Bona Fide Purchaser vs. Subsequent Lienholder: A Distinction with a Difference (in Ohio)

In the recent case of In re Oakes,[1] the chapter 7 trustee filed an adversary complaint seeking to avoid PNC Mortgage Company’s mortgage on real property owned by the debtors because of a defective acknowledgment of the debtors’ signatures. No one denied that the mortgage was defective or that there was precedent to avoid a mortgage containing a “blank” acknowledgment clause under § 544(a) and Ohio law, but PNC sought to dismiss the avoidance action based on the newly enacted Ohio Rev. Code § 1301.401, which deems the recording of a defectively executed mortgage to provide constructive notice.

Prior to the enactment of the new law, in Ohio bankruptcy trustees routinely avoided defectively executed mortgages on real property using their ability to obtain the status of a hypothetical bona fide purchaser who did not receive actual notice.[2] Ohio chapter 7 trustees’ ability to avoid defectively executed mortgages arose from a combination of Ohio statutory and case law providing that defectively executed mortgages were not entitled to be recorded and were invalid, and as such, any recording did not provide constructive notice to subsequent purchasers.[3] The enactment of Ohio Rev. Code § 1301.401 limited a trustee’s avoidance powers in Ohio insofar as trustees can no longer step into the shoes of a hypothetical bona fide purchaser without notice.

This is not the end of the story, however. Pursuant to § 544(a)(1), a trustee also gains the status of a subsequent judicial lien creditor deemed to have a perfected interest as of the date of the bankruptcy petition.[4] As such, a trustee may avoid a prepetition transfer of a debtor's property, including a mortgage lien, to the extent that such a judicial lien creditor could obtain a superior interest under relevant state law. Contrary to PNC’s position, this is a distinction with a difference. The bankruptcy analyzed Ohio law and held that while notice of a prior recorded, but defectively executed, mortgage has no impact on the lien-priority dispute, to be entitled to valid recording a mortgage must be properly executed. In other words, a defectively executed mortgage may provide constructive notice that eliminates bona fide purchase status, but is not valid against a trustee with the status of a subsequent judicial lien creditor. PNC’s Motion to Dismiss and for Judgment on the Pleadings was denied.

The obvious question then is, What does your state law provide as to constructive notice and recording validity?