Avoiding Mortgages: Local Rules Rule

Oliveras v. Banco Popular de Puerto Rico (In re Casanova), 595 B.R. 616 (Bankr. P.R. 2018) –

A chapter 13 trustee brought an adversary proceeding to avoid a bank’s mortgage lien using his strong arm powers as a hypothetical bona fide purchaser of real estate. The case turned on the effect of a lengthy delay in the recording process.

Under section 544 the Bankruptcy Code a trustee may avoid a transfer of property of a debtor that is voidable by a hypothetical bona fide purchaser of real estate as of the commencement of the bankruptcy case. Once the transfer has been avoided, the interest in property that had been transferred can be preserved for the benefit of the bankruptcy estate pursuant to section 551.

The bankruptcy court began by emphasizing that the debtor must first have an interest in property before there can be a transfer. Since property rights in bankruptcy are generally determined under state law, the court focused its analysis on state law.

Under applicable state law there is what is known as “the constitutive effect of recordation.” For mortgages this means that the mortgage deed must be recorded in a property registry to be validly constituted.

Under state statutory procedures, after a document is presented for recording, it is reviewed by the registrar. If the registrar issues a notice of defect and the defect is not corrected within 60 days, the registrar will issue an expiration note which has the effect of extinguishing the presentation entry. Otherwise the document will be recorded with a retroactive effective date as of the date of presentation.

It appears this process can take an incredibly long period of time. In this case the debtors purchased property through a deed and executed a mortgage deed in 2007. The deeds were presented for recording in 2012. When the debtors filed bankruptcy four years later in 2016 there had not been any notification of defects and the deeds were still pending recordation. (So, at the time of the court’s decision the final disposition of the deeds had been in limbo for over 10 years.)

The specific lot purchased by the debtors was segregated from a larger plot of land. The trustee’s challenge hinged on defects in the developer’s segregation deed. The trustee argued that since the defects were not timely corrected, the lot serving as collateral did not exist because it was not validly segregated from the overall development. Consequently, the bank could not have a mortgage since the debtors did not own the property.

Along those same lines, the trustee argued that even if the court found that the bank had a valid prepetition lien, the lien could not be perfected: The record showed uncorrected defects in the segregation deed, which meant that the purchase and mortgage deeds would eventually have to be notified with defects and could not be recorded.

The mortgagee responded by noting that the developer executed a new deed in 2018 correcting the segregation deed defects, and there was no reason to presume that the new deed would not be recorded. Similarly, the mortgage deed was filed and pending recordation that ultimately would have a retroactive 2012 recording date. Since the deeds were filed and pending recordation with no issued notices of defects, there was no reason to assume a defect notice would be issued, and the mortgagee’s interest should be deemed secured. Further, even if a defect notice was issued, the defects could be corrected within 60 days without violating the automatic stay.

The court acknowledged another bankruptcy case holding that a mortgagee did not have a secured claim where (1) there was a missing link in title because the deed of purchase was not registered and lapsed because defects were not timely cured, and (2) the mortgagee could not prove that it was a successor in interest to the original mortgagee. However, the court found that the case could be distinguished.

In particular, although the adversary proceeding complaint attached a 2015 notification of defect relating to the segregation deed, a 2017 certification from the registry included an entry that presentation of the original segregation deed was still pending recordation. The trustee argued that this was a mistake, but the court concluded that there was no documentation to support this claim.

Accordingly, the court found that the trustee did not demonstrate that he was entitled to relief and dismissed the adversary proceeding.

This case is another reminder that real estate laws are very state specific, and it would be a mistake to assume that real estate recording systems operate on a generally uniform basis similar to UCC filing systems.

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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