Another Sloppy Lender Takes Hit With Voided Lien In Homeowner's Bankruptcy Case As Mortgage Containing Incorrect Legal Description Falls Outside Property's Chain Of Title, Thus Failing To Provide Constructive Notice To BFPs; Bank Left Holding The Bag Without Loan Collateral, But At Least Wins Fight To File Belated Unsecured Proof Of Claim

From Bankruptcy-RealEstate-Insights:

• A Chapter 13 trustee and the debtor sought to use the strong arm powers of a hypothetical bona fide purchaser of real estate to avoid a mortgage based on the fact that an incorrect legal description was attached to the mortgage and it was indexed in the land records using the incorrect description.
  
  A debtor and his wife acquired property through a deed that correctly described the property by street address, parcel number, and legal description. A year later the debtor executed a note for ~$100,000 payable to a lender, and the debtor and his wife executed a mortgage on the property to secure the note.
  
  The first page of the mortgage granted a security interest in the “following described property” which referenced an attached legal description, and set forth the property tax parcel number and street address. Unfortunately for the mortgagee, although the street address and parcel number on the first page were correct, the attached legal description was for an entirely different property.
  
  Under Section 544 of the Bankruptcy Code, a trustee may avoid a mortgage that is voidable by a hypothetical bona fide purchaser under state law. Typically state law provides that a purchaser can take free of interests unless it has actual or constructive notice of the interest, and typically properly recorded documents provide constructive notice. Under Section 544, the trustee is able to exercise its strongarm powers without regard to any actual knowledge. So the key question was whether a purchaser would have had constructive knowledge of the mortgage despite the incorrect legal description.
  
  The debtor presented testimony about how a title search would be conducted and whether the search would have disclosed the mortgage: The witness said that if he has a deed, he would use the legal description of the property from the deed to begin the search. Alternatively, if he only had the name of the owner or the property address, he would use auditor and treasurer records to obtain a legal description.
  
  He further testified that a search is conducted based on the legal description and not a street address since it is more definitive than a street address and the recorder’s office indexes property based on its legal description. Similarly, the parcel ID number can be helpful in finding a legal description, but once the legal description is located, the description is what is used to review the records.
  
  Once a legal description is identified, the next step is to review the recorder’s index of names. The index identifies instruments and indicates the property subject to the instrument based on its legal description. In this case, the index showed that the debtor had interests relating to three different legal descriptions – identified as Bayberry Trail, Springview Acres, and Rose Estates.
  
  Springview Acres was owned by the debtor and was the property that should have been described in the mortgage. Rose Estates related to property that was not owned by the debtor, and Bayberry Trail described a different piece of property owned by the debtor that was in foreclosure. Thus, the witness testified that he would review only instruments related to the Springview Acres property to identify potential encumbrances in the chain of title. Although three mortgages showed up under the debtor’s name for Springview Acres, all three had been released by recorded documents.
  
  Since the mortgage in question was improperly indexed using the Rose Estates legal description, the witness testified that the mortgage would not fall in the chain of title for the Springview Acres property and would not have been reviewed as part of the title search. There were also no red flags that would have caused him to review instruments outside the chain of title. (For example, a circumstance where an instrument references only a street address and does not contain a legal description.)
  
  Under applicable state law, a purchaser has constructive notice of everything recorded in the chain of title. If a document is within the chain of title, a purchaser is deemed to have constructive notice even if the document is not properly recorded. However, a purchaser is required to examine only those items that “could reasonably be expected to exist in the record chain of title” and it is “not required to exercise a higher degree of diligence and undertake an exhaustive search of the records to discover the most remote adverse claims or encumbrances.”
  
  Although a document that is improperly recorded outside the chain of title might provide constructive notice, the court was clear that if a document improperly identifies the property so that it is recorded outside the chain of title through no fault of the recorder, a bona fide purchaser does not have constructive notice. The court distinguished a 6th Circuit case holding that a mortgage provided constructive notice when it included a correct street address. In that case the legal description was missing and there was no incorrect property information.
  
  Given that the lender’s mortgage did not provide constructive notice, it was subject to avoidance under Section 544. Although the plaintiffs sought to bar the lender from filing an unsecured proof of claim after the decision (arguing that it was too late to file a claim), the court relied on FRBP 3002(c)(3) – which generally provides that an “unsecured claim which arises in favor of an entity or becomes allowable as a result of a judgment may be filed within 30 days after the judgment becomes final” – to find that the lender was allowed to file an unsecured proof of claim.
  
  There are a surprisingly large number of cases in which there are errors in execution or property identification in mortgages. The consequence of errors frequently turns on state specific practices. For example, it may make a difference in the analysis if the official record is a grantor-grantee or a tract index. In any event it is a good idea both to pay attention to detail and to stay in touch with your friendly local real estate lawyer.

Source: Strong Arm Powers: Mortgage Boo-Boo Strikes Again.

For the court ruling, see Kellner v First Ohio Banc & Lending, Inc. (In re Geraci), 507 B.R. 224 (Bankr. S.D. Ohio 2014).