A chapter 7 trustee sought to avoid an unrecorded mortgage and preserve the lien for the benefit of the bankruptcy estate. The decision on the trustee’s motion for judgment on the pleadings turned on treatment of the mortgage under state law.
The debtor owned real property located in Puerto Rico. He executed a note and a mortgage deed over the property in favor of a lender. The mortgage deed was never presented to the Puerto Rico Property Registry for recording.
After the debtor filed a chapter 7 bankruptcy, the trustee filed an adversary action seeking to avoid the unrecorded mortgage and preserve the lien for the benefit of the estate. Generally, bankruptcy courts look to state law to determine rights in property. Under normal circumstances the trustee’s argument would be a “no-brainer.”
Typically, state law provides that an unrecorded mortgage is enforceable between the mortgagor and mortgagee, but a bona fide purchaser without notice will be able to acquire the mortgaged property free and clear the mortgage. The trustee’s strong-arm powers include the ability to avoid any transfer of debtor property that could be avoided by a hypothetical bona fide purchaser of real property as of the commencement of the bankruptcy case. The exercise of these powers is without regard to any knowledge of the trustee or any creditor.
Thus, under the facts of this case normally the trustee would be able to avoid the mortgage. And once a mortgage is avoided, section 551 of the Bankruptcy Code automatically preserves the avoided lien on the debtor’s property for the benefit of the bankruptcy estate. (This prevents junior lien holders from obtaining a windfall when a senior lien is avoided.) Unfortunately for the trustee, things turned out differently in this case due to the quirks of local law.
The court commented on several collateral issues. Among other things the court determined that the debtor was an indispensable party. However, the central issue was the status of an unrecorded mortgage under local law: Unlike most jurisdictions, recording a mortgage is a prerequisite to creating a valid lien in Puerto Rico. Since the mortgage was not recorded, the prepetition transfer (i.e. creation of the lien) never occurred. So, there was nothing to avoid and thus nothing to preserve for the benefit of the estate.
Accordingly, the court denied the trustee’s motion for judgment on the pleadings and dismissed the adversary proceeding.
Bankruptcy lawyers who tend to focus on personal property liens governed by the UCC may find it easy to overlook the fact that state real property law is far from uniform.
Vicki R Harding, Esq.