Tuesday, February 27, 2018

FYI: 6th Cir BAP Holds Constructive Notice Did Not Bar Bankruptcy Trustee's Challenge to Defectively Executed Mortgage

The Bankruptcy Appellate Panel of the Sixth Circuit recently held that the constructive notice provisions of section 1301.401 of the Ohio Revised Code do not limit a bankruptcy trustee's avoidance powers as a hypothetical judgment lien creditor under section 544(a)(1) of the federal Bankruptcy Code.


A copy of the opinion is available at:  Link to Opinion


In 2013, two debtors (Debtors) filed a petition for Chapter 7 bankruptcy protection.   Debtors' schedules listed the subject property and three mortgages against the subject property, two of which were held by the same mortgagee (Lender).


In 2014, the bankruptcy trustee ("trustee") filed an adversary action seeking to avoid Lender's first mortgage.  Notably, both parties agreed that the acknowledgment clause in the first mortgage was defective and did not substantially comply with the requirements of O.R.C. § 5301.01.  Thus, trustee alleged that the mortgage was avoidable under 11 U.S.C. § 544(a)(1) and 11 U.S.C.544(a)(3) and Ohio law. 


Lender moved for judgment on the pleadings in its favor as to the adversary proceeding shortly after filing an answer.  The bankruptcy court then entered an agreed order that stayed the proceeding pending the resolution of the following questions of law in In re Messer, 50 N.E.3d 495 (Ohio 2016) that were certified to the Ohio Supreme Court:


1) Does O.R.C. § 1301.401 apply to all recorded mortgages in Ohio?

2) Does O.R.C. § 1301.401 act to provided constructive notice to the world of a recorded mortgage that was deficiently executed under O.R.C. § 5301.01?


The Ohio Supreme Court ultimately answered both questions in the affirmative.  Thereafter, an opinion was issued by the bankruptcy court in Messer.  Notably, with reference to O.R.C. § 1301.401, the Messer court held that "[w]hether one claims the status of a hypothetical judgment lien creditor or a bona fide purchaser, constructive notice under state law precludes avoidance through Section 544 of the Code."


After the Messer opinion was issued, Debtors filed an amended complaint and Lender filed another motion for judgment on the pleadings. In light of the ruling in Messer, Lender argued that O.R.C. § 1301.401 impaired trustee's power to avoid recorded mortgages based on defects in their execution as: (1) a hypothetical bona fide purchaser ("BFP") under § 544(a)(3); and (2) a hypothetical judicial lien creditor ("JLC") under § 544(a)(1). However, the bankruptcy court disagreed and denied Lender's motion for judgment on the pleadings.


In so ruling, the bankruptcy court stated that "while O.R.C. § 1301.401 deems the recording of a defectively executed mortgage to provide constructive notice, such notice does not affect the priority of liens involving a defectively executed mortgage" noting that "a long line of Ohio case law and subtle distinctions in the recording statutes compel a different result." 


The bankruptcy court reasoned that, under Ohio law, notice – or lack thereof – is imperative to obtaining BFP status, but is irrelevant to prioritizing a defectively executed mortgage with other liens.  In other words, a "defectively executed mortgage derives no efficacy from being recorded and is not valid against subsequent properly executed and recorded lien even if the subsequent lienholder has notice."  Citing White v. Denman, 16 Ohio 59 (1847), the bankruptcy court noted that public policy favors those who comply with the recording statutes, and therefore, the important factor in the lien priority dispute is determining which lien is the first in time that strictly adhered to the recording statutes. 


Thus, contrary to the ruling in Messer, the bankruptcy court here held that trustee retained the power to avoid Lender's defectively executed mortgage as a hypothetical JLC under § 544(a)(1).


Lender appealed the interlocutory order and the Sixth Circuit Bankruptcy Panel granted leave in order to resolve the split between the lower courts.


The Panel explained that state law determines the extent of a bankruptcy trustee's avoidance powers under 11 U.S.C. § 544.  Therefore, a "trustee can prevail only if, under Ohio law, a person with the status described in § 544 (a)(1), (2), or (3) as of the commencement of the case could avoid [the mortgagee's] interest in the Debtors' property under the mortgage."


As you may recall, O.R.C. § 1301.401 provides in relevant part that the "recording . . . of any document . . . shall be constructive notice to the whole world of the existence and contents of either document as a public record and of any transaction referred to in that public record . . . [and] [a]ny person contesting the validity or effectiveness of any transaction referred to in a public record is considered to have discovered that public record any transaction referred to in the record as of the time that the record was first filed . . . or tendered . . . for recording." 


The Panel noted that the Ohio Supreme Court held that the act of recording a mortgage provides constructive notice of the existence of the mortgage and its contents even if it is defectively executed under O.R.C. § 1301.401. Thus, the Panel agreed with the Messer court's holding that a bankruptcy trustee may no longer avoid mortgages as a BFP under § 544(a)(3) and Ohio law when a defective mortgage is recorded.


However, the Panel disagreed with the Messer court's holding that a bankruptcy trustee may no longer avoid mortgages as a hypothetical JLC under § 544(a)(1) and Ohio law when a defective mortgage is recorded.


The Panel explained that O.R.C. § 1301.401 addresses constructive notice, but not whether a defective mortgage is entitled to be afforded priority over subsequent properly perfected liens.  The Panel thus found that JLCs are different than BFPs, noting that neither the Bankruptcy Code nor Ohio law requires a judgment creditor to lack notice of an unrecorded or defective lien in order to obtain a superior lien on a judgment debtor's property.


In so finding, the Panel disagreed with the Lender's contention that O.R.C. § 1301.401 defeated the trustee's status as a JLC because a JLC is always subordinate to a BFP.  The Panel explained that a "person's very status as a BFP presumes they have taken their interest for value without notice of any prior interests."  Thus, if a properly perfected judicial lien existed, a subsequent party could not obtain BFP status.  Therefore, the Panel held, the fact that trustee cannot obtain BFP status due to the constructive notice provisions of O.R.C. § 1301.401 does not defeat its ability to step into the shoes of a hypothetical JLC.


The Sixth Circuit Bankruptcy Panel also held that Lender's reliance on Kellner v. Fifth Third Bank (In re Durham) 493 B.R. 506 (Bankr. S.D. Ohio 2013) was misplaced.  In Durham, the bankruptcy trustee also sought to avoid a bank's unrecorded mortgage as a hypothetical JLC under § 544(a)(1).  There, however, the mortgagee filed a state foreclosure action and obtained a decree of foreclosure prior to the filing of the bankruptcy petition. Thus, the Panel noted that Ohio's codified doctrine of lis pendens distinguished the case. 


Under O.R.C. § 2703.26, "[w}hen a complaint is filed, that action is pending so as to charge a third person with the notice of its pendency.  While pending, no interest can be acquired by third persons in the subject of this action, as against plaintiff's title."  The Panel noted that O.R.C. § 2703.26 has been held to prevent all third parties, not just subsequent BFPs, from acquiring an interest in the property during the pendency of a foreclosure action. Thus, the Panel continued, the doctrine of lis pendens at issue in Kellner also barred the trustee in that case from avoiding the mortgage as a hypothetical JLC.


Here, however, the Panel found that the doctrine of lis pendens was inapplicable, and therefore, the basic rule that an unrecorded mortgage does not take priority over a bankruptcy trustee as a hypothetical JLC applied.  Thus, the Panel found that trustee as JLC takes priority over and may avoid the lender's mortgage.


The Sixth Circuit Bankruptcy Panel also considered the issue of whether the newly enacted O.R.C. §5301.07 applied retroactively to limit trustee's avoidance powers as a hypothetical JLC.  Notably, O.R.C. §5301.07, which became effective April 6, 2017, deems instruments that have been recorded for more than four years as cured from defects in the making, execution, and acknowledgment of the instruments.  Thus, applying O.R.C. §5301.07 retroactively would have cured the acknowledgment defect in the first mortgage at issue giving Lender priority over trustee as a hypothetical JLC.


However, O.R.C. §5301.07 provides that the statute shall be given retroactive effect unless "to do so would affect any accrued substantive right or vested rights in any person or in any real property instrument."  The Panel found that under § 544(a)(1) a trustee "steps into the shoes" of a hypothetical JLC that perfected its lien as of the date of the filing of the petition.  Thus, trustee's rights accrued prior to the enactment date of O.R.C. §5301.07, and therefore, it could not be applied retroactively.


Accordingly, the Sixth Circuit Bankruptcy Panel affirmed the bankruptcy court's denial of Lender's motion for judgment on the pleadings.




Ralph T. Wutscher
Maurice Wutscher LLP
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Direct:  (312) 551-9320
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Email: rwutscher@MauriceWutscher.com


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