Tuesday, February 14, 2012

FYI: 4th Cir Holds BK Trustee Imputed Only w/ Knowledge of Officially Recorded Liens, Trustee's Independent/Constructive Knowledge Irrelevant

The U.S. Court of Appeals for the Fourth Circuit recently held that a bankruptcy trustee was properly allowed to avoid a lien, ruling that a bankruptcy trustee could only be imputed with knowledge of liens filed in a jurisdiction's official recording index, and that the trustee's independent or constructive knowledge of a lien was irrelevant.   
A copy of the opinion is available at: 
This appeal arose from an adversary proceeding in which the bankruptcy trustee sought to avoid a lien on a tract of land.  The debtor obtained loan that was purportedly secured by a deed of trust on two parcels of the debtor's land ("Tract I" and "Tract II"), each consisting of multiple lots.  The jurisdiction in which the two tracts were located used a parcel identifier number ("PIN") index as its official recording index, but maintained an unofficial grantor/grantee index as a way to track recording instruments until such time as the instruments were entered on the PIN index. 
When the deed of trust was submitted for recording, it included only the PIN for Tract II.  The Tract II lien was thus the only lien recorded under the deed of trust in the official PIN index. 
Subsequently, the debtor obtained another loan, and secured the loan with a deed of trust on Tract I that was properly recorded in the jurisdiction's PIN index. 
Consistent with the administration of the bankruptcy estate, the trustee later sold some of the lots in Tract I and applied the proceeds of the sale to the properly recorded lien on Tract I.   The lender bank then filed a proof of claim for repayment of the earlier loan based on the deed of trust on both Tract I and Tract II. 
Seeking to avoid the lien on Tract I, the trustee filed a motion for summary judgment and claimed that the bank's deed of trust, while properly recorded in the official PIN index as to Tract II, was not so recorded as to Tract I.   In response to the trustee's motion, the bank argued that the trustee had constructive knowledge of the lien on Tract I based on the express terms of the deed of trust, and on notice obtainable through a search of the unofficial grantor/grantee deed index listing the lien on Tract I.
Both the bankruptcy court and the district court rejected the bank's arguments, concluding that under section 544(a)(3) of the Bankruptcy Code, the trustee stands in the shoes of a bona fide purchaser, and may therefore rely exclusively on the official recordation index to discover liens, regardless of any independent knowledge that the trustee may possess as to the existence of a lien.  The Fourth Circuit affirmed.
As you may recall, the Bankruptcy Code permits a trustee to avoid a lien on a debtor's property that would be voidable under applicable law by a bona fide purchaser at the time of the filing of the bankruptcy.  11 U.S.C. § 544(a)(3).  In addition, the applicable state law in this case (North Carolina) is a "pure race" jurisdiction in which the first to record an interest in land holds an interest superior to all other purchasers of the property, regardless of any notice of conveyances to other purchasers. See N.C. Gen. Stat. § 47-20(a). North Carolina also permits counties to select the PIN recording index as the official recordation index, which the jurisdiction in this case chose to do.   See N.C. Gen. Stat. §§ 161-22(a), 161-22.2(a).  Thus, as the court noted, if a lien is not properly recorded, a bona fide  purchaser takes the property as if no lien exists.
The Court of Appeals found unpersuasive the bank's various arguments, including the assertion that the deed of trust substantially complied with state law, because the lien was recorded in the proper county, with the proper legal descriptions, and was properly indexed under the unofficial grantor/grantee index.  The Court ruled that the bank could not demonstrate substantial compliance with the jurisdiction's recording requirement, because the bank had failed to record the Tract I lien on the official PIN index.
In addition, the Fourth Circuit rejected the bank's argument that the trustee could not occupy the status of a bona fide purchaser of Tract I under Section 544(a) because the trustee was imputed with notice as to the title status of all property in the bankruptcy estate, including Tract I. 
In ruling against the bank, the Fourth Circuit noted, first, that the Bankruptcy Code specifically provides that a trustee "is imputed with only the knowledge imputable to a bona fide purchaser" regardless of  the trustee's knowledge of the lien.  In observing, moreover, that the test under North Carolina law is not whether a bona fide purchaser had knowledge of a lien or whether the trustee in bankruptcy is imputed with such knowledge, but whether the lien was recorded in the official index, the Court concluded that in this case a deed of trust must be recorded in the PIN index in order to be effective against a bona fide purchaser, and thus against a trustee. 
Accordingly, as a title search as to Tract I in the PIN index would not have revealed the bank's lien, the Court permitted the bankruptcy trustee to avoid the lien.

Ralph T. Wutscher
McGinnis Tessitore Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
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Email: RWutscher@mtwllp.com

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