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Lien Perfection Issues in BK

by Jennifer M. West
South & Associates, P.C. – USFN Member (KS, MO)

Lawsuits against loan servicers have become commonplace in many bankruptcy courts throughout the country, with several aggressive bankruptcy trustees trying to take advantage of the negative perceptions currently associated with mortgage loan servicing. Bankruptcy trustees are reviewing security instruments with watchful eyes in the hopes that there may be some basis to void the lien because the lender’s security instrument has a perfection issue. Oftentimes, the lender has no knowledge that its security instrument was not properly perfected in accordance with relative state laws until it is blindsided with an adversary proceeding filed by the bankruptcy trustee, seeking to void the lien under Bankruptcy Code § 544(a)(3).

Despite increases in litigation, the mood of bankruptcy courts across the nation appears to be softening somewhat, and many courts are actually giving servicers the benefit of the doubt, at least as it pertains to perfection issues involving the lender’s security instrument. As such, this article will consider the impact of recent court decisions brought under § 544(a)(3) and provide some suggestions for servicers once a perfection problem is discovered during bankruptcy.

Some Good News for Servicers
Assuming the lien is not properly perfected, the bankruptcy trustee may attempt to void the creditor’s lien by filing an adversary proceeding. Under § 544(a)(3), the trustee has the power to avoid any transfer that would be voidable by a bona fide purchaser. In other words, the bankruptcy trustee “steps into the shoes” of a hypothetical bona fide purchaser. What constitutes a bona fide purchaser will vary depending on the jurisdiction. For instance, in Missouri a bona fide purchaser is defined as “one who pays a valuable consideration, has no notice of outstanding rights of others, and who acts in good faith.” See Johnson v. Stull, 303 S.W.2d 110 (Mo. 1957).

Many courts have been taking a pragmatic approach favoring validity of the security instrument, at least in cases where the mortgage has an erroneous legal description. Although the impact of these decisions may not be immediate, over time bankruptcy trustees in these jurisdictions may be less likely to pursue litigation upon discovery of an unperfected security instrument.

Hot off the press, the Sixth Circuit has affirmed a decision out of the Southern District of Ohio validating a mortgage that included the street address of residential property but failed to contain the legal description. In re Bunn, 2009 WL 2590054. According to the court, a bona fide purchaser “has a duty to make a reasonable inquiry when an irregularity or a suspicious circumstance is apparent on the recorded instrument.” Thus, the burden to inquire further appears to be on the bona fide purchaser in this case.

Additionally, the Tenth Circuit recently refused to void a lender’s mortgage, which contained an erroneous lot number but stated the correct street address and parcel identification number, stating that Kansas law “requires only that the property description be sufficient to identify the property.” In re Colon, 2007 WL 627664. In this case, there was a subordination agreement in the chain of title that referenced the lender’s lien, but contained the same lot number error as the lender’s mortgage. The court concluded that a reasonable search of the records would put a bona fide purchaser on notice of the lender’s lien, and refused to allow the bankruptcy trustee to exercise its strong-arm powers under § 544(a)(3).

Similarly, courts in states such as New York, Missouri, and Alabama were reluctant to invalidate a security instrument because of a scrivener’s error, particularly since in most cases, the lender played no role in causing the error. As seen from the In re Hojnoski case out of New York, 335 B.R. 282, the bankruptcy trustee sought unsuccessfully to void a mortgage that was incorrectly indexed under a misspelled name. Based on the evidence presented, the court concluded that it would be reasonable for a prospective purchaser to question whether there was an indexing error. See In re Gresham, 373 B.R. 914; In re Hagendorfer, 803 F.2d 647.

Conversely, an Ohio bankruptcy court in In re Easter, 367 B.R. 608, reached a different conclusion on similar facts and voided a lien with an erroneous legal description that provided the correct street address and parcel number, citing that this information is for the “convenience of the parties” and does not put a reasonable person on notice that he should make further inquiry. See also In re Hiseman, 330 B.R. 251. Very recently, a district court out of Michigan ruled that an affidavit of lost mortgage that included a copy of the original mortgage was insufficient to perfect the security instrument and voided the lien. In re Neal, 408 B.R. 288.

Suggestions for Servicers
If a mortgage is not properly perfected at origination, many times servicers will not discover this until after the borrower’s bankruptcy has been filed. As the cases referenced above illustrate, common lien perfection issues that arise may include an erroneous or omitted legal description, incorrect tax identification number, incorrect street address, or the failure of a husband and wife to both encumber the deed of trust.

While there are exceptions to the rule, often the servicer will discover the perfection issue before the bankruptcy trustee files an adversary proceeding. In this situation, there are many issues for the servicer to consider. It is imperative that the servicer discuss all options with local counsel, since rules and procedures will vary among jurisdictions.

One common question that arises is: when should the lender file a title insurance claim? Assuming that the lender has a final mortgage policy, it is prudent to file a title insurance claim with the underwriter immediately once a perfection issue is discovered. The burden then shifts to the underwriter to correct the problem with the security instrument, or to defend an adversary proceeding on behalf of the insured in the event that it becomes necessary. It also decreases the likelihood of a denial of insurance coverage due to delay.

Another delicate issue involves whether there is an ethical duty to notify the bankruptcy trustee once the perfection issue is discovered. Under 11 U.S.C. § 546(a), the trustee will have two years from the date of bankruptcy filing to file an adversary proceeding. Does this mean that a lender must wait for the statute of limitations to expire before attempting to perfect its mortgage and to enforce its security interest for the defaulted loan? Fortunately, lenders have more appealing and proactive options than playing the waiting game.

Here are a couple of suggestions for the servicer when considering the level of disclosure to the trustee that is required. First, if there is title insurance coverage, it is important to discuss disclosing the perfection issue to the trustee with the title insurance underwriter. Notifying the title insurer of this potential issue in writing is important because action taken by the insured lender post-title claim has the potential to result in a coverage dispute.

Second, servicers should also discuss disclosure requirements with local counsel. The best course of action may be dictated by timing. For example, the servicer may not have a duty to notify the bankruptcy trustee of a perfection issue while the bankruptcy is pending. However, if the lender files a reformation lawsuit to correct the problem after relief from stay is obtained, the bankruptcy trustee may be a necessary party to the lawsuit.

By having expertise and familiarity with a particular jurisdiction, local counsel can help servicers protect the security instrument in these delicate situations.

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