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Hiding in Plain Sight

Friday, October 7th, 2011

Enduring rights of parties in possession.

SPOKANE, WA–Clare House is a senior living community on the south side of Spokane. It has a 124-unit apartment complex, flanked by 28 “bungalow” units built in clusters much like attached homes.

Entrance to the Clare House community

The bungalows have been offered under a “Resident Agreement,” by which the buyer pays a lump sum at move-in for the right to occupy their bungalow and use common areas until they die or become unable to care for themselves. When occupancy ends, the resident or their heirs are entitled to repayment of 80 or 85% of the initial lump sum or, in some cases, 80 or 85% of the price received from resale of the bungalow. Each resident is also a member of the Clare House Bungalow Homes Residents Association, an association formed to represent their common interests.

The bungalows occupy a 2.68 acre parcel of land, which continues to be owned by the developer. Beginning in 2004, the developer took a series of loans from “hard money” lenders, secured by deeds of trust against the 2.68 acre parcel. The first of these loans was arranged by the Caudill Group, in the amount of $400,000, secured by a deed of trust in favor of the Caudill Living Trust. There were four subsequent loans, secured by deeds of trust totalling $565,000.

One of the Clare House bungalows

All of these deeds of trust were recorded in Spokane County land records. Prior to the first deed of trust, two of the Resident Agreements had been recorded, even though the bungalow residents did not have proper deeds conveying ownership of the real property.

All was well at Clare House until the developer filed bankruptcy. Then things got dicey. The lenders, headed by the Caudill Group, made known their wishes to foreclose against the 2.68 acre parcel, and oust the residents.

The Residents Association stepped in, and filed an adversary proceeding in the developer’s bankruptcy. The Association asked for a court order that the residents’ rights are superior to rights of the lenders.

The bankruptcy court ruled for the residents, in part. The court ordered that all members of the Residents Association (i.e., all those having a Resident Agreement with the developer) may continue to occupy their bungalows undisturbed by the lenders, even if the lenders foreclose and acquire the land. However, the court also held the residents’ rights to repayment upon termination of occupancy are contractual rights against the developer only, and are not enforceable against any lender.

Aerial view of the Clare House community, with apartment complex, lower left, and 2.68 acre parcel, highlighted

Citing “longstanding common law,” the court explained that one who acquires an interest in real property with actual or constructive notice of the rights of another takes subject to the other’s rights. In modern times, this rule has been refined by statute and case decisions so as to impose a duty on a subsequent purchaser (or encumbrancer) to inquire as to rights of parties in possession of land, “and a failure to inquire results in the new title holder taking title subject to whatever rights of occupancy existed.”

In this case, the court said a “casual observer” could see the bungalows were occupied as “single family residential units,” and inquiry would have disclosed the Resident Agreements. Likewise, these lenders who received financial information from the developer should have been aware of his “basic business model.” The court noted that two Residents Agreements were recorded in the land records, but this does not appear to have been decisive in the court’s reasoning.

So the residents win what amounts to a life estate in their bungalows, but must stand in line as unsecured creditors in the bankruptcy to recover what they can of promised repayments. For their part, the lenders can foreclose, but their security interests are subject to all Resident Agreements made with the developer–even those signed after deeds of trust were recorded.

Moral: Lessons here for everyone, since both residents and lenders now have much, much less than they bargained for.

The case is In re Clare House Bungalow Homes, L.L.C. (Clare House Bungalow Homes Residents Association v. Clare House Bungalow Homes, L.L.C.), 447 B.R. 617 (Bankr.E.D.Wash. 2011).

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False Security

Monday, September 12th, 2011

An unattested mortgage, even when recorded, fails its purpose.

ALPHARETTA, GA–On October 12, 2005, Bertha Hagler refinanced her home.

The property in question, center

She signed two security deeds (akin to a mortgage): A “first” securing repayment of $240,000, and a “second” for a lesser amount. But at closing somehow things got confused, and only the “second” got signed by the notary and witness who were there.

Weeks later when the security deeds were recorded no one noticed that the “first” was not properly attested to.

In April 2007 Bertha filed Chapter 7 bankruptcy, and a trustee in bankruptcy was appointed. The trustee noticed the defective security deed, and filed an adversary proceeding to avoid it as against Bertha’s home.

The trustee relied on Bankruptcy Code section 544(a)(3), the so-called “trustee avoiding power” or “strong arm” power. This code provision allows a trustee (or a debtor-in-possession) to avoid an interest in debtor real property that is not perfected as of the commencement of bankruptcy. (See our posting for 5/22/10, “Bankruptcy 101.”)

Fulton County Courthouse, where the questioned security deed was recorded and indexed in the land records

In this case, the trustee claimed the “first” was not entitled to be recorded in the land records, and thus “perfected,” because it did not comply with Georgia statutes requiring that a mortgage affecting real property be signed and acknowledged before a notary, attested to by the notary, and attested to by one additional witness, in order to be accepted for recording.

The bankruptcy court ruled in favor of the trustee, avoiding the mortgage and relegating the lender to status of an unsecured creditor for the $240,000 debt. The lender would stand in line for cents on the dollar.

The lender appealed, arguing that despite its flaws the mortgage was in fact recorded and correctly indexed in the land records. Anyone who searched the records should find the mortgage and readily understand it was intended to encumber the property. The lender relied on case law holding that a defective instrument once recorded may impart constructive notice of its contents.

The federal district court entertaining the appeal said the issue involved “an unclear question of Georgia law,” and asked the Georgia Supreme Court to decide whether, in Georgia, a recorded security deed with a “facially defective attestation” can provide constructive notice.

The Georgia Supreme Court building

The Supreme Court sided with the bankruptcy court. The Court allowed that a “duly recorded” albeit defective instrument can provide constructive notice, but said this security deed was not duly recorded because a lack of required attestations was apparent “on the face” of the instrument. Instead, the Court cited “longstanding law” that a mortgage recorded with “facial defects as to attestation” may not impart constructive notice.

The Court concluded saying the lender’s position would relieve it and other lenders “of any obligation to present properly attested security deeds.” It would “risk an increase in fraud,” and “shift to the subsequent bona fide purchaser and everyone else the burden of determining (possibly decades after the fact) the genuineness of the grantor’s signature.”

Moral: Another example of section 544(a)(3) at work, and a reminder (if we need one) that legal formalities matter.

The case is U.S. Bank National Association v. Gordon, ___ S.E.2d ___, 2011 WL 1102995 (Ga. 2011).

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Electronic Recording / To Err is Human

Monday, May 16th, 2011

eRecording is here to stay; so is human error.

SEYMOUR, TN–Here’s a failure of title, 21st century style.

The Greene home

Richard and Deana Greene were owners of this newer home in the Smoky Mountains of Tennessee.

In February 2009 the couple borrowed $204,517 from Homeowners Mortgage, giving a deed of trust against the property.

The title agent was Network Closing Services, a company offering regional services through affiliates in 21 states. Network Closing got the deed of trust signed and notarized, and delivered it to Simplifile, an electronic recording agent. Simplifile provides electronic recording services, converting paper documents into digitized images for transmittal via the Internet to local recording offices.

Sevier County Courthouse, home to the Register of Deeds. The statue on the courthouse lawn honors Dolly Parton

The Greene property is located in Sevier County, TN. The Sevier County Register of Deeds has a vendor relationship with Business Information Systems (B.I.S.), so the Register’s office only accepts imaged documents that are formatted and transmitted through B.I.S.

So it happened that this deed of trust went from Network Closing to Simplifile, then from Simplifile to B.I.S., and then from B.I.S. to the Register of Deeds.

The imaged deed of trust was received by the Register’s office on March 11, 2009. It was reviewed by Deputy Register Lois McMurry, who with a keystroke accepted the document and assigned it Instrument Number 09015404, recorded March 11, 2009, at Book 3300, Page 584.

But perhaps she had been too hasty. Before moving on, Ms. McMurry noticed the document had been mislabeled in a data field affixed by B.I.S. for the Register’s use, as “Miscellaneous” instead of “Deed of Trust,” and the Tennessee mortgage tax had not been paid. So she deleted the recording and returned the deed of trust to B.I.S. with advice it was rejected, but it still showed the recording information (Instrument Number, recorded date, and Book and Page numbers).

Moving on, Ms. McMurry re-assigned this identical recording information to the next document in her queue.

B.I.S. got the deed of trust and forwarded it to Simplifile, but failed to report it was unrecorded. Had Simplifile known, they would have advanced the mortgage tax payment and backcharged Network Closing.

The Greenes filed a Chapter 7 bankruptcy in June 2009, and their court-appointed Trustee in bankruptcy filed an adversary proceeding to avoid the unrecorded deed of trust as an interest in the Greene property. Mainly, the Trustee based his action on Bankruptcy Code section 544(a)(3), which allows a trustee to avoid an interest in debtor real property that is not perfected as of commencement of bankruptcy. This is the so-called “trustee avoiding power,” or “strong arm power.” (See our posting for May 22, 2010, “Bankruptcy 101.”)

The Trustee argued the deed of trust was not “perfected,” because there’s no record of it in county land records. The lender (Bank of America, as current holder of the loan) replied the deed of trust was duly recorded, and therefore perfected, because Tennessee law states that a document once accepted for recording cannot later be removed from land records for failure to pay a fee or tax.

The bankruptcy court ruled in favor of the Trustee, allowing that even though Ms. McMurry’s actions were “improper and contrary to statute,” the result was the deed of trust disappeared from Sevier County land records. And, the court concluded, intervening rights of the trustee in bankruptcy prevail over expectations of the lender.

So the lender loses its security, and becomes just another unsecured creditor.

Moral: We’ve said it before, “There’s no crying in bankruptcy.”

The risk that a mortgage or deed of trust is invalid or unenforceable against security property is typically covered by title insurance.

The case is In re Greene (Newton v. Bank of America), 2011 WL 864971 (Bkrtcy,E.D.Tenn. 2011).

The rejected deed of trust, as returned to Simplifile and Network Closing. Note entries in the data field, upper right, as "Miscellaneous" and "zero" mortgage tax (yellow). Note also recording information (red arrow). (Click to enlarge)

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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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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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