A chapter 7 trustee sought to avoid a defectively acknowledged mortgage using his “strong-arm” powers. The mortgagee countered that a state “savings” statute prevented the trustee from achieving the desired result.
Under section 544(a) of the Bankruptcy Code a trustee may succeed to the rights of a hypothetical judicial lien holder, execution creditor or bona fide purchaser of real property so that the trustee may avoid a prepetition transfer that would be avoidable under state law by any of these theoretical entities.
Typically, the way this plays out in the mortgage arena is as follows: Under state law (1) a bona fide purchaser of real estate can acquire title free and clear of interests unless it has notice, (2) if a document is recorded it provides constructive notice of the existence and contents of the document, so (3) a bona fide purchaser can take title to real estate free and clear of an unrecorded mortgage unless the purchaser has actual notice of the mortgage. Since a trustee exercises strong arm powers without regard to actual notice, this means that a trustee can avoid unrecorded mortgages.
Further, often there are detailed recording requirements (such as the precise form of a required acknowledgment) combined with case law holding that (1) if the requirements are not met, a document is not entitled to be recorded, and (2) even if a deficient document is actually accepted and recorded, it will still be treated as though it is unrecorded. Thus, there are a number of cases permitting a trustee to avoid mortgages on the basis that there is some minor technical execution deficiency – leading to the conclusion that a recorded mortgage should not have been recorded, and as an unrecorded document it is subject to avoidance using the trustee’s power as a bona fide purchaser of real estate.
Some states have reacted by adopting some sort of “savings” provision. Depending on the exact language, maybe this will save the day Portland deficiently executed mortgage, and maybe not.
In this case all parties acknowledged that the mortgage was defective: Although the mortgage was actually recorded and the debtors’ names and signatures appeared on the mortgage, their names did not appear in the acknowledgment block signed by the notary public. Thus the signatures were not properly acknowledged as required by the recording statutes. As a consequence the trustee argued that he could avoid the mortgage using his status as either a bona fide purchaser or judicial lien creditor.
However, the recording statutes had been amended in 2013 to provide that recording a document such as the mortgage “shall be constructive notice to the whole world of the existence and contents [of the document] as a public record and of any transaction referred to in the public record, including, but not limited to, any transfer, conveyance, or assignment reflected in that record.” Thus, the mortgagee argued that its recorded mortgage provided constructive notice and could not be avoided.
The bankruptcy court conducted a detailed review of state law. It ultimately agreed with the mortgagee on the effect of the statutory “savings” provision on a purchaser of property – namely the recorded mortgage provided constructive notice so that a purchaser of the property would take title subject to the mortgage.
However, the court concluded that a judicial lien holder was a different matter. In cases dating back more than a century state courts had held that knowledge of the defective mortgage was irrelevant to determining lien priority. Rather, the first lien that strictly adhered to the recording statutes was given priority regardless of any knowledge of a prior defectively executed recorded mortgage. As explained in an 1847 decision:
We can not aid [the mortgagee] in correcting the error, which a little care would have prevented, by thrusting aside those who have equal equity, and a better legal claim. The complainant can not be preferred to the judgment creditors, without establishing a precedent that will in effect give more efficacy, in a numerous class of cases, to a negligently executed and defective mortgage, than to one in all respects executed in compliance with the law.
Thus, a properly perfected lien took priority over a defectively executed but recorded mortgage regardless of actual or constructive notice. As a result, the trustee was able to avoid the defective mortgage using strong arm powers as a hypothetical judicial lien creditor.
The court noted a decision by another bankruptcy court reaching the opposite conclusion. The other court reasoned that (1) constructive notice precludes avoidance and (2) there was no reason to distinguish between a hypothetical judgment lien creditor and a bona fide purchaser. While acknowledging that this was not illogical, the Oakes court stood firm in its own interpretation based on the long line of state cases and subtle distinctions in the applicable statutes.
The court also noted that the state legislature apparently recognized the need for further clarification. It had adopted amendments not yet become effective that (1) established rebuttable presumptions to the effect that recordable instruments were effective as if all technical requirements had been met (overcome only by showing fraud, forgery, incompetency and the like), and (2) provided that documents with defects that are of record for more than four years are deemed cured and effective as though they were not defective.
There is an inherent tension between the sentiment expressed in the 1847 decision quoted above (which appears to be shared by a number of courts) and the view that voiding a mortgage based on a minor technicality provides an unjustified windfall for the borrower (which appears to have spurred some state legislatures to action). This case is only one of numerous decisions illustrating how painful a minor technical error in execution of a mortgage can be. It also illustrates that an attempt to legislatively resolve the issue that focuses on reversing a particular case may not accomplish the desired result.
Vicki R Harding, Esq.