In re First Mortgage Fund, Inc., 498 B.R. 180 (E.D. Mich. 2013) –

A debtor (First Mortgage), which was the mortgagee of record, foreclosed a mortgage and obtained title to the foreclosed property notwithstanding that it had assigned the note and mortgage to another party several years before the foreclosure sale.  After the assignee sought to make a claim based on the assignment, the debtor’s chapter 7 trustee sought to avoid the rights of the assignee using his strong-arm powers.  After the bankruptcy court found in favor of the chapter 7 trustee, the assignee appealed.

A borrower had obtained a loan that was secured by mortgages on four properties.  The original lender assigned the note and mortgages to the debtor, and the mortgages and assignments were recorded.  Shortly afterwards, the debtor assigned its interest in the note and mortgages to an affiliate (Stavenkan).  This second assignment was not recorded, and the debtor remained the mortgagee of record with no record evidence of Stavenkan’s interest.

About three years later the debtor foreclosed the mortgages and purchased the properties with a credit bid.  Sheriff’s deeds transferring the properties to the debtor were recorded.  Three years after that First Mortgage filed for bankruptcy.

After the bankruptcy filing, Stavenkan sought to assert its assignee interests for the first time.  (The court noted that the debtor and Stavenkan were affiliates and that the owner and operator of Stavenkan was also the majority shareholder and president of the debtor.  So, it appears that Stavenkan should have been aware of what was going on all along.)

The chapter 7 trustee sought to avoid the transfer of the debtor’s interests to Stavenkan using his strong-arm powers.  In particular, under Section 544(a)(3) of the Bankruptcy Code a trustee can assert the rights of a bona fide purchaser of real estate.  Under applicable state law, a bona fide purchaser took free of unrecorded interests.  Since Stavenkan’s interests were unrecorded, the bankruptcy court concluded that the transfer to Stavenkan could be avoided.

On appeal Stavenkan made several arguments that were rejected by the district court.

• The court responded to its argument that the foreclosure was void by noting that under state law a party is entitled to foreclose if it is the mortgagee of record (as evidenced by a record chain of title from the original mortgagee to the foreclosing party).
• Although the foreclosure was defective as a result of the assignment, defective foreclosures are voidable, not void ab initio.
  • Since Stavenkan had not challenged the foreclosure at the time the bankruptcy was filed, the debtor still had valid record title at that time, and it was too late to challenge the foreclosure (three years after the foreclosure sale and almost six years after Stavenkan failed to record its interests).
  • Under applicable state law, generally a non-judicial foreclosure cannot be challenged after the property is sold to a bona fide purchaser.
• Stavenkan’s request for the equitable remedies of quiet title, specific performance or constructive trust failed because the court found that the equities did not weigh in its favor given that it failed to take action for six years.  In addition, a bona fide purchaser would take free of any equitable claims.
• Stavenkan raised an argument based on case law holding that a bona fide purchaser cannot claim title if the chain of title includes a forged deed or a deed signed as the result of constructive forgery.  While acknowledging that line of cases, the court pointed out that state law did not treat all fraud as constructive forgery – citing a circumstance involving a swindler.  It concluded that any fraud in this case did not constitute constructive forgery.
• Stavenkan also argued that it still held the note, and since the mortgage is only security for payment of the note, it was entitled to payment.  Both the bankruptcy court and district court concluded that the right to payment should be addressed in the claims process, and did not affect the ability to avoid the transfer of the mortgage interest.

Consequently, the trustee was able to avoid Stavenkan’s unrecorded assignee interests in the mortgages.

There can be some interesting debates about the interaction between the rights of a noteholder under Uniform Commercial Code Article 3 and the holder of record of a mortgage securing payment of a note.  However, as illustrated by this case, those arguments do not assure that the assignee of a note will obtain the benefits intended by the parties.  An assignee fails to record an assignment of a mortgage at its own peril, and may fall victim to an unscrupulous and/or financially distressed assignor.

Vicki R. Harding, Esq.