Bankruptcy Co-Ownership Offset Disputes – Applying Partition Laws in a Section 363(h) Sale of Co-Owned Property – In re Flynn, 297 B.R. 599 (B.A.P. 9th Cir. 2003)

When a co-owner files for bankruptcy in a partition, the bankruptcy trustee or debtor-in-possession may seek to sell the co-owned property under Section 363(h) of the Bankruptcy Code (11 U.S.C. Section 363(h)). However, the Bankruptcy Court is empowered to apply California law on co-ownership offsets to ensure that the proceeds are equitably divided.

These bankruptcies can arise from an act of the defendant unrelated to the partition or sometimes seeking to stall the partition. In other cases, while a partition action is pending, the plaintiff decides that a bankruptcy needs to be filed due to a pending foreclosure, tax sale, or otherwise.

Regardless of the reason, bankruptcy courts are empowered to apply California partition law either independently or as a result of Section 363(j) of the Bankruptcy Code. What this means is that debtors and trustees cannot use bankruptcy to thwart co-owner rights to partition offsets. For example, perhaps the debtor in bankruptcy never paid the mortgage, taxes, insurance, or otherwise on the property they owned 50/50 with the plaintiff  in a partition action. When the property is sold in bankruptcy, the trustee is not required to divide the proceeds 50/50. Instead, the bankruptcy court can find that the debtor is entitled to something less than 50% interest after recovery of offsets in favor of the other co-owner.

Indeed, bankruptcy is used to discharge debts. However, the sums owed between co-owners reflect the value of the debtor’s rights in property, i.e., the value of the debtor or estate’s interest is worth somethind less than the equity in the property multiplied by the ownership interest. This means that it is not just each parties’ fractional interest divided by the equity that ends the story. Indeed, it is also not the end of the story in state court given that all partitions include an accounting under Wallace v. Daley.

This issue was best explained by the Ninth Circuit Bankruptcy Appellate Panel in the case of In re Flynn, 297 B.R. 599, 605 (B.A.P. 9th Cir. 2003), rev’d and remanded on other grounds, 418 F.3d 1005 (9th Cir. 2005), finding that:

In California, a partition may be by physical division of the property or by sale. Such an action normally includes an accounting so that the respective rights of the parties can be adjusted and settled. See, Lazzarevich v. Lazzarevich, 39 Cal.2d 48, 51, 244 P.2d 1 (1952); Harry D. Miller et al., California Real Estate § 12:19 (3d ed. 2001) (“Miller & Starr”). Commonly, a cotenant who has advanced funds to pay common expenses is entitled to be reimbursed from the sale proceeds before distribution. Miller & Starr § 12:19. Conversely, a cotenant out of possession can demand an accounting from a cotenant in possession for rents and profits in the division of sales proceeds. Miller & Starr § 12:19; see also Cal. Code. Civ. Proc. § 872.430;. Therefore, whether or not Stine had been in possession of the real property, she could have potentially been liable for an amount greater than the pro-rata fee expense awarded against her.

Additionally, when property is partitioned by sale in California, the sale proceeds are first used to pay general costs of the action. Costs reimbursed before any distribution to either cotenant include fees for any attorney engaged for the common benefit of the parties, as well as costs and expenses of any referee and third parties hired by the referee, the costs of title reports, and interest on any of these expenditures. Cal. Code. Civ. Proc. §§ 874.010—874.050; Miller & Starr § 12:19.

Upon completion of a partition sale, the California court may award attorneys’ fees that are paid by a party to the action for the common benefit of all co-owners. Furthermore, when the services of the attorneys for both parties are for the common benefit, the court may award fees to both parties. Riley v. Turpin, 53 Cal.2d 598, 603, 2 Cal.Rptr. 457, 349 P.2d 63 (1960); Miller & Starr § 12:19. However, attorneys’ fees should not be awarded for services not performed for the common benefit. Williams v. Miranda, 159 Cal.App.2d 143, 158, 323 P.2d 794 (Cal.Ct.App.1958); Miller & Starr § 12:19.

Flynn explained that: “The bankruptcy court’s award in this instance is consistent with these nonbankruptcy rules. Defending the property against a foreclosing creditor in a bankruptcy stay relief matter would be eligible for common benefit allocation under California law, as would legal fees in connection with selling the property, including negotiations and services directed towards the ability to deliver clear title. Thus, the sums that the court authorized to be paid from the sale proceeds, as a matter of California law independent of § 363(j), were appropriate.” In re Flynn, 297 B.R. 599, 605 (B.A.P. 9th Cir. 2003)

In 2020, an unpublished opinion from the Ninth Circuit Bankruptcy Appellate Panel quoted Flynn that “we construe § 363 in light of the property rights Stine and the trustee have under California law.” In re Ogletree, No. 19-50392-SLJ, 2020 WL 6557434, at *7 (B.A.P. 9th Cir. Nov. 4, 2020).