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Real Estate Law

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You Be the Judge

Sunday, July 11th, 2010

The case of the misfit mortgage.

BESSEMER, AL–Davis & Associates, LLC,  was the owner of two lots in Jefferson County, Alabama.

Davis & Associates borrowed $43,000 from Frank Bynum, giving Bynum a mortgage against the lots.  The mortgage identified the borrower as “Davis Associates, LLC.”  The mortgage was recorded in the land records maintained by the Jefferson County Probate Office.

Later, Davis & Associates conveyed the lots to TMS Properties and, a few months after that, TMS Properties conveyed the lots to Angel Barker.  Ms. Barker purchased the lots with a loan secured by a mortgage held by GMAC Mortgage.

Meanwhile, Davis & Associates failed to repay the loan from Bynum, and Bynum threatened foreclosure.

But Barker and GMAC said they didn’t know about the Bynum mortgage.  So Barker and GMAC filed suit for a judicial declaration that they were bona fide purchasers of the lots, without notice of the Bynum mortgage, and not subject to it.

In court, Barker and GMAC said the incorrect name on the Bynum mortgage (“Davis Associates” rather than “Davis & Associates”) caused the mortgage to be mis-indexed in county land records.

As provided by Alabama statutes, the land records consist of a grantor-grantee index, containing names listed alphabetically, maintained by the county probate office.  In 1984, the Jefferson County Probate Office converted its paper index books to a computer database.  Expert witnesses testified that a search of the computer database for “Davis & Associates” does not turn out the Bynum mortgage, because of the missing ampersand.

Bynum argued that all duly recorded documents become part of the land records, and impart constructive notice whether or not they are properly indexed in the computer database.  It follows, said Bynum, that Barker and GMAC had constructive notice of the mortgage and are subject to its enforcement.

You’re the Judge:  How do you rule?

Jefferson County courthouse, Bessemer Division: Home to the land records and trial court

The Alabama Supreme Court ruled in favor of Barker and GMAC.

The Court reasoned that the county land records were set up and maintained in full compliance with state statutes.  Persons relying on this index should not be charged with notice of recordings that can’t be found by searching a correct name.

Since the missing ampersand caused the Bynum mortgage to go undetected, the Court held the mortgage was outside the chain of title for Davis & Associates.  So the mortgage did not impart constructive notice, and it cannot be enforced against Barker or GMAC.

The case is Bynum v. Barker, 39 So.3d 1013 (Ala. 2009).

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Escrow School

Sunday, July 4th, 2010

A seller’s trick brings a teachable moment.

VICTORVILLE, CA–Wesley was the owner of this house in Victorville, between Los Angeles and Las Vegas.

The property in question, sold by Wesley to Maria

When he contracted to sell the house to Maria, an escrow was opened to handle the transaction.

The escrow company asked Wesley to fill out an “Information Request” form, giving contact information for Wesley’s mortgage lender.  Wesley completed the form, reporting two deeds of trust against the property.  The first deed of trust was held by EMC Mortgage Corporation, for which Wesley provided an address, phone number, and loan number.

Escrow contacted EMC and, within a week, got a payoff demand for $176,317 good through the end of the month.

Escrow paid the demand and the transaction closed.

Ten months later Maria and her mortgage lender got notices of default, saying an unknown deed of trust was delinquent and had entered foreclosure.  Someone called the title insurer.

It turned out Wesley had pulled a fast one.  The information he provided about the EMC deed of trust pertained to different property, also owned by Wesley, across town.  So escrow’s payment to EMC made the ‘other’ property free and clear.  One month after close of escrow, Wesley and his wife refinanced the other property giving a new deed of trust for $150,000.

Wesley's other property, made free and clear

Having pocketed sale proceeds of $122,000, plus new loan proceeds of $150,000, Wesley netted about $270,000.

The deed of trust that Wesley left behind, the one that should have been paid off, had a principal amount of $264,000.

The title insurer demanded that Wesley straighten things out, but he wouldn’t, so the insurer paid $293,647 to clear Maria’s title.

And here’s the teachable moment:  The deed of trust that was “left behind” identified “MERS,” Mortgage Electronic Registration Systems, as “nominee” for the lender during the life of the loan.  MERS is a corporation formed by mortgage lenders to track ownership of promissory notes secured by mortgages and deeds of trust.  Once a mortgage has been recorded in county land records, and registered with MERS, anyone wanting payoff information need only contact MERS for referral to the current loan servicer.  The information is free, easy to get, and guaranteed accurate.

If escrow had asked MERS, rather than Wesley, they would have gotten true information instead of a nasty loss.

The deed of trust that was "left behind." Note MERS mortgage identification number (MIN), upper arrow, and MERS contact information, lower arrow. (Click to enlarge.)

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Loose Ends

Sunday, June 27th, 2010

How not to close a credit line.

PARKER, CO–Most residential resales go smoothly, but some seem to follow one bad turn after another.

This newer home near Denver was owned by Paul and Robin.

The property in question: back on the market.

When the couple agreed to divorce, they applied for a home equity line of credit to finance the break-up.  Approved for a line of $100,000 by TCF National Bank, Paul and Robin gave TCF a deed of trust even as they contracted to sell the property to Jennifer.

Robin moved out and gave Paul a power of attorney to handle details of the sale.  The power of attorney was on a standard form, appointing Paul to act for Robin “to sell and convey” the property “for such price as to (him) may seem advisable.”

When it came time to close, the title agent got a payoff demand from TCF.  The demand, also on a standard form, called for a payoff of $80,462 within one week, by check to be mailed to TCF’s Consumer Payoffs department in St. Paul, Minnesota.  The demand specified, “(a) signed authorization from the customer requesting the account to be closed is also required.  The section below can be used to accomplish this.  Please return original signatures with the payoff funds.”

Paul signed the form, on the signature lines provided, for himself and Robin.  Underneath the line for Robin’s signature he wrote “/s/ Power of Attorney.”

The sale closed, and the title agent wired $80,462 to TCF.  Both Jennifer and her purchase money lender got title insurance.

One year later, Robin was dunned by TCF for overdue payments under the old credit line.  Her lawyer contacted TCF and was told, “(a) wire transfer of $80,462 was received…and applied as a payment on the account.  However, because TCF did not receive a signed authorization from the borrowers requesting that the account be closed, the account has not been closed.”

Wha??

After the sale to Jennifer, Paul continued to get monthly statements from TCF showing a zero balance and “available credit” of $100,000.  It was too tempting.  Paul made new draws until he maxed out the credit line, then he stopped making payments.

Robin too failed to pay, and TCF began foreclosure proceedings.

While all of this was unfolding, Jennifer fell behind in her mortgage payments, and her lender commenced foreclosure.

Unbeknownst of each other, the two lenders held foreclosure sales and each “took back” the property.

The title insurance company for Jennifer’s lender entered the picture, and paid $160,543 to redeem the property from TCF’s foreclosure.  So now the title was clear, and Jennifer’s lender could deal with the property.

Having taken care of its insured, the title insurer then sued TCF to recover its money.

At the center of this dispute was the escrow officer employed by the title agent, who had handled the payoff.  Answering TCF’s claim that it did not receive authorization to close the loan account, the escrow officer produced copies of the authorization and the power of attorney.  She vowed she ‘must have’ mailed the forms to TCF, as ‘normal practice.’  But TCF denied receiving the forms and, even if they did, said they would not rely on Paul’s signature for Robin because the power of attorney did not expressly authorize him to close the loan account.

TCF won the argument, and the title insure took the loss.  Paul doesn’t answer, and Robin is forgiven.

Moral:  Our story ends with a mystery–who dropped the ball?

It seems likely that escrow mailed the authorization to TCF, but whoever received it there may not have matched it with the payoff received by wire.  Or, just as likely, the recipient may have found the power of attorney as unreliable, but didn’t contact escrow to say so.

Modern real estate transactions frequently close, and go to record, with loose ends and unfinished business.  Take, for example, the closing with a release of lien or mortgage “to come”–as happened here.

In real estate, loose ends represent risk.

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Hide and Seek

Monday, June 14th, 2010

A plan to dodge tax liens runs aground.

McLEAN, VA–Alexandra Murnan wasn’t clear about paying taxes.  By 2001 there were multiple federal tax liens against her, totaling more than $100,000.

So when an uncle offered to give her a house in upscale McLean, Alexandra saw she would have a problem.  The tax liens were recorded in Fairfax County, and if she accepted a deed the liens would attach and the IRS might force a sale of the property to pay her tax bill.  What to do?

The gift property: A gift for the IRS?

Alexandra consulted a lawyer, and based (perhaps only partly) on advice she created a trust to take title to the property.  Four days later, the uncle signed a deed conveying the property to Alexandra, as Trustee of the “Murnan Spring Hill Trust,” and the Trust took title subject to the uncle’s mortgage in the amount of $420,905.

The Trust subsequently borrowed from a mortgage lender to make improvements to the property.  Incident to these borrowings the Trust gave a deed to the lender to secure repayment.  When the Trust failed to make payments, the lender recorded the deed and became owner of the property.

In February 2003, the Trust negotiated to repurchase the property for $819,604.  The repurchase was financed by a new mortgage loan.  As part of this transaction, the Trust obtained an owners policy of title insurance in the amount of $1,450,000 from Stewart Title Guaranty Co.  Although Stewart Title was aware of the recorded tax liens, the title policy in favor of the Trust did not include a specific exception for them.

Within months the recent mortgage was also in default, so the Trust offered the property for sale.  In September 2003, the Trust contracted to sell the property to Krishna Tayal for $1,140,000.

But this time several title companies, including Stewart Title, required that the tax liens against Alexandra individually be paid, before they would issue a new owners policy to Tayal with coverage against them.  The liens now totaled almost $300,000.

The Trust made a claim under its title policy, but Stewart Title denied coverage.  Tayal canceled his purchase contract, and the Trust filed suit against Stewart Title for breach of the insurance contract.

Albert V. Bryan U.S. Courthouse, at Alexandria, Virginia

A federal trial court ruled in favor of Stewart Title, and the Trust appealed.

The Fourth Circuit Court of Appeals affirmed the trial court, finding the liens against Alexandra individually would attach to this Trust property, because the Trust was revocable at the sole discretion of Alexandra, she had control of Trust assets (the house), and she was sole beneficiary of the Trust during her lifetime.  It follows that if the IRS should enforce its lien to acquire Alexandra’s interest in the Trust, it could revoke the Trust and become owner of the property.

The Court then held that the Trust’s title policy claim was excluded from coverage by a standard policy exclusion for matters “created, suffered, assumed or agreed to by the insured claimant.”  Alexandra allowed the liens to exist, by her non-payment of taxes, and Alexandra, as trustee, “‘suffered’ the liens on the property by accepting title on behalf of the Trust.”

Under the circumstances, the Court said Stewart Title’s knowledge of the tax liens prior to issuing the owners policy makes no difference.

Moral:  There may be ways to shield assets from creditors by use of a trust (see, “spendthrift trust”), but this wasn’t one of them.  And protection against your own pre-existing debts is not ordinarily covered by insurance.

The (unpublished) case is reported as Murnan Spring Hill Trust v. Stewart Title Guaranty Company, 105 A.F.T.R.2d 2010-1756  (4th Cir. 2010).

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Rules of the Road

Sunday, June 6th, 2010

A fixed easement blocks development.

WASHOE VALLEY, NV–Washoe Valley lies east of the Sierra Nevada mountains, midway between Reno and Carson City.  It’s a scenic place, with native pines, panoramic views and, until recently, few residents.

Washoe Valley, Nevada

But with a gaming capital up north, and the state capitol to the south, Washoe Valley is attracting developers who want to exploit its obvious growth potential.

The push for “growth” has been strongly opposed by long-time residents, who fear losing their rural lifestyle and dread “urbanization.”

Battle lines have been drawn, and in the face of local opposition developers have gone to court to advance their interests.  Some have filed lawsuits to force municipal entitlements, such as water and sewer services, for new subdivisions.

One prominent developer here is St. James Village, Inc., owner of a 1,600 acre project known as “St. James’s Village.”  St. James’s Village is a master-planned gated community of custom homesites, on acre-sized lots.

Main Gate to St. James's Village

On St. James’s drawing board is a plan to subdivide one of its parcels into 28 lots.  This parcel is adjacent to lands owned by families named Cunningham and Saladin (collectively, the Cunninghams).

In 1974, a predecessor of the Cunninghams acquired an easement over what is now the St. James parcel to provide access for the Cunninghams’ properties to an existing road, now known as “Joy Lake Road.”  The deed creating this easement used a metes and bounds description, making it clear where the easement would be located on the ground.

In drawing their subdivision plan, St. James determined they would have to relocate the 1974 easement in order to create 28 buildable lots, instead of a lesser number.  So the plan was drawn with a curved road to replace the easement, still connecting Joy Lake Road to the Cunninghams’ properties.

The St. James Parcel, showing Joy Lake Road (top), the 1974 easement (yellow), and the proposed relocated road (red). The Cunninghams' properties are lower right (not shown). (Click to enlarge.)

Problem was, the Cunninghams would not agree.  So St. James filed a lawsuit against the Cunninghams, contending “property owners can unilaterally relocate easements, if such relocation does not materially inconvenience the easement holder, in order to allow the development of their property.”

The Cunninghams responded, denying “inconvenience” as the issue, and instead asserting an absolute right to keep the easement in place based on Nevada case precedents.  Mainly, the 1969 case of Swenson v. Strout Realty, Inc., holds that location of an easement, once selected, cannot be changed by either the owner of the burdened property or an owner of benefited property without consent of the other.

The trial court ruled for the Cunninghams, and the case headed up to the Nevada Supreme Court.

While acknowledging Swenson and other precedents, the Supreme Court said the traditional rule no longer reflects public policy, and it fails to fairly deal with interests of a land owner and easement holder as they may change over time.

So the Court announced a new rule, holding an easement may be unilaterally relocated when no one’s rights will be impaired; except that an easement created with an agreed-upon location or dimensions cannot be changed without mutual consent of the land owner and easement holder.

In this case the 1974 easement was created with a fixed location and dimensions, so it can’t be relocated by St. James acting unilaterally.  Back to the drawing board.

1974 easement deed, showing metes and bounds description. (Click to enlarge.)

Moral:  This new rule in Nevada follows a modern trend to allow relocation of easements, while giving deference to the intentions of parties who created the easement.

This is basic contract law, and it hews to the rules of interpretation of contracts.  It’s a little known secret that much of “real estate law” is simply contract law, applied to real property.

The case is St. James Village, Inc., v. Cunningham, 210 P.3d 190 (Nev. 2009).

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Bankruptcy 101

Saturday, May 22nd, 2010
There’s no crying in bankuptcy.

SANTEE, CA–Here’s a tale that starkly illustrates the avoiding power in bankruptcy.

Will and Jill Deuel were owners of a unit in the Lakeview Carlton Hills condominiums.

The Lakeview Carlton Hills condominiums

The Deuels purchased the condo in October 1999, giving a purchase money deed of trust for $106,700 to North American Mortgage Company.  At the same time, the couple borrowed an additional $3,300 giving a second deed of trust.  In June 2001, the Deuels refinanced giving a deed of trust for $122,400 to American Mortgage Express Financial.

In September 2002, the Deuels refinanced again giving a deed of trust for $136,000 to Chase Manhattan Bank.  Problem was, the Chase deed of trust did not get recorded in the San Diego County recorders office.  All that got recorded was a release of the $122,400 deed of trust paid off by the Chase loan.

So, as a matter of record, it appeared the Deuels owned the condo “free and clear.”

In 2004, Jill Deuel filed chapter 7 bankruptcy.  Her schedules filed in bankruptcy court showed the $136,000 debt to Chase as “secured,” but Chase now realized their deed of trust was unrecorded.  So Chase filed a motion in the bankruptcy for an order confirming the debt as a security interest in the condo, effective retroactively to September 4, 2002.

Jacob Weinberger United States Courthouse, San Diego, CA

The bankruptcy court ruled in favor of Chase, but the federal court of appeals disagreed and held the deed of trust “avoided.”

The court based its decision on section 544(a)(3) of the Bankruptcy Code.  Section 544(a)(3) allows a trustee in bankruptcy (or a debtor-in-possession) to avoid an interest in debtor real property that has not been perfected as of the commencement of bankruptcy.

The purpose of section 544(a)(3) is to treat all of a debtor’s unsecured creditors equally, and prevent someone bound for bankruptcy from giving preferred (i.e., secured) status to a favored creditor.  It also discourages the debtor who might try to protect assets by slipping a deed to a relative or friend.

Section 544(a)(3) achieves its purpose by giving a trustee the legal status of a bona fide purchaser of debtor real property as of commencement of bankruptcy.  A BFP, without actual or constructive notice of off-record interests, can acquire property free of such interests.

In this case, the court reasoned a BFP would not be charged with constructive notice of the unrecorded deed of trust and, thus, would acquire the property free of the obligation to Chase.

Chase tried to argue that its deed of trust was as good as recorded, since Jill listed the debt as “secured” in her bankruptcy schedules, but the court disagreed saying “if schedules could defeat the trustee’s status as a bona fide purchaser…, a debtor could use simultaneous filing of (the) petition and the schedules to favor one creditor over others.”

Chase also argued it should at least have a security interest in the property to the extent of the loan it paid off (the $122,400 deed of trust), but again the court disagreed citing the overriding purpose of section 544 to treat creditors equally.

Moral:  This is a classic example of section 544(a)(3) in operation.  It is sometimes called the “avoiding” or “strong arm” power.

Seems harsh when you consider the Chase loan was, in a sense, purchase money; but there’s no crying in bankruptcy.

The result here benefits Jill’s unsecured creditors (a group that now includes Chase), and also benefits Jill to the extent her “homestead” may be exempt from claims in bankruptcy.  Since he is not a co-debtor in the bankruptcy, this decision does not affect Will’s interest in the condo (whatever that may be).

The case is In re Deuel (Chase Manhattan Bank v. Taxel), 594 F.3d 1073 (9th Cir. 2010).

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Time and Chance

Saturday, May 8th, 2010

Departing sellers play “the Gap.”

Not so many years ago this house in Rockville, Maryland, was owned by Elizabeth and Charles.

Elizabeth and Charles offered the property for sale and accepted a buyers’ offer of $388,000.  In April, an escrow was opened with a local title company.

The house: You could say they sold it twice

But while it was in escrow, Elizabeth and Charles arranged to take out a new loan against the property.  On July 9, they gave a second deed of trust to secure a loan of $135,000 from First Guaranty Mortgage.  This second deed of trust was recorded in the Montgomery County Clerk’s office on July 20.

Meanwhile, the pending sale came together and, on August 25, it closed.  Escrow disbursed about $208,000 to pay off the first deed of trust, plus sale proceeds of $150,000 to Elizabeth and Charles.  The deed to new owners and their purchase money deed of trust was recorded on September 22.

But what about that second deed of trust, for $135,000?  It went unnoticed, and unpaid through closing, because it wasn’t posted on the county’s online database until August 27–two days after the closing.  It should come as no surprise that Elizabeth and Charles neglected to mention the recent loan when they got their check.

Montgomery County Judicial Center, where the County Clerk was backlogged

The gap between recording of the document and its appearance in the county database was due to a “backlog” at the Montgomery County Clerk’s office.  So the only way the title company could have known about the document would have been to visit the clerk’s office and rummage around.  And, of course, since it had not been paid the “second” became a first deed of trust against the property.

Title insurance paid more than $140,000 to release the missed deed of trust.

Moral:  There are roughly 3,400 county recording offices throughout the United States, and each is its own fiefdom.  Mostly they do a pretty good job, but it’s up to local government and, occasionally, time and chance.

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50 Monkeys

Sunday, April 25th, 2010

Reverter:  A gift of land recalls its purpose.

SANTA ANA, CA–J. E. “Ed” Prentice came to Orange County in the early days, when it was just a farm belt dotted with a few small towns and whistle-stops.

He had  been a teacher, lawyer, and sometimes farmer in his native Kansas when, in 1912, he and his wife Edith came west.

They settled in Santa Ana, the county seat, and Ed got into business trading mules and horses.  He owned a stable in town and folks called him “Judge.”  At home, he kept a pet monkey.

Judge Prentice, with monkeys

By the 1920s, Ed was busy buying orange groves and making farm loans from an office he occupied in the First National Bank Building.  He now had four pet monkeys.

Then came the depression.

It was 1931 and Ed, now 44, held a mortgage against the Melwood Estate on the outskirts of town.  Melwood was 19.23 acres with a sixteen room mansion, a producing orange grove, water plant and packing shed.  The owner was in dire straits, and the mortgage was in default.  Ed foreclosed and got the property for $12,600.

Ed and Edith, who were childless, moved in at Melwood with Ed’s monkeys.  There, they rode out the depression until 1940, when Edith died.  After that, Ed lived alone with a succession of servants who, tormented by monkeys, kept quitting.

By 1949, the Melwood grove was in decline and suffered from disease.  Ed got the idea to give some land to the city for a park.  The gift was accepted, and a deed was recorded conveying twelve acres to the City of Santa Ana, with “conditions.”

The deed conditions were that the land was to be used for a park only, to be named “Prentice Park,” and “at all times ample accommodations shall be provided for 50 monkeys.”  If the monkey population should fall below 50, the land would automatically revert to Ed or his heirs.

The Santa Ana Zoo at Prentice Park opened in 1952.  Ed continued to live next door, but he became irritated that city officials underfunded the park and it looked shoddy.  He called them “knuckleheads,” and grumbled that they should return the zoo to him so he could run it.

The Santa Ana Zoo at Prentice Park

Eventually Ed moved away, and in 1959 he died at age 81.

For more than 50 years all went well at the zoo.  Monkeys played and children came to ogle.  Then, in August 2008, the city got a letter from an attorney representing one Joseph Powell, a grand-nephew of J.E. Prentice.  The letter demanded proof that the zoo had 50 monkeys or, the letter said, “we plan to proceed with our rights under the grant deed to have the property revert back to Mr. Prentice’s heirs.”

It seems the cagey Mr. Powell had visited the zoo and counted monkeys.  There were only 49, he claimed, after the death of a 35-year-old silver langur named Geni.  Within months, the count dropped again with the death of a capuchin named Monty.

The City Council began to fret.  Healthy monkeys, to live in captivity with others of their endangered species, are hard to come by.  International rules have to be followed.

Maya, right, with baby clinging to her back

Then a wondrous thing happened.  The little monkeys rose to the legal challenge mounted by Powell, and a golden lion tamarin named Maya gave birth to twins.

In ensuing months, a pair of crested capuchins named Romeo and Juliet added another offspring, bringing the monkey population to 51.

And zoo officials aren’t sitting on their tails, either.  They announced they will build their collection of “bona fide” monkeys (no lemurs or gibbons) to at least 55.  Romeo and Juliet are, after all, on loan from Brazil.

Moral: The reverter clause is legally enforceable by the Prentice heirs (and who knows how many there are), so this monkey census is serious business.

The stakes are high.  The twelve acres in central Orange County are now worth millions.

It comes down to law; the law of the jungle.

The 1949 deed, with reverter

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Typo 2

Sunday, April 18th, 2010

“There must be some mistake….”

David and Roshan were the first owners of this house in San Marcos, California.

A buyer stuck with his sellers' debt

Within two years the couple refinanced three times, and took out a home equity credit line. Then Roshan filed for divorce.

The court ordered that the house be sold. Since Roshan was uncooperative, David handled the details.

The buyer, Kirk, was quite happy with the home, but puzzled by letters he was getting about an old credit line deed of trust. It seemed the credit line remained open, and was in arrears. Worse, the deed of trust continued to encumber Kirk’s property and the lender threatened to foreclose.

Kirk notified his title company, and within days the mystery was explained.

When it handled Kirk’s purchase, the title company had searched the title but failed to find the problem deed of trust because of a typographical error in its description of the property. Mainly, the document described the correct lot number, but an incorrect map number. Instead of referring to Map No. 13915 (the correct number) the deed of trust made it Map No. 13925. Otherwise, the deed of trust had the correct property address and assessor’s parcel number.

The title company had relied on a search of their proprietary (privately owned) computer database.  This database is programmed with a geographical index.  So in this case the mysterious deed of trust was missed because the searcher entered Map No. 13915, the correct number, in the search field. If instead they had searched the grantor-grantee index in the county recorder’s office, the title company should have found the deed of trust and it would have been taken care of when Kirk bought the house.

In California, as in other states, recording laws state that a duly recorded document imparts constructive notice of its contents. So, legally speaking, Kirk acquired the property subject to the deed of trust, and it could be foreclosed against his ownership.

In other words, he was stuck with his sellers’ debt.

Title insurance paid $110,000 to obtain a release of the deed of trust, and the insurance company has only hopes of recovery from David and Roshan.

Moral: To meet customer expectations title companies have had to expedite real estate transactions through computerized processes and streamlined procedures. There may be new risks involved, but hidden risk has always been a reason for title insurance.

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Typo

Sunday, April 11th, 2010

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.

The house on Lot 79

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).

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