A chapter 7 trustee brought an adversary proceeding to avoid a defectively acknowledged mortgage by exercising a trustee’s strong-arm powers as a bona fide purchaser of real property or a judicial lien creditor. The bankruptcy court denied the mortgagee’s motion for judgment on the pleadings, the Sixth Circuit BAP affirmed, and the mortgagee appealed to the Sixth Circuit.
The debtors granted a mortgage on real property that they owned. However, execution of the mortgage was defective because the debtors’ signatures were not acknowledged before a notary as required by law.
As outlined by the court, the elements of a bona fide purchaser are (1) valuable consideration, (2) purchase in good faith, and (3) no notice of claims. When the trustee seeks to avoid a mortgage using the status of a bona fide purchaser, the usual dispute is whether the trustee has constructive or inquiry notice of the mortgage.
Under applicable state law, recording a document provided constructive notice of the document and its contents. However, if the document was not properly executed and acknowledged, it was not entitled to be recorded and courts held that it did not provide constructive notice – even if the document was actually accepted for recording.
This principle led to a number of bankruptcy cases holding that a trustee could avoid defectively executed mortgages by exercising the rights of a bona fide purchaser of real property. In response, the state legislature amended the recording statutes in 2013 to provide:
Any person contesting the validity or effectiveness of any transaction referred to in a public record is considered to have discovered that public record and any transaction referred to in the record as of the time that the record was first filed with the secretary of state or tendered to a county recorder for recording.
The state supreme court decided this meant that recording a mortgage provided constructive notice even if it was defectively executed. As a result, it was no longer necessary that a recorded mortgage be properly executed in order to take priority over a subsequent bona fide purchaser. Recording a deficient mortgage was sufficient to provide notice of the mortgage lien, and thus prevent avoidance.
However, a trustee can also exercise the rights of a hypothetical creditor as of the commencement of a bankruptcy case that obtains a judicial lien on all property on which a creditor on a simple contract could have obtained a judicial lien. The analysis of the rights of a bona fide purchaser did not necessarily resolve the question of whether a trustee could avoid a defective mortgage using the powers of a judicial lien creditor.
In analyzing this issue, the court noted that notice was not relevant to the status of a judicial lien creditor. Recording a defective mortgage still did not perfect the mortgage lien, and as a result the mortgage did not have priority over a subsequently perfected lien.
Consequently, a defective mortgage could still be avoided by a trustee exercising the rights of a judgment lien creditor. Accordingly, the Sixth Circuit affirmed the lower court denial of the mortgagee’s motion for judgment on the pleadings.
The state of the law in this area can be rather fluid. The court notes in a footnote that the state legislature took further steps to address the effects of recording a document. As revised in 2017 the recording statute provided that filing a mortgage creates a rebuttable presumption that it is “valid, enforceable, and effective.” Further a defectively executed mortgage is considered cured of any defects when it is of record for more than four years. So, before relying on cases allowing avoidance of a mortgage based on defective execution, it would be prudent to confirm that there have not been any significant changes to the applicable recording statutes.
Vicki R Harding, Esq.