Deed in Lieu: Sometimes It Works, and Sometimes It Doesn’t (Round 2)

In re Kaltenheuser, 474 B.R. 305 (Bankr. D. D.C. 2012) –

In Kaltenheuser, a deed in lieu of foreclosure was executed and placed in escrow in connection with a settlement agreement approved by a state court order.  If the mortgagor failed to make a payment of $1.1 million by a specified date, the escrow agent was authorized to immediately record the deed in lieu conveying the mortgaged property to the mortgagee.

The payment was not made in time, but before the lender could have the deed recorded, the revocable trust that held title to the property filed bankruptcy.  Although the trust bankruptcy was dismissed on the basis that the trust was not an eligible debtor, the settlor revoked the trust (becoming the owner of record of the property), and filed a chapter 11 bankruptcy herself – once again invoking the automatic stay.

The bank moved for relief from the automatic stay based on the debtor’s lack of interest in the property as a result of the deed in lieu.  In response, the debtor argued that she would be able to avoid the deed in lieu using the “strong arm” powers of a hypothetical bona fide purchaser of real estate under Section 544 of the Bankruptcy Code.  (See Bankruptcy “Strong Arm” Powers: Bye Bye Mortgage.)  Since the deed in lieu and settlement agreement were not recorded, under state law a bona fide purchaser of real estate would not have constructive notice and could avoid the transfer.

Notwithstanding the lack of constructive notice that would arise from recorded documents, the lender contended that the recorded mortgage was sufficient to trigger an inquiry that would lead to discovery of the deed in lieu.  Its argument was based on a variety of cases involving suspicious facts or particular information that would put a purchaser on inquiry notice.

However, the court did not agree that the mere existence of a mortgage created a duty of inquiry.  Further, even if there was a duty of inquiry resulting from the recorded mortgage, it required a “generous dose of speculation” to conclude that the inquiry would lead to notice of the litigation, the settlement agreement and the resulting deed in lieu of foreclosure.

As a final attempt to overcome the debtor’s argument, the lender contended that there was no point in avoiding the deed, since the property would still be subject to the mortgages.  However, the only issue before the court in connection with the request for relief from the automatic stay was the lender’s claim of ownership.

As a separate matter, the court noted that if the mortgage debt exceeded the value of the property, the debtor might not be able to propose a confirmable plan.  In that case, the lender could seek relief from the stay under a provision of Section 362 of the Bankruptcy Code that provides for relief from the stay when the debtor does not have equity in the property and it is not necessary for an effective reorganization.  However, the lender did not seek relief under that provision in the motion before the court.

Even if a deed in lieu survives fraudulent transfer and other similar challenges (see Deed in Lieu: Round 1), if it is not recorded before the borrower files bankruptcy, the deed will almost certainly be subject to avoidance.

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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