Wednesday, March 20, 2019

FYI: 6th Cir Rules Ohio Amendment on Defective Mortgage Executions Did Not Bar BK Trustee's Avoidance Action

The U.S. Court of Appeals for the Sixth Circuit held that a recent change to Ohio law involving notice of a defective lien had no bearing on a bankruptcy trustee's ability to avoid the defective lien because such notice is irrelevant to a trustee's status as a judicial lien creditor.


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


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


The borrowers ("Borrowers") filed a Chapter 7 bankruptcy petition that included real property ("Property").  The mortgagee ("Mortgagee") held a first mortgage lien on the Property, which mortgage was recorded in 2003.


However, the mortgage lien was not executed in accordance with the laws of Ohio, as the Borrowers' signatures were not acknowledged before a notary public. 


In 2013, the Ohio legislature enacted legislation to offer further protection to mortgage holders.  Ohio Rev. Code § 1301.401(C) provides that "[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 and any transaction referred to in the record as of the time that the record was filed with the secretary of state or tendered to a county recorder for recording."


The Chapter 7 Bankruptcy Trustee ("Trustee") therefore sought to avoid the Mortgagee's mortgage because it was not properly recorded.


The bankruptcy court stayed the proceeding pending a ruling from the Ohio Supreme Court on two certified rulings related to O.R.C. § 1304.401. 


Subsequently, the Ohio Supreme Court in In re Messer, 50 N.E.3d (Ohio 2016) held that O.R.C. § 1304.401 applied to all recorded mortgages, and that the statute acts to provide constructive notice of a recorded mortgage, even if the mortgage was deficiently executed. 


The Trustee thereafter filed an amended complaint and the Mortgagee filed an answer and motion for judgment on the pleadings. 


The bankruptcy court denied the Mortgagee's motion, finding that the constructive notice provided by the Ohio law had no effect on "the Trustee's ability to avoid [Mortgagee's] defectively executed mortgage as a hypothetical judicial creditor pursuant to 11 U.S.C. § 544(a)(1)."  On appeal, the Bankruptcy Appellate Panel affirmed. 


The matter was then appealed to the Sixth Circuit.


After confirming that it had jurisdiction to hear the appeal, the Sixth Circuit noted that "[b]ankruptcy trustees, in exercising their avoidance powers, may succeed to the rights of judicial lien creditors, execution creditors, and bona fide purchasers." 


The Sixth Circuit further observed that relevant to the issue was section 544 of the Code, which concerns the avoidance powers as a bona fide purchaser or judicial lien creditor.


The Court explained that "[p]reviously in Ohio, a bankruptcy trustee could avoid defectively executed mortgages by acting as a bona fide purchaser without actual notice." 


However, after O.R.C. § 1304.401 was enacted and in light of the Ohio Supreme Court's interpretation of that statute, "a bankruptcy trustee can . . . no longer avoid mortgages as a bona fide purchaser," because "[t]he constructive notice provision of § 1304.401 subverts the bona fide purchaser's ability to claim lack of notice."


But, "[n]otice . . . is not relevant to the status of a judicial lien creditor."  Instead, in Ohio "a defectively executed mortgage is invalid to a subsequent lienholder even if the subsequent mortgagee-lienholder had actual knowledge of the prior defectively executed mortgage."


Thus, "[u]nder Ohio law, notice – whether constructive or actual – does not affect the priority of recordings," so "regardless of notice, a defectively executed mortgage is not 'perfected' so it does not trump a subsequently perfected lien." 


As a result, because the Mortgagee's mortgage was "defectively executed," it did not "perfect" that mortgage, whereas the Trustee, as a judicial lien creditor, "perfected" his lien on the Property upon the Borrowers' filing of the bankruptcy. 


"Therefore, under Ohio law, because the Trustee was the first to record a perfected lien, the Trustee's lien has priority – the Trustee cuts ahead of [Mortgagee] in line."


As a result, under section 544(a)(1) the Trustee could avoid subsequent competing liens such as the Mortgagee's defectively executed mortgage, and the Trustee could avoid the defectively executed mortgage even though it had notice of it under section 1304.401, because "[s]uch notice is irrelevant for his status as a judicial lien creditor." 


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





Ralph T. Wutscher
Maurice Wutscher LLP
The Loop Center Building
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Chicago, Illinois 60602
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