A chapter 7 trustee sought to avoid a prepetition transfer of property resulting from a mortgage foreclosure sale. The mortgagee argued that the completed sale extinguished all of the debtor’s interest even though the foreclosure deed and related documents were not recorded until postpetition.
The debtor financed purchase of property with a mortgage loan. After she defaulted, the mortgagee bank initiated a foreclosure. The sequence of events was as follows:
- April 21: The bank conducted a foreclosure sale and acquired the property as the highest bidder. It executed a memorandum of sale that day, but for some reason there was a delay in completing the rest of the sale documentation.
- June 12: A foreclosure deed transferring title to the sale purchaser was executed.
- June 16: An affidavit of sale (as required by law) was executed.
- July 9: The debtor filed a chapter 7 bankruptcy.
- August 12: The foreclosure deed and affidavit of sale were finally recorded with the register of deeds.
The chapter 7 trustee sought to avoid the transfer of the property to the bank (as the foreclosure sale purchaser) using his “strong arm” powers as a bona fide real estate purchaser pursuant to section 544(a)(3) of the Bankruptcy Code. This section allows the trustee to avoid a transfer of real estate to the extent that it could have been avoided under state law by a theoretical bona fide purchaser as of the commencement of the bankruptcy case.
The trustee argued that because none of the foreclosure documents were recorded as of the date the petition was filed, a bona fide purchaser would not be charged with notice of the foreclosure sale. Consequently its interests would be superior to those acquired through the foreclosure sale.
The bank countered that because the foreclosure sale had been completed prepetition the debtor did not have any interest in the property. Consequently the sale transfer was not avoidable. It further argued that allowing the trustee to set aside a foreclosure sale based on a delay in recording the transfer documents would force buyers to immediately record foreclosure documents to protect against an intervening bankruptcy – which it described as “absurd.”
The court began by noting that under applicable state law “a conveyance of an estate in land is not valid against any person unless the transfer is recorded or unless that person has ‘actual notice’ of the unrecorded conveyance.” Since the Bankruptcy Code provides that the knowledge of the trustee and creditors is not considered, the question boiled down to whether an examination of instruments in the chain of title would provide notice of the foreclosure sale.
Further, unlike most states, a purchaser is not charged with “inquiry notice” with respect to matters not in the record. (For example, possession of the property by a third party would be sufficient to put a purchaser on notice that it should inquire further about the rights of the third party.)
Finally, the court mentioned that the applicable state was a “title theory” (as opposed to a lien theory) state:
In [a title theory state], a mortgage splits the title into two parts: the legal title, which becomes the mortgagee’s, and the equitable title, which the mortgagor retains. … The title held by a mortgagee is defeasible, and upon payment of the note by the mortgagor… the mortgagee’s interest in the real property comes to an end.
Inherent in this structure is the mortgagor’s “equity of redemption” – meaning the right to redeem legal title from the mortgagee by paying the loan in full. Under applicable state law the mortgagor’s equity of redemption was considered an estate in property, and under the Bankruptcy Code, termination of a debtor’s equity of redemption is recognized as a “transfer.”
Putting all of these pieces together, pursuant to the foreclosure sale the bank transferred legal title to itself (as purchaser) – which did not constitute a transfer of the debtor’s interest. However extinguishment of the debtor’s equity of redemption also constituted a transfer, and this transfer did involve the debtor’s interests. Thus the trustee did not have the power to recover legal title, but he potentially could avoid the extinguishment of the debtor’s equity of redemption.
Turning back to the rights of a bona fide purchaser, the court concluded that in the applicable jurisdiction the foreclosure documents would have to be recorded in order to provide constructive notice of the foreclosure sale. It distinguished decisions reaching a contrary result based on the fact that those cases applied state law that charged purchasers with inquiry notice. Thus documents such as the recorded mortgage, notices of default, and published notices of sale could impose a duty on the purchaser to make inquiries that would have led to discovery of the foreclosure sale. However this analysis was not applicable in this case.
Since there were no documents of record indicating that the debtor’s equity of redemption was transferred to the bank (i.e. extinguished through the foreclosure sale), that transfer (but not the bank-to-bank transfer of legal title) was avoidable and that interest could be brought back into the bankruptcy estate.
This case highlights the fact that real estate law is very state specific. It is not unusual to find that a decision turns on a subtle point of real estate law with the consequence that there may be diametrically opposite results depending upon which state law governs.
Vicki R Harding, Esq.