Articles and Publications

11/19/2020

Mortgage lenders can successfully defend their liens against the bankruptcy trustee's avoidance powers

The COVID-19 pandemic has caused, among other things, significant delays in the recording of real property-related instruments by county officials. Before the pandemic, county recorders processed mortgages submitted for e-filing within a matter of days; now, in Cook County alone, it often takes six to eight weeks for a document to appear in the county’s land records. This development is especially problematic for lenders who rely on the timely recording of mortgages to perfect their security interests in real estate and, ultimately, ensure repayment of their borrowers’ mortgage loans.

Because of the recording delays and difficult economic conditions caused by the COVID-19 pandemic, borrowers are increasingly filing for bankruptcy after they have closed on the purchase of new homes but before their mortgages have been recorded. Additionally, borrowers are filing for bankruptcy within 90 days of taking out residential mortgage loans. Due to the recording delays, these transactions may qualify as preferential transfers. In both situations, the bankruptcy trustee may seek to avoid the mortgage lien and treat the lender’s claim as unsecured. Although the trustee typically wins in an avoidance action, there are certain situations where lenders can successfully defend their liens. This article discusses these situations and the limits of the trustee’s avoidance powers.

Bankruptcy trustee’s avoidance powers

The trustee has a number of avoidance powers under the United States Bankruptcy Code. Under Section 544, the trustee has the rights of a hypothetical bona fide purchaser, which empower the trustee to avoid any mortgages that are not recorded at the time of the borrower’s bankruptcy filing. Additionally, the trustee has the power under Section 547 to avoid preferential transfers, which are transfers that occur on or within 90 days of the borrower’s bankruptcy filing. For purposes of this section, a transfer occurs on the date of the mortgage loan so long as the mortgage is recorded within 30 days of the loan; otherwise, the transfer is deemed to occur on the date on which the mortgage is recorded. Given current recording delays, it is more likely that a mortgage will not be recorded within 30 days, thus increasing the likelihood that the transaction will qualify as a preferential transfer if the borrower files for bankruptcy.

Unrecorded mortgages

Where a mortgage is unrecorded at the time of a borrower’s bankruptcy filing, a lender may succeed against the trustee, thus preserving its lien, if it can successfully provide an equitable subrogation argument. Under equitable subrogation, if a mortgage lender makes a loan to refinance an existing mortgage on the property then that lender can step into the shoes of the prior lender. Often, a refinancing mortgage will be recorded shortly after the loan transaction closes; only then will the prior mortgage on the property be released.

With the current recording delays, it is likely that a borrower will file for bankruptcy after the refinancing mortgage loan has closed—and after the prior mortgage has been paid off—but before the refinancing mortgage has been recorded. The good news for lenders is that courts typically will apply equitable subrogation principles to hold that the trustee’s avoidance powers are defeated so long as the prior mortgage is still of record. In that case, the trustee is deemed to have constructive knowledge of the refinancing mortgage. It is important to note that, although the bankruptcy trustee’s avoidance powers arise under federal law, their scope is governed by state law, including equitable subrogation.

Preferential transfers

A Michigan bankruptcy case, In re Schmiel, provides an avenue for attempting to defeat a trustee’s claim to avoid a mortgage as a preferential transfer. In that case, a mortgage was taken out to refinance a prior mortgage on the subject property. The mortgage was submitted to the county recorder’s office, but due to a backlog, it was not stamped until three months later. The borrowers filed for bankruptcy about 60 days after the mortgage’s recording. The trustee then filed an adversary proceeding seeking to avoid the mortgage as a preferential transfer. Specifically, the trustee argued that the mortgage was not recorded until it was officially stamped; because that was within 90 days of the bankruptcy filing, the trustee argued that he could avoid the mortgage as a preferential transfer.

After examining Michigan state law, the bankruptcy court held that a mortgage is deemed to be recorded upon receipt of the document by the recorder so long as the mortgage satisfies the statutory requirements for being a recordable mortgage. The court determined that the necessary requirements were: (1) the mortgage must be received by the recorder; (2) the mortgage must meet the technical requirements for a mortgage; and (3) the recording fee must be paid when the mortgage is submitted. 

Importantly, the court noted that it is unfair to penalize the lender when it has done everything possible on its end to record the mortgage and the mortgage remains unrecorded only because of the recorder’s delay in performing her statutory duty. Ultimately, this case provides some hope for lenders that they can defend their liens against the trustee’s avoidance powers in certain circumstances.

Feel free to consult with a Chuhak & Tecson Banking attorney who will be happy to answer questions regarding this topic.

Client alert authored by Aaron D. White, Jr. (312 855 6414), Associate.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.