A short course on “notice,” and rights of a “bona fide purchaser.”

TOPEKA, KS–When they gave a mortgage against their home Jorge and Toni Colon could not have imagined what was to follow.

The trouble began with a typo. The Colons owned Lot 79 in the Arrowhead Heights Subdivision, but a typist made it “Lot 29” in the mortgage that got recorded.

No one noticed the typo until the Colons filed Chapter 13 bankruptcy, and the bankruptcy court appointed a trustee for the debtors’ estate. Seeing opportunity, the trustee filed pleadings to avoid the mortgage as an interest in the debtors’ real property. If successful the trustee’s action would make the mortgage lender an unsecured creditor, perhaps getting cents on the dollar instead of full repayment.

The trustee’s action was based on section 544(a)(3) of the Bankruptcy Code. This statute operates to ensure that unsecured creditors are treated fairly and equally, by making it difficult for a favored creditor to gain a security interest in debtor real property on the eve of a bankruptcy filing.  It does this by allowing a trustee in bankruptcy (or a debtor-in-possession) to avoid any interest in debtor real property that is not perfected as of the date of commencement of bankruptcy.

To achieve its purpose section 544(a)(3) entitles a trustee to claim the legal status of a bona fide purchaser (or “BFP”) of debtor real property as of the bankruptcy filing.  A BFP, as we know, is one who pays value for property without notice of claims of others to the same property.  Thus, a BFP acquires property free of such claims and has legal protections against them.

But what constitutes “notice?” There are two types: Actual notice (what one knows) and constructive notice (including, among other things, what is shown by public records).

In this case, the trustee argued a BFP would not be charged with constructive notice of the mortgage referring to Lot 29 because it would not be found by a title search.

The bankruptcy court agreed with the trustee, and ordered the mortgage avoided for the benefit of the debtors’ estate (controlled by the trustee). The mortgage lender could not foreclose, and would have to get in line as an unsecured creditor.

The court explained that the Shawnee County recorder’s office maintains two indices for land records:  A grantor-grantee index (an alphabetical listing by names of parties) and a geographical index (a listing by property legal description). The court said a purchaser (or a title searcher) might rely on the geographical index, solely, and in searching Lot 79 would not find the mortgage against Lot 29. It made no difference, in the court’s opinion, that the mortgage shows a correct property address and assessor’s parcel number.

The mortgage lender appealed, and a federal court of appeals reversed the bankruptcy court decision.

The appeals court focused on the Kansas recording statutes, which state that each recorded document imparts notice of its contents, and that each county must maintain a grantor-grantee index. The geographical index is optional.

The court reasoned that Kansas statutes charge a purchaser with constructive notice of an owner’s entire “chain of title,” which is the record of ownership to be found by searching names in the county grantor-grantee index. In this case, there were at least four documents in the chain of title linking the Colons with the correct lot number, and by comparing the documents a person with “common sense” should know the disputed mortgage was intended to encumber the Colon home.

So the mortgage lender won, and the mortgage is enforceable.

Moral: Forget the bankruptcy stuff, this is an important case for understanding the legal notion of constructive notice, which is the reason for land records and key to our system of property rights.

Most state recording statutes are similar to those in Kansas, and this well-written decision offers clarity for courts elsewhere. It should have nation-wide implications.

Today’s title companies rely heavily on geographical databases to search land records.  The geographical search is faster and cheaper than a grantor-grantee search, but is also prone to error and may miss the recording with a bad legal description.  Look for title insurance to cover the risk.

The case is reported as In re Colon, 563 F.3d 1171 (10th Cir. 2009).