In re Thulis, 474 B.R. 668 (Bankr. W.D. Wis. 2012) –

Typically an unrecorded mortgage will be void as against a bona fide purchaser under state law.  This in turn will allow an unrecorded mortgage to be avoided in a bankruptcy using the “strong arm” powers under Section 544 of the Bankruptcy Code.  Thulis reaches this result after a discussion of circumstances that may provide notice to a purchaser besides constructive notice from a recorded document.

The debtors owned two adjoining parcels described as Lot 1 and Lot 2.  The mortgage securing a loan to finance construction of a residence on Lot 1 was supposed to encumber both lots.  Unfortunately for the bank, only Lot 2 was included in the legal description attached to the mortgage.  When the construction loan was refinanced, the new mortgage also referenced only Lot 2.

Although all parties acknowledged that the bank intended to take a mortgage on Lot 1, the bankruptcy trustee pointed out that “it is not the thought that counts, but what is recorded with the register of deeds.”  (The court commented in a footnote that a Google search of this phrase turns up a response attributed to Winnie-the-Pooh that: “If it is the thought that counts, why are there fingers?”  However, it also noted that in many situations the observation of a 19^th century naturalist that “the smallest deed is better than the greatest intention” is more applicable.)

This case involves a typical state statute that provides that unrecorded mortgages are void as against subsequent good faith purchasers.  Normally a purchaser receives constructive notice of prior interests through recorded documents.  However, the court acknowledged that there are limited circumstances in which a purchaser is deemed to have notice of interests through other sources (which would mean that it would not be a good faith purchaser).

Under applicable state law if a purchaser has actual notice of the prior interest, it would not be entitled to the benefit of the statute providing that unrecorded interests are void.  However, this does not apply in the context of exercising the rights of a bona fide purchaser under Section 544 of the Bankruptcy Code since this section specifically provides that the rights are “without regard to any knowledge of the trustee or of any creditor.”

The court acknowledged that a purchaser could also be held responsible under state law for things that would be revealed by the public record or the property itself.  One example was a sale involving a boundary dispute.  The court concluded that the key was possession.  Another similar example was a purchaser under an unrecorded land contract that was in sole possession of the property.  The focus is on “use or occupancy” of the property that would provide notice of the interest.

Although the court characterized it as “possible” that a visit to the property or discussion with the owners might happen to lead a buyer of Lot 1 to learn about a mortgage on the adjacent Lot 2, that was not legally relevant. The court determined that there was nothing in the circumstances of this case that would have provided affirmative notice of the bank’s intent to encumber Lot 1.

The bottom line is that the bank was out of luck:  It could have protected itself by recording a mortgage with a proper legal description.  The bank’s mortgage was outside Lot 1’s chain of title and a subsequent good faith purchaser would not have had any notice of the bank’s mortgage.  Consequently, the mortgage was void as against a bona fide purchaser, and the bank’s claim was treated as unsecured.

As illustrated in several prior blogs (for example, Strong Arm Powers: Bye Bye Mortgage), minor errors in a mortgage can have major consequences in a bankruptcy.  Thulis serves as a reminder that attention to detail is critical since the mortgage lien itself is at stake.

Vicki R. Harding, Esq.