Bankruptcy 101 – Back to Basics with Butner

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Contributed by Rich Mullen

Every bankruptcy practitioner has his or her “go to” case citation for certain propositions.  Few, if any, bankruptcy cases could be considered a “go to” more than Butner v. U.S., 440 U.S. 48 (1979).  Most of us learned early on that Butner stands for the proposition that rights created by state law will be honored unless a specific bankruptcy provision or policy requires differently.  Certainly, each of us have cited to or seen Butner cited in a memorandum, brief, or judicial opinion – Butner has been cited thousands upon thousands of times.  But, how many of us have actually taken the time to sit down and get to know Butner and the specific, narrow facts that it considered?  In this installment of “Throwback Thursday,” we take a look at Butner and the fundamental principle of bankruptcy law it created.

In Butner, the Supreme Court framed a narrow question:  whether the right to use rents collected during the period between a mortgagor’s bankruptcy and the foreclosure sale of the mortgaged property is determined by a federal rule of equity or by the law of the state where the property is located.

After Golden Enterprises, Inc. had filed a petition for arrangement under chapter 11 of the Bankruptcy Act, the bankruptcy judge approved a plan that consolidated various liens on North Carolina real estate owned by Golden Enterprises.  As a result, Butner, who would later petition the Supreme Court, acquired a second mortgage securing a $360,000 debt, but did not receive any express security interest in, or assignment of, the rents earned by the property.  The bankruptcy judge, however, did appoint an agent to collect the rents, ordering that the money should be applied to tax obligations, payments on the first mortgage, fire insurance premiums, and interest and principal on the second mortgage that Butner held.

The plan was never confirmed, and two years later Golden Enterprises was adjudicated a bankrupt.  A trustee was appointed and ordered to collect and retain the rents from the mortgaged property.  The trustee eventually sold the property to Butner on a $174,000 credit bid, thus leaving him with a deficiency claim of $186,000.  As of the date of the sale, the trustee had collected and was holding rents of $162,971.32.  Butner filed a motion claiming a security interest in the fund holding the rents and sought to have it applied to his remaining claim.  So started the litigation that led to Butner. 

The bankruptcy judge originally denied the motion, holding that Butner’s remaining claim was a general unsecured claim.  The district court reversed, recognizing that North Carolina law deemed a mortgagor the owner of the land subject to the mortgage and, thus, entitled to rents and profits so long as the mortgagor “retains possession” of the property.  The district court found that the appointment of an agent to collect the rents satisfied the state law requirement of a change of possession and ruled in favor of Butner.  The Fourth Circuit reversed and reinstated the bankruptcy court’s ruling because it determined that Butner did not satisfy the change of possession requirement because he did not make any request during the bankruptcy case for a sequestration of rents or the appointment of a receiver.

The Supreme Court granted certiorari not to decide the state law question, but rather to resolve a circuit split that then existed.  The majority group – the Second, Fourth, Sixth, Eighth, and Ninth Circuits – had determined that state law should resolve the question of whether a security interest in property extends to the rents derived from the property.  On the other hand, the minority group – the Third and Seventh Circuits – had adopted a federal rule of equity that afforded a mortgagee a secured interest in the rents even if state law would not recognize any such interest until after foreclosure.  The minority group reasoned that a mortgagee’s right to rents should not be dependent upon a state court foreclosure action because a bankruptcy judge had the ability to deprive the mortgagee of any such state law remedy.

The Supreme Court was short and to the point, recognizing that Congress, while empowered to establish “uniform Laws on the subject of Bankruptcies throughout the United States,” had not chosen to legislate a rule defining a mortgagee’s interest in the rents earned by a property in a bankruptcy estate.  The Court then succinctly stated the proposition for which Butner is routinely cited:

Property interests are created and defined by state law.  Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.

The Court reasoned that a uniform treatment of property interests by state and federal courts would reduce uncertainty, discourage forum shopping and prevent a party from receiving a windfall merely because of a debtor’s bankruptcy.  The Court further explained that “undefined considerations of equity” provided no basis for a rule affording mortgagees an automatic interest in the rents of the underlying property as soon as the mortgagor is declared bankrupt.

In the end, the Court affirmed the Fourth Circuit, declining to review the state law change of possession question.  Butner, thus, was not entitled to a security interest in the rents, but his name is now widely recognized amongst bankruptcy practitioners.  That has to count for something (at least in certain circles).

Although the Bankruptcy Code has since superseded the Bankruptcy Act, under which Butner was decided, the proposition set forth in Butner remains at the heart of the federal bankruptcy framework.  In the absence of some specific bankruptcy interest or provision, bankruptcy courts will take nonbankruptcy rights as they are found.  A debtor’s relationship with the outside world will, thus, largely remain unaltered – only the arena and procedures change.  We can thank Butner for that.