ABI NORTHEAST CONSUMER WINTER CONFERENCE
Suffolk University Law School, Boston, Massachusetts
January 17, 2011
THE TRUSTEE’S STRONG-ARM POWERS
MORTGAGE CHALLENGES, CLAIMS AND DEFENSES
A. Introduction
One of the unintended consequences of the boom in “sub-prime” mortgage financing was that, in the rush to create mortgage debts to supply the securitization market, many mortgages were poorly documented and executed. This has been something of a boon to Chapter 7 trustees, because it has created numerous opportunities for trustees to seek to avoid improperly executed mortgages. Conversely, it should raise caution flags not just for mortgagees’ counsel, but for debtors’ counsel as well.
B. The Trustee’s Strong-Arm Power as a Bona Fide Purchaser
Section 544(a)(3) of the Bankruptcy Code grants strong-arm powers to trustees to avoid certain liens as hypothetical bona fide purchasers of real property as of the commencement of the bankruptcy case.[1] The trustee holds the real estate, not as the debtor held the real estate, but with the rights and powers of a bona fide purchaser who bought the real estate from the debtor.[2] The bankruptcy court must look to state law to determine property rights under § 544(a).[3] A bona fide purchaser has been defined in Massachusetts as “[o]ne who buys something for value without notice of another’s claim to the property andwithout actual or constructive notice of any defects in or infirmities, claims, or equities against the seller’s title….”[4] While Massachusetts law states that one cannot be a bona fide purchaser if he or she had actual notice,[5] under 11 U.S.C. § 544(a) the trustee takes as a bona fide purchaser regardless of any actual knowledge of the trustee.[6] However, the trustee is still subject to constructive notice under Massachusetts law.[7] A party is charged with having constructive notice as a matter of law if—but only if—the instrument has been properly recorded.[8] Thus, the trustee takes the debtor’s real estate on the date of the bankruptcy filing as a bona fide purchaser, subject to all of the properly recorded liens and encumbrances and subject to the debtor’s exemption in any equity.
After the trustee avoids a mortgage, 11 U.S.C. § 551[9] automatically preserves the mortgage in the same secured position it had prior to avoidance so that a junior mortgage does not gain priority over it to the detriment of the bankruptcy estate. Otherwise, the trustee would first have to pay off all the junior liens before the trustee could realize any benefit of equity for the estate. The trustee stands in the shoes of the creditor whose mortgage was avoided. Similarly, a debtor with an otherwise valid homestead exemption does not benefit from a trustee’s avoidance of a lien; instead, since a homestead is subordinate to even a subsequently recorded mortgage as a matter of Massachusetts law, it remains subordinate to the voided mortgage.[10]
A mortgage may be recorded, but may nonetheless be invalid. Absent a bankruptcy filing, a mortgagee may reform its mortgage.[11] Once a bankruptcy has been filed, however, the trustee’s strong-arm powers under §544(a) will prevent the mortgagee from reforming the mortgage,[12] leading to the mortgagee’s loss of its lien.
C. Recent Massachusetts Decisions
The first recent successful attack on mortgage acknowledgements occurred in Agin v. Mortgage Electronic Registration Systems, Inc. (In re Giroux)[13] In 2008 the debtor (“Giroux”) filed a chapter 7 bankruptcy petition and schedules, which listed his real property subject to two mortgages held by Countrywide. Countrywide filed a motion for relief from automatic stay to foreclose on the first mortgage. In response, the trustee filed a complaint to avoid the mortgage pursuant to 11 U.S.C. § 544. The trustee argued that the mortgage contained a material defect and therefore could be avoided by him, as the acknowledgement clause of the mortgage in question did not specifically refer to Giroux as the person who appeared before the notary public.[14] While there was no dispute that Giroux signed the mortgage in the presence of a notary public, the notary’s acknowledgement did not specifically state that Giroux signed and acknowledged the mortgage as his free act and deed; instead, it left a blank line where Giroux’s name should have been.[15]
The trustee relied on Mass. Gen. Laws ch. 183, § 30, which provides that a deed or other instrument requires an acknowledgement by one or more grantors or the attorney executing it, and Mass. Gen. Laws ch. 183, § 29, which states that a deed shall not be recorded without an acknowledgement or proof of its due execution.[16] As the acknowledgement was fundamentally incomplete, the trustee argued that the mortgage contained a material defect and should not have been recorded.[17] Because the materially defective mortgage in this case was recorded improperly, it did not provide constructive notice to the trustee, who stood in the position as a hypothetical bona fide purchaser at the commencement of the bankruptcy case, and was therefore voidable under the strong-arm provision.[18]
In response, Countrywide argued that the mortgage was not defective because, as a whole, the document identified Giroux as the mortgagor and, although the acknowledgement clause had a blank, the language in the clause indicated that the signer acted of his own free act and deed.[19] Countrywide, therefore, argued that the mortgage complied with the law and should not be avoided.
The bankruptcy court first determined that the mortgage was defective because applicable law requires a notary public to recite both the evidence relied upon to establish the identity of the signer, and that the signer executed the mortgage as his free act and deed.[20] The court next considered whether the mortgage was so materially defective as to be incapable of providing constructive notice to a bona fide purchaser—the trustee. Persuaded by Sixth Circuit case law,[21] and attempting to predict how the Massachusetts Supreme Judicial Court would decide the issue, the court found that the mortgage was, in fact, materially defective.[22] The court recognized that the policy behind the requirement of a recorded and valid acknowledgement is to substantiate the identity of the instrument’s signer, which is necessary for a “fraud-free system” to enable a “free market.” The requirement instills confidence in buyers and sellers of real property.[23] Absent such an acknowledgement, others cannot be certain who, if anyone, acknowledged the instrument or whether the instrument was signed as a free act and deed.[24]
Although the name of the mortgagor may have been set forth elsewhere in the instrument, and therefore logically should have been the name listed in place of the blank in the acknowledgement clause, this was insufficient to confirm the signature.[25] The court, therefore, rejected the notion that substantial compliance with relevant law could cure the deficient acknowledgement or eliminate the requirement.[26]The court also rejected the idea that the acknowledgement requirement could be overcome by the mortgagor’s intent.[27] Since intent is specific to the person who is acknowledging, if that person is not named in the acknowledgement, it is impossible to substantiate his or her intent.[28] Consequently, the court held that the mortgage was both materially and patently defective, and should not have been accepted for recording.[29]
Next the court had to determine the consequences of the defect. Under Massachusetts law, a mortgage that is defective when recorded does not provide constructive notice to a bona fide purchaser for value.[30] An unrecorded deed is valid only against the grantor, his heirs and devisees, and persons having actual knowledge pursuant to Mass. Gen. Laws ch. 183, § 4.[31] While Countrywide claimed that the trustee had actual knowledge of the mortgage’s validity, the court stated that any personal knowledge of the mortgage’s validity would not be imputed to the bankruptcy estate because, according to 11 U.S.C. § 544(a), the trustee is bestowed the strong-arm power without regard to actual knowledge.[32] Therefore, the court concluded that the trustee could avoid the mortgage pursuant to 11 U.S.C. §544(a)(3), and preserve the mortgage lien pursuant to 11 U.S.C. §§ 550(a) and 551.[33] Judge Feeney’s opinion was subsequently affirmed by the District Court.[34]
In another recent case, the same trustee reached the same result before a different Massachusetts Bankruptcy Court judge. In Agin v. Mortgage Electronic Registration Systems, Inc., et. al., (In re Bower)(referred to as “Bower”)[35], the facts were essentially indistinguishable from those in Giroux, and Judge Hillman reached the same result, holding that “[t]the execution of a mortgage acknowledgement is not a ‘purposeless formality.’ Mortgage acknowledgements must be strictly executed in the manner prescribed by Massachusetts law or they are invalid.”[36] The defendant tried to argue that, since the funds lent in connection with the avoided mortgage were used at least in part to pay prior mortgages, it should be equitably subrogated to those mortgages. The Court rejected the argument, because the trustee’s rights as a bona fide purchaser without notice cut off any rights for equitable subrogation. Finally, the Court rejected the defendant’s argument that avoiding the mortgage would lead to unjust enrichment, writing that even if some of elements of the doctrine were satisfied, the mortgagee’s own negligence compelled a conclusion that any “impoverishment” of the mortgagee was unjustified. “The Mortgage is subject to avoidance under 11 U.S.C. Sec 544(a)(3) because of the assignor’s negligence in executing the acknowledgement and failure to satisfy the statutory requirements to acknowledge and record the Mortgage.[37]
Not all potential defects in a mortgage acknowledgement are sufficient to constitute a material defect. In In re Dessources[38] the acknowledgement properly identified the debtor; however, it failed to specify how the notary identified the mortgagor, i.e., by personal knowledge, driver’s license, or other identification. In response to a motion for relief from stay, the Chapter 13 debtor asserted that the failure rendered the mortgage voidable. While the Court ruled that the Debtor had standing to raise the issue, at least in the context of objecting to stay relief,[39] the Court denied the debtor’s challenge to the validity of the mortgage. The Court found that there was a critical distinction between a failure to identify the mortgagor, which is required by the statutory form acknowledgement,[40]and a failure to include the manner of identification, a requirement which is not in the statutory form but appears only in a 2004 Executive Order by the Governor. The latter did not have the force of law, and therefore its absence from the acknowledgement was not fatal to its validity.[41]
What if the mortgage is granted by a party other than the maker of the note for which the mortgage is intended to act as security? In In re D & S Contractors, Inc., [42] the mortgage was executed by the corporate debtor, and properly acknowledged. However, the note, which was issued in connection with a refinancing of the property, was executed by the sole shareholder individually. In response to the mortgagee’s motion for relief from stay the trustee asserted that as the original note executed by the corporate debtor had been satisfied, the mortgage no longer secured any debt. The Bankruptcy Court rejected the trustee’s argument. Relying on Massachusetts case law, the Court determined that the mortgage was clearly intended to secure the note, even if not signed by the debtor, and that since there was consideration for the note, i.e., the refinancing of the earlier obligation, the mortgage remained as security for the note. At best, the failure to have the note executed by the corporate debtor rendered the obligation non-recourse.[43]
Alteration of the mortgage after it has been executed can lead to avoidance, as illustrated by yet another recent case, Agin v. South Point, Inc. (In re Kurak).[44] On May 21, 2008, Debra A. Kurak (“Kurak”) filed for chapter 7 bankruptcy protection.[45] She listed ownership of real estate that was subject to a lien for which she had no contractual liability.[46] South Point, Inc. (“South Point”) filed a motion for relief from automatic stay to enforce its rights under the note and first mortgage. In turn, the trustee filed an adversary proceeding against South Point challenging the validity of the mortgage as pertaining to Kurak and seeking a determination that South Point could not reform the mortgage in light of the trustee’s strong-arm powers under 11 U.S.C. § 544(a).
The trustee’s challenge to the validity of the mortgage focused on the capacity in which Kurak executed the mortgage.[47] The real estate closing occurred at Kurak’s home, which she co‑owned with Manuel Lopes (“Lopes”), who did not file for bankruptcy. The closing attorney took the signed mortgage back to his office and made three copies. It is undisputed that Kurak signed the mortgage in the presence of a notary public and initialed each page, as did Lopes. However, two different versions of the same mortgage eventually came to light. In one version (hereinafter the “First Version”), the first page of the mortgage did not list Kurak as a borrower; only Lopes was listed.[48] The signature page of the First Version was executed by Kurak above the word “witness,” that was typed in separately and the word “borrower” was crossed out.[49] Lopes executed as a borrower. A second version of the mortgage was recorded with the registry of deeds (hereinafter the “Second Version”).[50] The first page of the Second Version identified both Lopes and Kurak as the borrowers, but Kurak’s name appeared in a different typeface than Lopes’ name.[51] On the signature page, both Lopes and Kurak signed over the word “borrower.” Apparently after the closing, the attorney’s assistant faxed a signed copy of the mortgage to South Point, which asked that Kurak’s name be added to the first page as a “borrower.”[52] The closing attorney guessed that South Point’s office crossed out the word “borrower” and typed in the word “witness” on the signature page of the First Version of the mortgage because that did not appear on the recorded mortgage or the copy that was at the attorney’s office.[53]
Even though Kurak signed the mortgage in the presence of a notary public and initialed each page, the predicament in this case is that, when she signed the mortgage, she was not a defined borrower.[54] The issue was thus whether the alteration of the mortgage after its execution was a material alteration. The trustee argued that the mortgage was invalid as to Kurak because the attorney’s office altered the document after its execution.[55] A mortgage is a contract, and to determine the terms of the contract one must look at its four corners, absent extringent evidence.[56] Therefore, the trustee argued that, at the time of the mortgage’s execution, it was simply a mortgage from Lopes to South Point—not a mortgage from Lopes and Kurak. Adding Kurak to the first page as a “borrower” after she signed the mortgage could not expand the scope of the mortgage to something it was not.[57]
The Bankruptcy Court ruled in the trustee’s favor, finding the mortgage to be unenforceable against Kurak’s interest in the property. The court found that Kurak’s name did not precede the granting language in the mortgage, but was later added without her authority, and without the re-acknowledgement of her signature.[58] According to common law, an unauthorized alteration of a written instrument by a party or holder voids the instrument, and the person who altered it cannot recover upon it as altered.[59] Therefore, the court held that the mortgage was ineffective to divest property rights from Kurak to South Point and accordingly invalid.[60] Due to the trustee’s position as a bona fide purchaser, South Point was prevented from reforming the mortgage. This opinion has also recently been affirmed by the District Court.[61]
These are, of course, only a few of the potentially material defects that could lead to avoidance. The names of the mortgagors or mortgagees may be misspelled or omitted. Property descriptions may be incorrect or absent altogether. The mortgage may not cover all of a debtor’s property, if it has been acquired in several parcels over a number of years. Mortgages or acknowledgements may be incorrectly dated. The notary’s commission may have expired. Mortgages are sometimes recorded in the Registry of Deeds when they ought to be filed in the Land Court side of the Registry. To the extent that these defects are sufficiently material that a bona fide purchaser would not be on record notice of the mortgage, they may provide trustees opportunities to avoid liens.
In light of these opinions it is critical for bankruptcy counsel—both for lenders and debtors—to carefully review mortgage documentation before filing any pleadings with the bankruptcy court. For mortgagees’ counsel, the reasons are obvious. Trustees are giving all mortgages extra scrutiny in search of opportunities to exercise their avoiding powers. Filing a motion for relief from stay obviously invites a trustee to review the note and mortgage for any defects. If mortgagee’s counsel has any questions about the enforceability of the lien, he or she may want to reconsider whether to seek relief, or wait until a case is closed.
The need for debtors’ counsel to review the mortgage documentation is slightly less obvious, but equally important, especially in situations in which debtors intend to retain the real estate. If the trustee discovers a material defect in a mortgage and successfully avoids the lien for the benefit of the estate, the equity created by the avoidance is superior to any homestead exemption that may be available to the debtor.[62]The trustee is under no obligation to simply take monthly payments for the duration of the term of the note. Instead, the next step for the trustee will be attempting to realize funds for the avoided lien. If the debtor wants to keep the property he or she will need to have a means of compensating the trustee for the value created by the avoided lien. In the current economic climate especially, this can be problematic, to say the least. It the debtor cannot do so, the trustee may sell the lien position to a third party, or he or she may even be able to sell the property altogether.
In other words, bankruptcy attorneys not only need to be knowledgeable about the Bankruptcy Code, we need to be experts in real estate law as well, in order to avoid unforeseen problems for our clients.
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