey, your borrower secretly transfers the real property collateral to a newly-created, single-member LLC. And then the really bad news comes: the LLC has filed for chapter 11, and your collateral is claimed as “estate property”. So now, you are both litigating against the borrower in state court, and being dragged neck-deep into a bankruptcy case in order to somehow recover your security. This scenario, or something close to it, plays out regularly in bankruptcy courts across the country. And while the Bankruptcy Code has provisions designed to assist in these situations (think bad faith filings, dismissals and stay relief), the time and expense inherent in getting the “right” result can be prohibitive.

But don’t lose all hope just yet. The Bankruptcy Court for the Central District of California recently considered a factual scenario much like the one noted above in the case of In re Domum Locis LLC, Case No. 14-23301-RK, and its memorandum decision entered on November 17, 2014 [Docket No. 21] should make it easier for lenders to combat this type of collateral shuffling, at least under California law.

In the Domum Locis case, the debtor filed an adversary proceeding seeking a determination that the real properties at issue were property of the debtor’s estate under 11 U.S.C. § 541 (rather than property of the non-debtor borrower) The lender responded by filing a motion to dismiss the adversary proceeding on the basis that the transfers of the real properties were void ab initio under California state law and therefore not estate property.

The Court first confirmed that state law governs the question of property ownership, citing In re Pettit, 217 F.3d 1072, 1078 (9th Cir. 2000). Memorandum Decision, p. 6. As a result, the initial inquiry became whether the borrower, as sole owner, had the power to transfer the real properties under California law once the court-appointed receiver took over possession and management of the properties pursuant to state law receivership orders.

The Court then noted that property subject to a court-appointed receivership is held in custodia legis, or in the custody of the court itself, as the receiver “is an agent and officer of the appointing court.” City of Santa Monica v. Gonzalez, 43 Cal.4th 905, 930 [need to complete cite with court/date]. As such, the receiver represents not only the lender, but all persons interested in the property, and the property itself remains under the court’s supervision and control. Further, the Court stated that “California law vests the power to dispose of property subject to a receivership in the receiver alone, and that power is subject to prior authorization from the appointing court.” Memorandum Decision at 14.

So far, so good. But does that mean that the owner of the property cannot legally transfer title? YES, at least in certain circumstances!

The debtor argued that, at best, the transfer of the property in the possession of a receiver is merely voidable, but not void ab initio. The Domum Locis Court disagreed, finding that “any attempt to transfer an interest in property held in custodia legis is void and ineffective….” Id. at 20. More specifically, the Court held that the borrower’s attempt to transfer the properties was void ab initio because the borrower lacked the ability to transfer title without permission of the state court. As stated by the Court: “The notion that a debtor can transfer property in the possession of a court-appointed receiver holding it under court supervision in custodia legis to a wholly controlled entity to remove it from court supervision in a receivership is a remarkable proposition because it is flatly inconsistent with the California law of receiverships and is, in this court’s opinion, ultimately erroneous.” Id. at 25.

As a result, the Court granted the lender’s motion to dismiss the adversary proceeding and agreed to grant relief from stay for the state court litigation to proceed, given that the real property was not property of the estate under § 541. While finding the transfers to be void clearly brings about the “right” result, a challenge in this case was finding the appropriate mechanism to enable the Court to consider such a decision, and supporting the request to dismiss the adversary proceeding with compelling state law. Though the Memorandum Decision is an unpublished opinion, future lenders dealing with similar issues in the California bankruptcy courts may now have an additional arrow in their quiver to rewind this type of borrower behavior.

*Update- on December 4, the debtor filed a notice of appeal to the Bankruptcy Appellate Panel for the Ninth Circuit. Stay tuned for more information!

[NOTE: Squire Patton Boggs (US) LLP represents the lender in the case reported above.]