Bankruptcy “Strong Arm” Powers: Bye Bye Mortgage

Rhiel v. Central Mortgage Co. (In re Kebe), 469 B.R. 778 (Bankr. S.D. Ohio 2012) –

Kebe provides a classic example of the exercise of bankruptcy “strong arm” powers.  Based on a defective notarization, the lien of a mortgage was avoided, and the bankruptcy court left open the possibility that the value of the lien could be recovered from the mortgagee in the future.  Not a happy prospect.

Section 544 of the Bankruptcy Code gives the debtor or trustee the ability to assert the rights and powers of, and to avoid transfers that are voidable by, a bona fide purchaser of real estate as of commencement of the bankruptcy.  To the extent that a bona fide purchaser would have been able to void or take clear of an interest, the debtor or trustee will be able to do the same.  State real estate law commonly provides that a bona fide purchaser of real estate can take free of unrecorded interests.  In that case, if a mortgage is not recorded, the lien of the mortgage can be avoided in bankruptcy.

Kebe is one of a long string of cases that finds that defective or improper notarization of a mortgage results in the mortgage being treated as unrecorded under Ohio law.  In this case the mortgage was properly executed by the mortgagors, but the notary failed to insert the name of the mortgagors so that the acknowledgement block read “This instrument was acknowledged before me this 20th of September, 2004 by ________.”

Interpreting Ohio law, the bankruptcy court held that the mortgage was not properly recorded, and consequently did not provide constructive notice to a bona fide purchaser of the property.  It was not persuaded by arguments that there would have been actual notice because any reasonable purchaser would have searched the land records and found the mortgage even though it didn’t have a legal status as properly recorded.

Thus the court granted the Chapter 7 trustee’s request to avoid the lien of the mortgage.  In case you wonder what happened to the lien, it was preserved for the benefit of the estate.  Whatever the mortgagee could have recovered as a result of the mortgage lien would be for the benefit of the bankruptcy estate instead.  However, that was not the only relief requested by Chapter 7 trustee.

Under Section 550 of the Bankruptcy Code, when a transfer is avoided the value of the property transferred may be recovered from the transferee if the court orders.  In connection with avoided mortgages, trustees and debtors have been using this section to attempt to recover the amount of the mortgage lien from the mortgagee.  In a world of seriously underwater mortgages, this presents an opportunity for the trustee or debtor to recover more than they would be able to get from selling the property, and leaves the mortgagee coping with the fact that it may be required to pay the estate more than it will be able to recover itself.

In this case, the court concluded that recovery was not yet appropriate.  The trustee was seeking to sell the property, so that avoiding the mortgage was potentially a sufficient remedy.  However, the court left the door open for the trustee to renew its request for recovery of the value of the lien if the trustee was unable to sell the property.

This case illustrates that formalities can really matter.  There is certainly room to litigate various issues, including how to value the grant of the mortgage lien, but no lender will want to find itself in this position in the first place.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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