Typo

A short course on constructive notice, and the bona fide purchaser.

TOPEKA, Ks–When they gave a mortgage against their home Jorge and Toni Colon could not have imagined what was to follow.

The trouble began with a typo. The Colons owned Lot 79 in the Arrowhead Heights Subdivision, but a typist made it “Lot 29” in the mortgage that got recorded.

The house on Lot 79

No one noticed the typo until the Colons filed Chapter 13 bankruptcy, and the bankruptcy court appointed a trustee for the debtors’ estate. Seeing opportunity, the trustee filed pleadings to avoid the mortgage as an interest in the debtors’ real property. If successful the trustee’s action would make the mortgage lender an unsecured creditor, perhaps getting cents on the dollar instead of full repayment.

The trustee’s action was based on section 544(a)(3) of the Bankruptcy Code. This statute gives a trustee (or a debtor-in-possession) legal status of a bona fide purchaser of the debtor’s real property as of commencement of bankruptcy. The purpose is to prevent a debtor from giving favored creditors preferential treatment just prior to bankruptcy.

So section 544(a)(3) offers a trustee protected status of a hypothetical bona fide purchaser, allowing the trustee to avoid a security interest in the debtor’s property (such as a mortgage) that has not been perfected (i.e., recorded) as of the bankruptcy filing date.  A bona fide purchaser, as we know, is one who pays value for property without notice of claims of others to the same property. The bona fide purchaser acquires property free of such competing claims, and has legal protections against them.

But what is legal “notice?” There are two types: Actual notice (what one knows) and constructive notice (as disclosed by public records).

In this case, the trustee argued a hypothetical bona fide purchaser would not have notice of the defective mortgage because it would not be found by a search of land records in the office of the county recorder for Shawnee County, Kansas.

The bankruptcy court agreed with the trustee, and ordered the mortgage avoided for the benefit of the debtors’ estate (controlled by the trustee). The mortgage lender could not foreclose, and would have to get in line as an unsecured creditor.

The court explained the county recorder maintains two indices for land records, a grantor-grantee index (an alphabetical listing by names of parties) and a geographical index (a listing by property legal description). The court said a purchaser (or a title searcher) might rely on the geographical index, solely, and in searching Lot 79 would not find the mortgage against Lot 29. It made no difference, in the court’s opinion, that the mortgage shows a correct property address and assessor’s parcel number.

The mortgage lender appealed and a federal court of appeals reversed the bankruptcy court decision.

The appeals court focused on the Kansas recording statutes, which state that each recorded document imparts notice of its contents, and that each county must maintain a grantor-grantee index. The geographical index is optional.

The court reasoned that the Kansas statutes charge a purchaser with constructive notice of an owner’s entire “chain of title,” to be found by searching names in the county grantor-grantee index. In this case, there were at least four documents in the chain of title linking the Colons with the correct lot number, and by comparing the documents a person with “common sense” should know the disputed mortgage was intended to encumber the Colon home.

So the mortgage lender won, and the mortgage is enforceable.

Moral: Forget the bankruptcy stuff, this is an important case for understanding constructive notice (and when you’re stuck with it). These notions of constructive notice, and rights of a bona fide purchaser, are at the heart of our system of property rights.

Most state recording statutes are similar to those in Kansas, and this well-written decision offers clarity for courts elsewhere. It should have nation-wide implications.

Today most searchers and title companies rely on geographical databases when handling real estate transactions. The geographical search is simply faster and less costly than a grantor-grantee search. But it’s also true the geographical search is prone to error and may miss the document with a bad legal description. Property owners and lenders look to title insurance to cover the risk.  See, for example, the next post, “Typo 2.”

The case is reported as In re Colon, 563 F.3d 1171 (10th Cir. 2009).

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