Screw-Up In Preparing Loan Document Invalidates Lender's Lien In Borrower's Bankruptcy Proceeding; Contention That Trustee Had Constructive Notice Of Mortgage Falls On Deaf Ears

From a post on the blog Bankruptcy-RealEstate-Insights.com:

• Typically an unrecorded mortgage will be void as against a bona fide purchaser under state law. This in turn will allow an unrecorded mortgage to be avoided in a bankruptcy using the "strong arm" powers under Section 544 of the Bankruptcy Code.Thulis reaches this result after a discussion of circumstances that may provide notice to a purchaser besides constructive notice from a recorded document.
  
  The debtors owned two adjoining parcels described as Lot 1 and Lot 2.The mortgage securing a loan to finance construction of a residence on Lot 1 was supposed to encumber both lots. Unfortunately for the bank, only Lot 2 was included in the legal description attached to the mortgage. When the construction loan was refinanced, the new mortgage also referenced only Lot 2.
  
  Although all parties acknowledged that the bank intended to take a mortgage on Lot 1, the bankruptcy trustee pointed out that "it is not the thought that counts, but what is recorded with the register of deeds." (The court commented in a footnote that a Google search of this phrase turns up a response attributed to Winnie-the-Pooh that: "If it is the thought that counts, why are there fingers?"However, it also noted that in many situations the observation of a 19th century naturalist that "the smallest deed is better than the greatest intention" is more applicable.)
  
  This case involves a typical state statute that provides that unrecorded mortgages are void as against subsequent good faith purchasers. Normally a purchaser receives constructive notice of prior interests through recorded documents. However, the court acknowledged that there are limited circumstances in which a purchaser is deemed to have notice of interests through other sources (which would mean that it would not be a good faith purchaser).
  
  Under applicable state law if a purchaser has actual notice of the prior interest, it would not be entitled to the benefit of the statute providing that unrecorded interests are void. However, this does not apply in the context of exercising the rights of a bona fide purchaser under Section 544 of the Bankruptcy Code since this section specifically provides that the rights are "without regard to any knowledge of the trustee or of any creditor."
  
  The court acknowledged that a purchaser could also be held responsible under state law for things that would be revealed by the public record or the property itself. One example was a sale involving a boundary dispute. The court concluded that the key was possession. Another similar example was a purchaser under an unrecorded land contract that was in sole possession of the property. The focus is on "use or occupancy" of the property that would provide notice of the interest.(1)
  
  Although the court characterized it as "possible" that a visit to the property or discussion with the owners might happen to lead a buyer of Lot 1 to learn about a mortgage on the adjacent Lot 2, that was not legally relevant. The court determined that there was nothing in the circumstances of this case that would have provided affirmative notice of the bank's intent to encumber Lot 1.
  
  The bottom line is that the bank was out of luck: It could have protected itself by recording a mortgage with a proper legal description. The bank's mortgage was outside Lot 1's chain of title and a subsequent good faith purchaser would not have had any notice of the bank's mortgage. Consequently, the mortgage was void as against a bona fide purchaser, and the bank's claim was treated as unsecured.
  
  As illustrated in several prior blogs (for example, Strong Arm Powers: Bye Bye Mortgage), minor errors in a mortgage can have major consequences in a bankruptcy. Thulis serves as a reminder that attention to detail is critical since the mortgage lien itself is at stake.

Source: Mortgage Legal Descriptions: When Is A "Boo-Boo" Fatal (Round 1)?

For the court ruling, see In re Thulis, 474 B.R. 668 (Bankr. W.D. Wis. 2012).

(1) With regard to the effects on the bankruptcy trustee, the court made the distinction between "actual notice" and "constructive notice", and the effect on the trustee of the rights of others arising from use or occupancy of real estate by others pursuant to some unrecorded property interest:

• In addition, Wis. Stat. § 706.09(2)(a) describes the limited situations in which a purchaser is deemed to have notice of a prior claim apart from the title record. A purchaser is presumed to have affirmative notice of a prior claim apart from the title record only if there is "notice, actual or constructive, arising from use or occupancy of the real estate by any person at the time such purchaser's interest therein arises."[13]
  
  Actual notice means exactly what it says. Someone who actually knows about a prior claim or interest cannot claim the benefit of the recording statute.
  
  However, actual notice is no defense against the bankruptcy trustee. In re Sandy Ridge Oil Co., 807 F.2d 1332, 1336 (7th Cir. 1986) ("actual knowledge is irrelevant under § 544(a)").
  
  Constructive notice is a different story. Courts have typically concluded that a bankruptcy trustee's avoidance powers are subject to any state law limitations regarding constructive notice. See In re Probasco, 839 F.2d 1352 (9th Cir. 1988); Brown v. Job (In re Polo Builders, Inc.), 433 B.R. 700 (Bankr. N.D. Ill. 2010). In that regard, Wisconsin law reflects a public policy that prospective purchasers are subject to any liabilities or interests which could have been discovered through a reasonable degree of care in consulting certain "avenues of information." Bump, 133 N.W.2d at 299.
  
  The relevant avenues are the records in the office of the appropriate register of deeds, other public records, and the land itself, by which it is possible to "discover by observation the rights which arise outside of the recording system by virtue of possession or use." Bump, 133 N.W.2d at 300 (emphasis added). If it is possible to discover something (such as evidence of a competing claim) by reviewing one of these resources, a subsequent purchaser cannot rely on the recording statute.

***

• The purpose of the recording statute is to ensure a "clear and certain system of property conveyance." Brown, 656 N.W.2d at 61. Wis. Stat. § 706.09(2)(a) addresses situations in which a purchaser is deemed to have notice of a prior claim "apart from the record." Because the bank's mortgage is outside the chain of title, it is void against the claim of the trustee as a subsequent purchaser unless such a purchaser would have had constructive notice of the mortgage "arising from use or occupancy of the real estate by any person at the time such purchaser's interest therein arises."
  
  As Wisconsin courts have noted, "No other types of constructive notice are detailed." See Bank of New Glarus v. Swartwood, 2006 WI App 224, 297 Wis. 2d 458, 725 N.W.2d 944, 956 (2006). The policy behind this provision is a compromise between two competing goals — namely, merchantability of title and the protection of legitimate but otherwise hidden land interests. Id. (citing Lubahn, 365 N.W.2d at 621).
  
  In balancing these goals, Wisconsin courts have imputed notice to purchasers only in limited situations, such as instances involving the adverse rights of someone actually in possession of the property or where the purchaser was deemed to have notice of issues with the property that were visible upon physical inspection.
  
  In this regard, the land is a "universal manuscript, open to the eyes of all," and a purchaser is expected to read that manuscript to discover any evidence of the rights of third parties. See Horicon State Bank v. Kant Lumber Co., 165 Wis. 2d 543, 478 N.W.2d 26, 28 (Wis. Ct. App. 1991) (citation omitted).
  
  Bump, for example, involved a boundary dispute. The defendant purchased part of an adjoining lot and landscaped the property to "physically incorporate" it into his yard. The sale was not recorded and the subsequent purchasers of the adjoining property contended that they owned the entire lot. The court concluded that the subsequent purchasers had constructive notice of the initial purchaser's claim because they could have located the actual boundaries of the property with relative ease and did not do so.
  
  The court observed that the possession of land is constructive notice of "whatever rights the possessor may have in the land if such possession is visible, open, clear, full, notorious, unequivocal, unambiguous, inconsistent with, or adverse to the title or interest of the vendor." Id. at 298.[20] The key to this inquiry is possession, as an occupant with an adverse interest isn't likely to hide it when asked.
  
  This concept fueled the result in both Fitzpatrick (which was cited by the bank) and this Court's own Fibison decision, both of which involved a dispute between a bankruptcy trustee and purchasers who acquired their interests pursuant to unrecorded land contracts.
  
  In each case, the trustee was found to have constructive notice of the land contract interests because the property was held by someone whose interest was inconsistent with record title.[21] A land contract purchaser who has sole possession of the property is clearly the sort of "inconsistent or adverse interest" that could be discovered through a simple inquiry.
  
  Under Wisconsin law, a bankruptcy trustee would clearly have constructive notice of such an interest. See Wis. Stat. § 706.09(2)(b) (a purchaser has notice apart from the record arising from "use or occupancy of the real estate by any person at the time such purchaser's interest therein arises"); Fitzpatrick, 29 B.R. at 704; Fibison, 2011 WL 6149269, at *4.

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For the rights of persons in possession of real estate pursuant to an unrecorded interest, or by reason of some equity, see generally, Bona Fide Purchaser Doctrine, Possession Of Property By Occupants Other Than The Vendor & The Duty To Inquire.