Third Circuit Decision is a Cautionary Tale about the “Security” of Tax Lien – Certificate Holders’ Security in Bankruptcy

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Tax lien certificates are a marketable commodity in several jurisdictions, including New Jersey.  The Third Circuit’s recent decision in In re Hackler v. Arianna Holdings Company, LLC, No. 18-1650, __ F.3d __, 2019 2019 WL 4309510 (3d Cir. Sept. 12, 2019), however, will leave certificate holders insecure about their tax lien rights in the face of the Bankruptcy Code’s avoidance powers.  Notwithstanding a properly executed, pre-petition tax lien certificate auction and subsequent foreclosure, the Third Circuit, in affirming the United States Bankruptcy and District Courts for the District of New Jersey, held that a tax lien certificate foreclosure, within 90 days of the homeowners’ chapter 13 bankruptcy filing, was an otherwise avoidable preferential transfer under Section 547 of the Bankruptcy Code and, as a result, the property was returned to the Debtors.


A tax lien certificate is generally “a certificate of a claim against a property that has a lien placed upon it as a result of unpaid property taxes.  Tax lien certificates are generally sold to investors through an auction process.”  The auction process is typically run by a local municipality and the property taxes in question must be in default for a set period of time before an auction can proceed.  Auction participants bid on the interest rate they are willing to receive and the lowest bid will win.  See N.J.S.A. 54:5-32.  A certificate reflecting the redemption amount is issued representing what the property owner must pay to recover the lien and prevent ultimate foreclosure, consisting of accrued taxes plus interest, not a value derived from the underlying property.  See N.J.S.A. 54:5-58.  Lastly, New Jersey is known as a strict foreclosure state such that if redemption is not made (i.e. paying the unpaid and subsequently accrued taxes plus the 18% interest), the certificate holder can file for a foreclosure judgment 2 years later.  See N.J.S.A. 54:5-67.

A preferential transfer, pursuant to Section 547 of the Bankruptcy Code, is a transfer that becomes avoidable if: (i) made within 90 days prior to a bankruptcy filing; (ii) made to or for the benefit of a creditor; (iii) made while the debtor is insolvent (which the debtor is presumed to be in the 90 days before a bankruptcy filing under Section 547(f)); (iv) made on account of an antecedent debt (i.e. a debt owed prior to the transfer); and (v) such transfer allows a creditor to receive more, as a result of that alleged “preferential transfer” than such creditor would have received had the case been a hypothetical chapter 7.  In a nut shell, Section 547 it is the Bankruptcy Code’s attempt to claw back payments made when a debtor is presumed insolvent (in the days nearing bankruptcy) – with a statutory framework to equitably redistribute assets to creditors.  This equitable redistribution, or pro rata distribution to similarly situated creditors, is contrasted with the “preferential” treatment afforded a certain creditor who was paid by the debtor within the 90-day pre-petition (preference) period, while another creditor was left unpaid.

Hackler Case

In Hackler, the homeowners failed to pay property taxes due on their residential real property and a duly advertised tax sale or public auction for the unpaid municipal tax lien took place in June 2013. The prevailing bidder proposed a 0% interest rate, paid $13,500 over the value of the lien, paid the outstanding taxes and began charging the statutorily permitted 18%.  After waiting the required 2-year period, the tax lien certificate holder, Phoenix Funding, Inc., filed its intent to foreclose on its certificate and filed a – still – uncontested foreclosure complaint.  Phoenix transferred its interest to Arianna Holding Company, LLC and after the Hacklers failed to redeem the tax lien certificate, Arianna obtained a final judgment in foreclosure, causing the title of the property to vest with Arianna.

A little more than 60 days later, and well within the 90-day period, the Hacklers filed a voluntary joint petition for chapter 13, listing on the Schedules of Assets and Liabilities, their residence, which they asserted was worth $335,000 and the Arianna tax lien certificate claims as $42,561.21.  As part of their case, the Debtors proposed to pay the full-face value of the Arianna tax lien claim, over a period of time, consistent with their proposed chapter 13 plan.  The same day they initiated their bankruptcy, the Debtors filed an adversary complaint seeking to unwind the foreclosure as an avoidable, preferential transfer under Section 547 of the Bankruptcy Code, or alternatively, as a fraudulent transfer under Section 548.

The Bankruptcy Court ultimately granted summary judgment in favor of the Debtors, denied a stay of a motion pending appeal, and the District Court subsequently affirmed the Bankruptcy Court’s findings.

In reaching its decision to affirm the Bankruptcy and District Court rulings, the Third Circuit, first recognized that the very purpose of the Bankruptcy Code was to ensure the “equality of distribution among creditors” and the avoidance of situations where some creditors receive a windfall at the expense of others.  The Court observed the incongruence of a tax lien foreclosure (and the underlying value of a certificate) as compared to the reasonable value of the underlying property (which is typically substantially more than the certificate), making it more likely that a foreclosing tax lienholder will receive an unjustified windfall.  As a result, after finding that all of the elements of a preferential transfer existed, the Court held that, the tax lien foreclosure – the “transfer” – was an avoidable preference to be set aside and causing the property to be returned to the Debtors.

In its analysis, the Court distinguished tax lien foreclosures from mortgage foreclosures, which typically enjoy protection from preference or fraudulent transfer litigation under the Bankruptcy Code.  See 11 U.S.C. § 548 and BFP v. Resolution Trust Corp., 511 U.S. 531 (1994).  The Court held that unlike in the mortgage foreclosure context, where competitive bidding is based upon the reasonable value of the property, the tax lien certificate bidding process is wholly unrelated to the value of the underlying property in question upon which the tax liens attach.  See N.J.S.A. 54:5-32.  Accordingly, mortgage foreclosures, even where occurring within the 90-day pre-petition (preference) window, will likely continue to enjoy general protection from preference claims.

Lastly, the Third Circuit rejected the lienholder’s additional arguments that treating title derived from the tax lien foreclosure process as voidable is inconsistent with principles of federalism and inappropriately interfered with state law.  The Hackler Court disagreed and noted that “Congress has plenary power over bankruptcy [and, thus] New Jersey state law is not germane to this case.”

In sum, investors who wish to purchase tax lien certificates should consider the risk that an intervening bankruptcy may hinder their ability to successfully take title through the tax lien foreclosure process.

As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.

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