A bankruptcy trustee acquires, as of the commencement of a case, the status of a hypothetical judicial lien creditor and "may avoid" any lien or encumbrance on property of the debtor that is voidable by such a creditor under state law. Under this provision, federal and state law work in tandem. First, the substance of the trustee's rights as judicial lien creditor is determined by reference to state law. If the trustee has priority over a third party's interest under state law, federal law prescribes the consequence. Under § 544(a)(1), the trustee may entirely avoid the inferior third-party interest in the property, and the third party is left with only an unsecured claim.
The debtors filed for relief under Chapter 13 of the Bankruptcy Code. The creditors for those vehicles had not recorded their liens. The trustee brought an action to avoid the liens as unperfected security interests, which the court granted.
Can the creditors' liens be avoided?
The court entered judgment for the Chapter 13 trustee and against the creditors in the Chapter 13 trustee's lien avoidance actions. The Court held that the creditors' claims survived only as unsecured claims. The trustee's avoidance of the creditors' liens resulted in nullification of the transfer of property represented by those liens, and the security transactions were ineffective not only as to the trustee but also as to the debtors and creditors themselves as the immediate parties to the transactions. While lien avoidance rendered a security transaction ineffective, the avoided lien did not vanish but was preserved for the benefit of the estate. The former lienholder's interest in the debtors' property automatically became property of the estate and merged with any residual interest in the debtors which passed to the estate when the bankruptcy case commenced. While the debtors would retain the vehicles, they would have "purchased" them by paying into the plan an amount of money equal to their value as of the effective date of the plan.