Defective Real Estate Documents: What Are the Consequences?

Editors’ Synopsis: This Article discusses recent case law regarding whether a recorded but defectively executed or acknowledged mortgage may be deemed valid, whether it imparts constructive notice to, and is entitled to priority over, subsequent judgment creditors and lienholders with validly executed and recorded documents, and particularly, whether a trustee in bankruptcy may avoid the defectively executed mortgage. This Article also addresses the impact of errors in the indexing of real estate documents, the title insurer’s liability if the mortgage is deemed invalid because of a defect in it or the underlying note, and whether improperly executed documents should be reformed or deemed invalid.

INTRODUCTION
A flurry of recent case law addresses the issue of whether, notwith-standing a defective execution or acknowledgment (or other defect), a recorded document is still effective for the purpose of imparting construc-tive notice to other lienholders and judgment creditors who have properly recorded their interests without any defect. The resolution of this issue is extremely important to mortgage lenders, mortgage brokers, issuers and holders of securitized mortgages, and title insurance companies. Resolution of the issue is also critical to determining priorities when a bankruptcy proceeding is filed by or against the mortgagor. Section 544(a) of the Bankruptcy Code (the so-called Astrong-arm@ provision that enables the trustee to invoke state law remedies) provides that, at the commencement of the case, the trustee has the rights of a bona fide purchaser of real property, without regard to any knowledge of the trustee or any creditor, and may avoid an unperfected transfer of land.1 Furthermore, the trustee generally is deemed to lack notice of a properly recorded, but otherwise defective, mortgage.2 But the trustee cannot otherwise avoid a transfer after being put on constructive notice or inquiry of a properly recorded prior claim.3 Applicable state law determines the bankruptcy trustee=s status as a bona fide purchaser, pursuant to section 544(b) of the Bankruptcy Code.4 Recent case law, both state and federal, generally upholds strict compliance with state law regarding the validity of defective recorded documents and whether they provide sufficient notice to third parties, but some notable exceptions exist, based on the specific facts of the case and applicable state law.

CONCLUSION
As evidenced by the cases and statutes discussed in this Article, many states require that an instrument be acknowledged in order to be entitled to recordation, and a few of these even hold that an unacknowledged document is unenforceable against third parties with actual knowledge of the documentCa strong incentive for notaries not to sign false acknowledgments or acknowledge documents outside the presence of the parties whose signatures are to be notarized. The purpose of the notarization is two-fold: first, to be sure the parties are who they say they are; and second, to be sure that the execution of the document is their voluntary act and deed. Conscientious notaries ask for identification and will not notarize a document if it is apparent that the signature is under a disability or obvious duress. Another reason for caution and carefulness with respect to the correct completion and acknowledgment of a mortgage and related documents is the specter of an adversary claim by the trustee or debtor in possession if a bankruptcy proceeding is subsequently filed by or against the mortgagor. As noted earlier in this Article, the Astrong arm@ language of section 544(b) of the Bankruptcy Code264 enables the trustee or debtor in possession to avoid any transfer of an interest of the debtor in property that is avoidable under applicable state law. Section 544 vests a bankruptcy trustee with the rights of a hypothetical lien creditor whose lien was perfected at the time of the filing of the bankruptcy petition. If another creditor who claims a lien against the applicable property has not properly perfected its lien as of the filing of the bankruptcy petition, the trustee or the debtor-in-possession can avoid that creditor=s lien, and that creditor then becomes a mere unsecured creditor of the estate. The purpose of section 544 is to arm the trustee with sufficient powers to acquire and evaluate all the property of the estate. The trustee or debtor-in-possession is considered a bona fide purchaser of real property in the bankruptcy estate and may avoid obligations of the debtor that are voidable by such a purchaser. Section 544, as well as sections 547 and 548 of the Bankruptcy Code, also avoids one creditor being given favored treatment by a debtor, to the detriment of debtor’s other creditors, on the eve of bankruptcy. This occurs when a debtor gives title to property, or a security interest therein, to one creditor just before filing bankruptcy, thus, forsaking all others. In response, the drafters of the Bankruptcy Code created remedies to avoid unperfected security interests as of the commencement of bankruptcy (section 544), preferential transfers not supported by new value (assets) received by the debtor immediately prior to bankruptcy (section 547), and fraudulent transfers by the debtor, within two years of the date of filing, with the intent to defraud creditors or while the debtor was insolvent and without reasonably equivalent value (assets) being received by the debtor (section 548). (Section 548(a)(1) of the Bankruptcy Code was amended in 2005 to extend the Areach back@ period or avoidance of fraudulent transfers from one year to two years.265) While the drafters of the Bankruptcy Code created a few “safe harbor” defenses to the operation of these sections, pre-bankruptcy payments by the debtor are not among them. Again, the true purpose of these statutory provisions is not to cancel the debt (although that is often the result), but is instead to treat all creditors equally and fairly with respect to access to the debtor’s assets. Finally, the enactment of savings statutes, which provide (whether under a substantial compliance test or otherwise) that defectively executed or performed acknowledgments will not cause a recorded document to be deemed defective and will nonetheless constitute notice to third parties, should be encouraged. Such legislation, which local and state bar associations should be encouraged to promote, provides certainty and reliability of land records and elevates substance over form, making life easier for title insurers. It also cures the unintended effect of lack of notice that defective acknowledgments receive in bankruptcyCwhich presently permits trustees and debtors-in-possession to avoid entire liens and encumbrances based on legal technicalities that differ among the states.