Bankruptcy law may be uniform throughout the U.S., but results around the country aren’t always the same, even when the facts are identical. Why? Because many questions under bankruptcy law actually turn on state law.
Here’s a fine example: A trustee has the right to avoid and preserve an unrecorded mortgage for the benefit of the estate under Section 551. But as shown in an August 6 opinion from the First Circuit, the trustee cannot preserve an unrecorded mortgage when state law says that an unrecorded mortgage confers no interest in property.
The facts were simple. A couple in Puerto Rico purchased a home and took down a mortgage. However, the lender never recorded the mortgage.
The couple filed a chapter 7 petition and claimed a homestead exemption. The lender filed a secured claim. The debtors objected to the claim, contending it was not secured. The bankruptcy court granted the objection, ruling that the claim was unsecured because the mortgage had not been recorded.
The trustee filed an action to avoid the unrecorded mortgage under Section 544(a)(3) and preserve the mortgage for the benefit of the estate under Section 551.
The bankruptcy court ruled that the trustee could not preserve the mortgage, even though it was unrecorded. The Bankruptcy Appellate Panel affirmed, and so did Circuit Judge Sandra L. Lynch.
The decisions in the lower courts turned on a few key words in Section 544(a) and (a)(3). The sections says that the
trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor . . . that is voidable by—
(c) a bona fide purchaser of real property [that] obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists. [Emphasis added.]
Judge Lynch began from the proposition that “[s]tate law governs interested parties’ property rights.” She demonstrated the difference that state law makes by comparing Massachusetts law with the law in Puerto Rico.
Massachusetts has a “title theory” of mortgages. A mortgage is a conditional transfer of title. Recording makes the lien a matter of public record and gives notice to third parties.
If a mortgage is not recorded in Massachusetts, the lender retains superior title compared to the mortgagor and anyone with actual knowledge of the mortgage.
On the other hand, the holder of an unrecorded mortgage in Massachusetts has inferior title compared to anyone without actual knowledge. Nonetheless, the lender “retains an interest in the underlying real property,” even though the mortgage was not recorded, Judge Lynch said.
Puerto Rico has a different system, known as the “property registry system.”
Recording in Puerto Rico does more than provide public notice. Recording is part of the process of creating a valid property interest. Under Puerto Rico law, Judge Lynch said that “a mortgage must be recorded for it to confer any interest in the underlying real property.” Consequently, an unrecorded mortgage in Puerto Rico only gives the lender an unsecured personal guarantee.
Judge Lynch therefore held that “an unrecorded mortgage in Puerto Rico does not trigger the trustee’s avoidance powers under 11 U.S.C. §§544(a) and (a)(3) [because] the holder of the unrecorded mortgage lacks any title to the underlying property.” She ruled that the unrecorded mortgage did not transfer property, thus preventing the trustee from avoiding the unrecorded mortgage while preserving the mortgage for the benefit of the estate.
Bankruptcy law may be uniform throughout the U.S., but results around the country aren’t always the same, even when the facts are identical. Why? Because many questions under bankruptcy law actually turn on state law.
Here’s a fine example: A trustee has the right to avoid and preserve an unrecorded mortgage for the benefit of the estate under Section 551. But as shown in an August 6 opinion from the First Circuit, the trustee cannot preserve an unrecorded mortgage when state law says that an unrecorded mortgage confers no interest in property.