The Ohio legislature didn’t go far enough to protect mortgage lenders from predation by bankruptcy trustees feasting on defectively executed mortgages, as the Sixth Circuit explained in a March 5 opinion.

Using judicial sleight of hand, the appeals court found appellate jurisdiction even though the order on appeal wasn’t final, strictly speaking.

The Defective Mortgage

A couple filed chapter 7 owning a home where they had lived for 10 years. When the couple purchased the home, they did not acknowledge the mortgage before a notary. Everyone agreed that the mortgage was defectively executed.

Ordinarily, avoiding the mortgage would be a walkover for a trustee exercising rights under Section 544(a)(1) and (a)(3) as a bona fide purchaser or a hypothetical judicial lien creditor. However, the Ohio legislature adopted a statute in 2013 designed to salvage some defective mortgages.

The Ohio Supreme Court interpreted the statute in 2016 to mean that a defectively executed mortgage nonetheless provides constructive notice of the mortgage, allowing the defective mortgage to prevail over a bona fide purchaser.

So, the couple’s trustee lodged a complaint to avoid the mortgage, asserting the trustee’s rights as a judicial lien creditor, not as a bona fide purchaser. The holder of the mortgage filed a motion to dismiss, arguing that the Ohio statute should preclude attack from a judicial lienholder just as it does from a bona fide purchaser.

The bankruptcy court denied the lender’s motion to dismiss. To resolve a split among Ohio judges, the Bankruptcy Appellate Panel granted leave to appeal an interlocutory order. The BAP affirmed.

BFPs and Judicial Lienholders Aren’t the Same

Writing for the appeals court, Circuit Judge Julia Smith Gibbons upheld the lower courts. She said “it is no longer necessary that the mortgage be properly executed to take priority over the interest of a subsequent trustee acting as a bona fide purchaser.”

On the other hand, Judge Gibbons said that notice is not relevant to a judicial lien creditor, because Ohio law does not require a judicial lien creditor to have the same attributes as a bona fide purchaser in terms of notice.

Neither the Bankruptcy Code nor Ohio law, Judge Gibbons said, requires a judgment creditor “‘to lack notice of an unrecorded or defective lien in order to obtain a superior lien on a judgment debtor’s property,’” quoting Stubbins v. Wells Fargo Bank NA (In re Gibson), 395 B.R. 49, 57 (Bankr. S.D. Ohio 2008) (Preston, Bankr. J.). In Ohio, she said, “a defectively executed mortgage is invalid to a subsequent lienholder,” even if the subsequent mortgagee-lienholder had actual knowledge of the defective mortgage.

Upholding the lower courts and effectively avoiding the mortgage, Judge Gibbons held that actual or constructive notice “does not affect the priority of recordings. That is, regardless of notice, a defectively executed mortgage is not ‘perfected’ so it does not trump a subsequently perfected lien.”

Appellate Jurisdiction

You may wonder how the circuit court had appellate jurisdiction when the lender was appealing an interlocutory denial of a motion to dismiss. So do we.

Judge Gibbons said that the ruling below “would ordinarily not be a final appealable order and we would lack jurisdiction.” [Emphasis in original.] Citing the Ninth Circuit, she said there was appellate jurisdiction “based on the bankruptcy court’s ruling in favor of the Trustee on this issue, which effectively rendered the judgment in [the lender’s] case ‘final.’”