UNPUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT


In Re: ED L. MAHAFFEY; In Re:
VIOLET L. MAHAFFEY,
Debtors.

                                                                    No. 95-2411
BRENDA ALLEN SATTERFIELD; ED L.
MAHAFFEY; VIOLET L. MAHAFFEY,
Plaintiffs-Appellants,

v.

WAYNE SIGMON, Trustee,
Defendant-Appellee.

Appeal from the United States District Court
for the Western District of North Carolina, at Shelby.
Lacy H. Thornburg, District Judge.
(CA-93-98-4, CA-94-22-4, BK-93-40009)

Argued: March 7, 1996

Decided: July 10, 1996

Before MURNAGHAN and ERVIN, Circuit Judges, and
BUTZNER, Senior Circuit Judge.

_________________________________________________________________

Vacated and remanded by unpublished opinion. Senior Judge Butzner
wrote the opinion, in which Judge Murnaghan and Judge Ervin
joined.

_________________________________________________________________
COUNSEL

ARGUED: Judith C. Fraser, Waynesville, North Carolina, for Appel-
lants. P. Wagne Sigmon, GRAY, LAYTON, DRUM, KERSH, SOL-
OMON, SIGMON & FURR, P.A., Gastonia, North Carolina, for
Appellee.

_________________________________________________________________

Unpublished opinions are not binding precedent in this circuit. See
Local Rule 36(c).

_________________________________________________________________

OPINION

BUTZNER, Senior Circuit Judge:

Ed and Violet Mahaffey, an elderly couple, conveyed their mobile
home to their daughter, Brenda Satterfield, two months before filing
for bankruptcy under Chapter 7. Although the deed on its face con-
veyed a fee simple interest in the property, the Mahaffeys and their
daughter agreed that Violet Mahaffey retained the right to live on the
property for the rest of her life. The bankruptcy court held this to be
a fraudulent transfer, and it denied the Mahaffeys' claim for a home-
stead exemption in the property. The district court affirmed.

We remand the case with directions to the bankruptcy or district
court (collectively "the court") to decide, in the exercise of its equity
power, whether to reform the deed to Mrs. Satterfield. Such reforma-
tion could give effect to the intention of the parties by recognizing the
reservation of a life estate in the property. The trustee can avoid the
transfer of the remainder pursuant to the constructive fraud provisions
of the bankruptcy code.

I

By way of preamble, we note that it appeared to the district court
that the Mahaffeys did not act in bad faith or with fraudulent intent.
Moreover, if the Mahaffeys had been advised to retain their property,

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they could have claimed a homestead exemption. The trustee told the
bankruptcy court, "it is a sad situation." But quite properly he pressed
the rights of the bankruptcy estate. Affirming the bankruptcy court,
the district court concluded its opinion by writing:

          Application of the law to the facts here presented forces
          this Court to the conclusion that Appellants [the Mahaffeys]
          have no relief available to them and therefore must lose their
          home. This case is compelling because of the ages and
          health considerations of the Appellants. Indeed, the Appel-
          lants' need for their home certainly far outweighs the need
          of creditors for a proportionate distribution of the sum in
          question. Nonetheless, when Appellants chose to seek the
          relief of the bankruptcy provisions, they also stepped into
          the realm of bankruptcy law. This Court is bound to uphold
          that law unless and until a higher court advises that the
          interpretation rendered is inaccurate.

(footnote omitted).

II

Ed and Violet Mahaffey live in a mobile home in Polk County,
North Carolina. The Mahaffeys have had trouble making their
monthly mortgage payments. Violet Mahaffey is sickly, taking sev-
eral medications, often costing between $200 and $300 per month,
and suffering from depression and a heart condition. She testified that
her husband is an invalid. Violet Mahaffey earns $274 per month. Her
husband does not earn a salary.

Brenda Allen Satterfield, the Mahaffeys' daughter, helped her par-
ents with the monthly mortgage payments over a period of several
years. On November 16, 1992, the Mahaffeys transferred their mobile
home and two lots of land located in Polk County to their daughter.
The November 16 deed did not contain any words limiting the estate
that was transferred. Yet both parties understood that Violet Mahaffey
would live in the home for the remainder of her life. Violet Mahaffey
stated: "I assigned the place to her because she said I could have it
to live there as long as I lived." Mrs. Satterfield echoed this senti-

                      3
ment: "[T]he deal was that I would make the payments for her and
help her and she would live there, you know, the rest of her life."

The Mahaffeys filed a Chapter 7 bankruptcy petition on January
13, 1993. At that time, they had personal property totaling $2,550 and
debts equaling $29,905.49. The real property that they transferred was
appraised during the bankruptcy proceedings at $34,000. Tryon Fed-
eral Savings and Loan had a mortgage on the property in the amount
of $20,069.58. In the petition, the Mahaffeys claimed that if the
trustee recaptured the real property, they were entitled to a homestead
exemption under North Carolina law in the amount of the difference
between the market value of the home and the lien on the property.

The trustee objected to the Mahaffeys' election of an exemption in
the property. On April 1, 1993, the trustee filed an adversary proceed-
ing against Mrs. Satterfield, seeking a return of the property. By a
deed recorded on April 19, 1993, before any hearing in the adversary
proceeding, Brenda Satterfield, together with her husband, conveyed
the property back to the Mahaffeys to avoid the perception that they
were engaging in a fraudulent transfer. Mrs. Satterfield explained:

          [W]hen we assigned the property back to my mother, I was
          so upset because we didn't want it to appear that I had
          accepted this property just to protect it from bankruptcy at
          all. And so I wanted that transferred back to prove--because
          I have never had dealings like this before and I didn't want
          anybody to think that we were trying to be dishonest at all.

The bankruptcy court held that the trustee could avoid the transfer
from the Mahaffeys to Mrs. Satterfield for lack of adequate consider-
ation pursuant to 11 U.S.C. § 548(a)(2). With respect to the convey-
ance from the Satterfields back to the Mahaffeys, the bankruptcy
court allowed the trustee recovery under § 550(a), which permits the
trustee to recover property from the "initial transferee" or "any imme-
diate or mediate transferee of such initial transferee." 11 U.S.C.
§ 550(a)(1),(2). The bankruptcy court also held that the Mahaffeys
could not exempt the property under 11 U.S.C. § 522(g), which
allows exemptions for property the trustee recovers if the transfer
"was not a voluntary transfer" of the property. The district court
affirmed.

                    4
The Mahaffeys rely on the "no harm, no foul" principle enunciated
in In re Treiber, 92 B.R. 930, 932 (Bankr. N.D. Okla. 1988). Under
this approach, a transfer of property that could have been exempted
cannot constitute a fraudulent conveyance since the property would
be immune from the claims of creditors if it were not conveyed. As
a majority of courts that have considered the issue have noted, how-
ever, the "no harm, no foul" approach seemed more appropriate under
the old Bankruptcy Act, in which exempt property was not part of the
bankruptcy estate. See, e.g., In re Wickstrom, 113 B.R. 339, 350
(Bankr. W.D. Mich. 1990) (citing cases). Under the new Bankruptcy
Code, in contrast, all property, including potentially exempt property,
is part of the estate until the debtor claims an exemption. See 11
U.S.C. § 541(a). Consequently, a transfer of potentially exempt prop-
erty could harm creditors. In the case before us, both the bankruptcy
and district courts declined to follow In re Treiber. We agree, and we
find no error in their interpretation of the code. Because of the differ-
ence between the old and the new bankruptcy codes, we do not rely
on the "no harm, no foul" approach as a basis for our decision.

Generally, federal appellate courts do not consider issues that the
parties have not raised either below or on appeal. See Singleton v.
Wulff, 428 U.S. 106, 120 (1976). Yet in "exceptional circumstances,"
to prevent injustice, we may raise issues sua sponte. Id. at 121;
Washington Gas Light Co. v. Virginia Electric and Power Co., 438
F.2d 248, 250-51 (4th Cir. 1971). In this case, we have enough facts
before us about the parties' intentions that we can, to prevent injus-
tice, remand the case for the court to consider reformation of the deed
of transfer.

III

Bankruptcy courts are courts of equity. Katchen v. Landy, 382 U.S.
323, 336 (1966). As courts of equity, they have the power to reform
written instruments, including deeds, to effectuate the intent of the
parties. See generally American Employers Ins. Co. v. St. Paul Fire
& Marine Ins. Co., Ltd., 594 F.2d 973, 977 (4th Cir. 1979) (insurance
policy); In re Cleveland, 53 B.R. 814, 817 (Bankr. E.D. Va. 1985)
(deed). North Carolina courts are empowered to reform deeds. Light
v. Equitable Life Assurance Society of the United States, 286 S.E.2d
868, 872 (N.C. App. 1988). Federal courts look to state law in defin-

                     5
ing property interests. Butner v. United States , 440 U.S. 48, 55
(1979).

Durham v. Creech, 231 S.E.2d 163 (N.C. Ct. App. 1977), dealt
with a situation similar to the one we consider. Grantors, by reason
of mistake, conveyed real property in fee simple though they intended
to reserve a life estate in the property. The court ordered reformation
of the conveyance to reserve a life estate to the grantors. For addi-
tional examples of reformation of a fee simple to a life estate, see
Restatement of Restitution § 49 & illus. 4 (1936) (gratuitous transac-
tions).

North Carolina courts do not allow reformation, however, if the
rights of a bona fide purchaser would be prejudiced. Hice v. Hi-Mil,
Inc., 301 N.C. 647, 653, 273 S.E.2d 268, 272 (1981). The Bankruptcy
Code grants to trustees the "rights and powers" of bona fide purchas-
ers of real property. 11 U.S.C. § 544(a)(3). The Code does not auto-
matically make the trustee a bona fide purchaser; rather, it extends to
the trustee the powers possessed by such figures. In re Wilkinson, 186
B.R. 186, 191 (Bankr. D. Md. 1995).

To determine bona fide status, bankruptcy courts apply state law.
See In re Morse, 30 B.R. 52, 54 (Bankr. 1st Cir. 1983); David G.
Epstein, Steve H. Nickles, James J. White, 2 Bankruptcy § 6-61, at
129 (1992). Although a trustee's actual knowledge will not preclude
bona fide status, constructive notice, as determined by state law, will
"defeat the trustee's rights under § 544(a)(3) just as such notice would
defeat the rights of any bona fide purchaser of real property." Collier
Bankruptcy Manual ¶ 544.02, at 544-11, 12 (Lawrence P. King ed.,
3d ed. 1996).

Under North Carolina law, a bona fide purchaser is one who "pays
valuable consideration and buys without actual or constructive notice
of any claims on title." Creech, 231 S.E.2d at 167. Constructive
notice includes information found in the chain of title of the property
and facts obtainable through "such inquiry as a cautious and prudent
[person] would make." New Hanover County v. Holmes, 15 N.C.
App. 548, 550, 190 S.E.2d 396, 397 (1972). For the sale of real prop-
erty, such an inquiry would encompass an examination of the prop-
erty to ensure that no party was in possession. See Metropolitan Life

                    6
Ins. Co. v. Dial, 209 N.C. 339, 350-51, 183 S.E. 609, 615-16 (1936).
Dial relied on the longstanding rule in North Carolina that possession
constitutes constructive notice. It quoted Heyer v. Beatty, 83 N.C.
244, 248 (1879), in which the North Carolina Supreme Court
explained:

          Possession is suggestive of title or right in the possessor,
          and a prudent man should and would inquire into such
          apparent right before trading with another; and, if he do not,
          it is but just to the rights of the party in possession to hold
          the purchaser as affected with notice of the equities in his
          favor . . . .

See also Morehead v. Harris, 262 N.C. 330, 339, 137 S.E.2d 174, 183
(1964) (dictum).

To reiterate, under 11 U.S.C. § 544(a), a court need not be con-
cerned with the trustee's actual knowledge regarding the possession
of real estate. The proper inquiry is whether, under North Carolina
law, a hypothetical purchaser of real estate would have attained the
status of a bona fide purchaser.

If the deed is reformed, the reserved life estate would not be
included in the property that the trustee seeks to avoid, because, hav-
ing been reserved, it was never fraudulently conveyed. In that event,
the court should consider the status of Ed Mahaffey. Did the parties
intend that he have a life estate in the mobile home? If so, would the
estate be measured by his life or Violet's life? It seems unlikely that
the parties intended him to have no interest in the home, but this is
a possibility.

The remainder interest is a different story. Section 548(a) outlines
two types of transactions that constitute fraud. The first addresses
actual fraud--where the debtor makes a conveyance with a subjective
intent that evidences fraud. Section 548(a)(1) allows the trustee to
avoid transfers that the debtor makes "with actual intent to hinder,
delay, or defraud any entity to which the debtor was. . . indebted
. . . ." As the district court noted, and as the testimony of the parties
reveals, the Mahaffeys did not perpetrate actual fraud.

                     7
The second type of fraud is "constructive fraud." This species of
fraud allows the trustee to

          avoid any transfer of an interest of the debtor in property,
          or any obligation incurred by the debtor, that was made or
          incurred on or within one year before the date of the filing
          of the petition, if the debtor voluntarily or involuntarily . . .
          received less than a reasonably equivalent value in exchange
          for such transfer or obligation; and . . . was insolvent on the
          date that such transfer was made or such obligation was
          incurred, or became insolvent as a result of such transfer or
          obligation . . . .". 11 U.S.C. § 548(a)(2)(A),(2)(B)(i)).

The transfer of the remainder took place on November 16, 1992,
less than one year before the Mahaffeys filed for bankruptcy on Janu-
ary 13, 1993. The Mahaffeys received less than reasonably equivalent
value for the remainder. Satterfield promised to make mortgage pay-
ments in the future, but an "unperformed promise to furnish support
to the debtor" does not constitute value. 11 U.S.C. § 548(d)(2)(A).
Finally, the Mahaffeys were insolvent on the date of the transfer; their
debts exceeded their assets.

The transfer of the remainder constitutes a fraudulent transaction
which the trustee can avoid. Despite the Satterfields' beneficial inten-
tions, the transfer back to the Mahaffeys does not remedy the finding
of constructive fraud. The trustee may recover from either the "initial
transferee," Mrs. Satterfield, or from the "immediate . . . transferee of
[the] initial transferee," the Mahaffeys. 11 U.S.C. § 550(a)(1),(2). The
Mahaffeys cannot protect the remainder from the trustee pursuant to
11 U.S.C. § 522(g) since they voluntarily transferred the property.

IV

The next question concerns homestead exemptions. North Carolina
has opted out of the exemptions listed in the federal code. N.C. Gen.
Stat. § 1C-1601(f) (1995). Consideration of the applicable homestead
exemption in this case therefore depends solely on North Carolina
law. See Cheeseman v. Nachman, 656 F.2d 60, 62 (4th Cir. 1981).

                     8
Section 1C-1601 of the North Carolina Code delineates the prop-
erty exempt from the bankrupt's estate. Of relevance to this case,
§ 1C-1601(a)(1) exempts "[t]he debtor's aggregate interest, not to
exceed ten thousand dollars ($10,000) in value, in real property or
personal property that the debtor or a dependent of the debtor uses as
a residence . . . ." North Carolina law requires continued ownership
and use of the property to claim an exemption. In re Love, 42 B.R.
317, 319 (E.D.N.C. 1984). If the exempt residence ceases to be used
as a residence or is no longer owned by the debtor, then the home-
stead exemption does not apply. Id. The effect of the exemption is to
render such property "free of the enforcement of the claims of credi-
tors for indebtedness incurred before or after the exempt property is
set aside . . . for so long as the debtor owns it." N.C. Gen. Stat. § 1C-
1604(a). The exemption scheme is designed to give debtors a "fresh
start"--a chance to retain enough possessions to"begin anew."
Nachman, 656 F.2d at 63-64. For this reason, exemptions are to be
liberally construed. See, e.g., In re Hollar, 184 B.R. 25, 28 (Bankr.
M.D.N.C. 1995).

By its terms, § 1C-1601(a)(1) does not confine exemptions to hold-
ers of a fee simple interest in real estate. "The debtor's aggregate
interest" is broad enough to include a life estate. A life estate entitles
its holder to "exclusive possession and control" during its existence.
1 American Law of Property: A Treatise on the Law of Property in
the United States § 216, at 129 (1952). The owner of a life estate has
--with minor exceptions, such as the need to avoid"waste"--as com-
plete a present ownership in the property as the holder of a fee simple
interest in property. If Violet alone has a life estate, she can claim a
$10,000 exemption in the value of her life estate. If Ed has an estate
in the property, he, too, is entitled to claim a $10,000 exemption.

Tryon Federal Savings and Loan Association's $20,070 mortgage
is not affected by the exemption. The mortgage is a secured claim,
which is not discharged by bankruptcy. See David G. Epstein, Steve
H. Nickles, James J. White, 2 Bankruptcy § 7-10, at 300 (1992).
Although certain liens can be limited to the extent they conflict with
exemptions, mortgages do not fall into this category. See 11 U.S.C.
§ 522(c); Fitzgerald v. Davis, 729 F.2d 306 (4th Cir. 1984). Nor
would the remainder be affected by the homestead exemption.

                     9
If the deed is not reformed, the district court may re-enter its previ-
ous order. The judgment is vacated, and the case is remanded for fur-
ther proceedings consistent with this opinion. Each side should bear
his or her costs.

VACATED AND REMANDED

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