“Strong Arm” Powers Round 3: What Happens If A Mortgage Is Recorded Before a Deed?

Olsen v. Heaver (In re Heaver), 473 B.R. 734 (Bankr. N.D. Ill. 2012) –

The short story is that when a deed and mortgage are executed at the same time, but the mortgage is recorded before the deed, the recorded mortgage does not provide constructive notice and can be avoided in a bankruptcy – at least under Illinois law as interpreted by the Heaver bankruptcy court.

As discussed in prior blogs (Bye Bye Mortgage and Round 2: Mortgage Survives), Section 544 of the Bankruptcy Code gives a debtor or trustee the power to avoid a transfer of property that is voidable by a hypothetical bona fide purchaser of the property (or a creditor that extends credit and has a judgment lien or unsatisfied execution) at the beginning of the case.

Under Section 544(a), the hypothetical purchaser is not charged with any actual knowledge of the trustee or a creditor, although it can be charged with constructive notice of matters under state law.  Typically a mortgage or other document must be recorded in order to provide constructive notice, and a document that is not properly recorded can be avoided under Section 544.

Heaver takes this concept a step further and holds that under Illinois law a mortgage that is recorded outside the chain of title does not provide constructive notice.  Further, in determining whether a document is outside the chain of title, the only relevant dates are the dates of recording.

In this case, the debtor acquired the property by warranty deed dated September 30, 2008, and signed a promissory note and mortgage of the property in favor of the mortgagee on the same day.  The mortgage was recorded on October 24, and the deed was recorded on October 31.

The grantor-grantee index is the official record of recorded documents in Illinois.  So, a key question was: once the deed was recorded, was a third party required to search the grantor-grantee index for conveyances and grants of interest by the owner starting with the date of recording or the earlier date of execution of the deed?  The Heaver court concluded that constructive notice was determined based on the date of recording, so that a mortgage recorded during the gap period would not provide constructive notice since a third party would not be required to search the grantor-grantee index prior to the date of recording of the deed.

The court made a couple of other related points:  Even if the mortgage would have been found during a review of a tract index, that would not be sufficient to preserve the mortgage since as a legal matter the tract index was an unofficial record and did not charge third parties with constructive notice (unlike the grantor-grantee index, which is the official record).

Also, a deed is not effective until it is delivered – which supports the court’s decision to look to the recording date rather than the execution date.  In some cases a deed may be executed prior to closing as a matter of logistics, and in other cases there may be a more extended delay as a deed is executed and placed in escrow to be released in connection with subsequent events (such as payment in full of an installment contract or the occurrence of release conditions in connection with a deed in lieu).  Consequently, the date of execution may not be a relevant date.

Illinois is certainly not the only state that provides that its grantor-grantee index is the official index for purposes of determining what is in a chain of title, and consequently what gives people constructive notice.  However, the Illinois statute does include language that may be more extreme than is typical.  It provides:

“All deeds, mortgages and other instruments of writing which are authorized to be recorded, shall take effect and be enforced from and after the time of filing the same for record, and not before, as to all creditors and subsequent purchasers, without notice; and all such deeds and title papers shall be adjudged void as to all such creditors and subsequent purchasers, without notice, until the same shall be filed for record.”

The Illinois language may be stronger than the statutes in other states (for example, statutes that speak in terms of priority, as opposed to documents being void).  However, the issue of whether third parties are charged with notice of documents recorded (i) after the date of execution of the deed or (ii) only after the date the deed is recorded can arguably be raised any time the governing principle is whether something is within the chain of title established through a grantor-grantee index.

At the end of the day, it would be better to plan ahead and avoid the issue entirely by assuring that all relevant documents are recorded and that they are recorded in the proper order so that each party has an interest of record before it attempts to grant rights or convey an interest to other parties.

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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