Avoiding Mortgages: What Happens When A Stranger to The Transaction Files a Discharge in Error?

Kelley v. Ocwen Loan Servicing, LLC (In re Bowers), 595 B.R. 869 (Bankr. M.D. Ga. 2018) –

A chapter 7 trustee sought to avoid a security deed based on the fact that as of the petition date satisfactions of the security deed had been recorded. The secured party contended that its security interest was still enforceable because the satisfactions had been recorded in error, and alternatively asked for equitable recognition of its interest by subrogation or reinstatement.

The debtor purchased real estate and granted a security deed in favor of a mortgage company that was recorded. Two years later a satisfaction was recorded that stated (1) the security deed had been paid in full and (2) the signatory was the owner of the security deed by assignments from the mortgage company. A little more than a year after that a second satisfaction was recorded making the same statements. In each case the satisfaction was signed by an assistant secretary of H&R Block Bank. The real estate records did not show that H&R Block ever had a recorded interest in the property.

The holder of the security deed at the time of the bankruptcy filing (DBNT) stated that the satisfactions were recorded in error. In addition to the fact that H&R Block had no recorded interest in the property, DBNT offered the following in support of its position:

  • The debtor provided an affidavit stating that she understood the security deed was still outstanding and that she continued to make payments on the note.
  • An affidavit from DBNT’s servicer stated that it reviewed the assignment of the note and saw no indication that H&R Block ever held any interest in the note.
  • When H&R Block executed a cancellation of a mortgage originated by the mortgage company on another property, it filed an affidavit of missing assignment before filing the cancellation. There was no such filing in this case.

(Although this information supported the claim that the satisfactions were recorded in error, ultimately this fact was not particularly relevant to the outcome of the case.)

The trustee asserted rights as a hypothetical bona fide purchaser of real estate as of the commencement of the bankruptcy pursuant to section 544(a)(3) of the Bankruptcy Code. The real estate records showed a security deed followed by two Satisfactions of Mortgage. Thus, the trustee could take the position that as a matter of record the property was no longer subject to the security deed.

Under state law a bona fide purchaser can acquire property free and clear of unrecorded interests unless it has actual or constructive knowledge of the interests. Under the Bankruptcy Code the trustee can assert the purchaser’s rights without regard to actual knowledge, but is still subject to constructive knowledge. So, the issue boiled down to whether a purchaser had sufficient notice that it would have inquired about the status of the security deed as opposed to simply relying on the satisfactions.

As a general proposition, state law provided that the chain of title as reflected in the real estate records was the starting point. A purchaser was deemed to have notice of matters in its deed and in other instruments “forming an essential link in the chain of instruments” to which it obtained title, as well as recorded instruments pertaining to the property executed by entities with a recorded interest in the property at the time of execution.

DBNT first argued that since the satisfactions were executed by an entity without a recorded interest in the property, they were outside the chain of title and could not be relied on by a bona fide purchaser. In similar circumstances courts had held that a “wild deed” (i.e. a deed executed by someone without an interest in the property) should be disregarded. However, the bankruptcy court rejected this argument because the document in question was cancellation of a security interest, not a deed, and state statutes permitted cancellation by a party without a recorded assignment of the security deed.

DBNT next argued that even if the satisfactions were in the chain of title, a purchaser would have inquired about the authority of H&R Block since it did not have a recorded interest in the property. The bankruptcy court rejected this argument since there were cases holding that a cancellation of a security interest with unauthorized signatures did not create constructive notice that the security interest was still outstanding. Rather, there must be something inconsistent in the chain of title. After reviewing a case that involved inconsistencies, the court concluded there were no inconsistencies in the current case.

The court also specifically rejected the argument that ruling in favor of the trustee would mean that any mortgagor could file a fraudulent cancellation to effectively release a security interest. First, the discharge would be effective only if the purchaser did not have actual or constructive notice of the continuing security interest. Second, as a matter of policy state recording statutes protected bona fide purchasers. In the court’s view, unless there was a legal defect that could be identified based on the face of recorded documents, the purchaser was entitled to protection.

After further discussion of the facts, the court determined that there was “nothing that would have ‘excited the attention’ of a hypothetical purchaser. The purchaser reviewing [instruments in the chain of title] would have no reason to suspect the Security Deed remained effective despite the Satisfactions.”

Finally, the court rejected DBNT’s fallback claim for equitable reinstatement of the security deed. Notwithstanding the fact that the court could reasonably find that the satisfactions were recorded in error, given the holding that the trustee had no notice of DBNT’s interests, the court felt compelled to reject equitable reinstatement.

Accordingly, the bankruptcy court ruled in favor of the trustee, finding that a bona fide purchaser would not have notice of the continuing security interest. As a result, the bankruptcy estate’s interest in the property was free and clear of the security deed.

If, as appears to be the case, the security deed was effectively discharged in error by a stranger to the transaction, this seems to be a rather harsh result. In jurisdictions where the official index is a grantor-grantee index (as opposed to a tract index), a reasonable argument could be made that the satisfactions were not part of the chain of title and a purchaser should inquire further about authorization. However, as a practical matter people rely on recitals in documents (such as a name change or relationship as successor-in-interest) without further inquiry all of the time.

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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