Defective Mortgages: Variations on a Theme

Harker v. PNC Mtg. Co. (In re Oakes), 581 B.R. 500 (6th Cir. B.A.P. 2018) –

A chapter 7 trustee sought to avoid a recorded mortgage with a defective acknowledgment using his strong arm powers. The bankruptcy court ruled in favor of the trustee, and the mortgagee appealed to the Bankruptcy Appellate Panel (BAP).

The consequences of a defective acknowledgment are determined in the first instance by state law. Typically, if a mortgage does not comply with recording requirements (such as being properly acknowledged), it should not be recorded. In many states, if a mortgage is nevertheless accepted and actually recorded, it will still be treated as though it is unrecorded and thus there will be no constructive notice of the mortgage to a purchaser. This in turn means that a bankruptcy trustee will likely be able to avoid the mortgage using the powers of a hypothetical bona fide purchaser of real estate that has perfected its interest.

Mortgages were routinely avoided in Ohio using this approach until the state statutes were amended to provide that the recording of a document “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.” As a result, under Ohio law as revised (which governs this case) if a mortgage is actually recorded, a bona fide real estate purchaser is no longer able to avoid the mortgage solely because execution or acknowledgment was defective.

However, this did not stop the trustee from seeking to use his strong arm powers to avoid the mortgage. Instead of asserting the rights of a bona fide purchaser under section 544(a)(3) of the Bankruptcy Code, he relied on the status of a judicial lien creditor under section 544(a)(1). This gives the trustee the rights of a creditor that extends credit and obtains a judicial lien on all property on which a creditor on a simple contract could obtain a judicial lien as of commencement of the bankruptcy.

Relying on a case holding the trustees may no longer avoid a mortgage as a bona fide purchaser when a defective mortgage has been recorded, the mortgagee argued that the state statute regarding constructive notice also precluded a judicial lien creditor from avoiding a defective recorded mortgage. In rejecting this argument, the bankruptcy court noted that while lack of notice is important to obtaining the status of a bona fide purchaser, it was not relevant to disputes involving lien priority.

Instead, determining the relative priority of a judicial lien and the mortgage depends upon which is first in time given strict compliance with the recording statutes. The bankruptcy court quoted an 1847 Ohio case for an explanation of why a subsequently filed judgment lien should have priority over a defectively executed first mortgage: “We can not aid [the mortgagee] in correcting this error, which a little care would have prevented, by thrusting aside those who have equal equity, and the better legal claim.”

The court acknowledged a different result in another bankruptcy case where the court reasoned that the fundamental purpose of recording is to provide notice to third parties including lien holders, and there was no reason to give lien holders more favorable treatment in bona fide purchasers. However, the bankruptcy court rejected this approach based on a long line of Ohio cases.

On appeal the BAP agreed with the bankruptcy court: the amended statute addressed only constructive notice and did not deal with whether a defective mortgage is entitled to be recorded or given priority. The BAP went on to emphasize the differences between a bona fide purchaser and a judicial lien creditor. Consequently, the BAP affirmed denial of the mortgagee’s motion.

In closing the BAP opinion reiterates a point made by the bankruptcy court that subsequently enacted Ohio legislation may make this decision irrelevant for future cases. However, the statute did not apply retroactively so the significance of that statute was left for another day.

This case is a good reminder that (1) there are several different grounds for avoidance actions with subtle differences in how they can be used – so if one avenue does not work, maybe try another one, and (2) the law frequently evolves – so it is important to check for case and statutory updates before relying on existing decisions.

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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