On the Record: The Case against Debtors Having the Ability to Avoid Unrecorded Mortgages in Chapter 13 Bankruptcy Proceedings

 

Dateline: January, 2002

 

Overview:

Sometimes when a mortgagee commences a foreclosure action, or when a mortgagor files a petition in bankruptcy, the parties discover that the mortgage on the realty was never recorded.  In the case of a bankruptcy, an astute Trustee or Debtor may attempt top avoid the mortgage obligation entirely.  11 U.S.C. Section 544, which treats a Trustee as a bona fide purchaser, allows Trustees to avoid unrecorded mortgages when doing so benefits the debtor’s estate.  Debtors in Chapter 13 proceedings may attempt to avoid their own unrecorded mortgage obligations by relying on this section of the Bankruptcy Code.

 

Does the Bankruptcy code give Chapter 13 Debtors Avoidance Powers?

The issue of whether a Chapter 13 debtor may avail itself of the avoidance powers given a Trustee in 11 U.S.C. Section 544, and thus be awarded the ability to avoid the obligations accompanying unrecorded mortgages, has not been established in the District of New Jersey.  Elsewhere, the law is divided on the issue of whether Chapter 13 debtors may avail themselves of the strong-arm powers of Section 544(a). 

 

The text of the Bankruptcy Code itself supports the proposition that the avoidance powers of Section 544 should not expand to Chapter 13 debtors.  Section 1303 defines the rights and powers of a Chapter 13 Debtor.  That section does not specifically list the strong-arm powers of Section 544 as one of the powers bestowed upon a Chapter 13 debtor.    

 

By looking elsewhere in the Code, it appears that Congress did not intend for the Courts to give Chapter 13 debtors the strong-arm powers of Section 544 either.  Section 1303 specifically enumerates the powers of a Chapter 13 debtor as, “the rights and powers of a trustee under section 363(b), 363(d), 363(e), 363(f) and 363(l) of this title.”  Conversely, Section 1107, which outlines the rights, powers and duties of a Chapter 11 debtor-in-possession, grants a debtor-in-possession all the rights and powers of a Trustee, other than the right to compensation under Section 330.  Further, Section 1203, grants a Chapter 12 debtor-in-possession, subject to such limitations as the court may prescribe, all the rights and powers of a Trustee, other than the right to compensation under Section 330.  Thus, by virtue of specifying parallel powers to the exclusion of Section 544, it appears not to have been Congress’ intent to confer avoidance powers upon a Chapter 13 Debtor 

 

If Congress wanted a Chapter 13 debtor to have the avoidance power of Section 544, it would have enumerated it in Section 1303.  Or, Congress would have given Chapter 13 debtors all of the trustee’s powers, and specifically curtailed those powers as Congress did in Sections 1107 and 1203.  Lastly, if Congress wanted the Courts to use discretion in deciding which powers Chapter 13 debtors could use, Congress could have employed language similar to the opening language of Section 1203 indicating its desire for judicial discretion.  Congress did none of these things, thus demonstrating its intent to curb a Chapter 13 debtor’s ability to avoid unrecorded mortgages by relying on Section 544.

 

The Bankruptcy Code unambiguously gives avoidance powers to bankruptcy trustees and to Chapter 11 and Chapter 12 debtors, but not to Chapter 13 debtors.  Section 1301, by its own terms, does not provide a Chapter 13 debtor with avoidance powers.  In light of the explicit statutory language of the Bankruptcy Code, Courts should not bestow upon debtors the avoidance powers given Trustees in 11 U.S.C. Section 544(a).

 

The Bankruptcy Code does not grant a Debtor any “strong arm” rights as it does a Trustee under Section 544.  As the Debtor, the very person who executed the mortgage, cannot possibly argue that he was a bona fide purchaser, or was otherwise unaware of the mortgage, he should not be entitled to avoid the legal responsibilities that attend the execution of a mortgage.  Section 1303 simply does not confer standing on the debtor to pursue avoidance actions. Without the moniker of a “bona fide purchaser” the Debtor is not entitled to have a mortgage he or she executed be classified as an unsecured claim.

 

Do Equitable Arguments give Chapter 13 Debtors Avoidance Powers?

Equitable arguments also weigh in favor of Chapter 13 debtors not being able to treat unrecorded mortgages as unsecured.  A Chapter 13 Debtor cannot argue that the lien is unperfected because the New Jersey Recording Statute does not apply to the parties who execute the document in question.

 

Title 46, section 22-1 of the New Jersey recording statute provides: “Every deed or instrument.... until duly recorded or lodged for record in the office of the county recording officer in which the affected real estate or other property is situate, be void and of no effect against subsequent judgment creditors without notice and against all bona fide purchasers and mortgagee for valuable consideration, not having notice thereof, whose deed shall have been first duly recorded or whose mortgage shall have been first duly recorded or registered; but any such deed or instrument shall be valid and operative, although not recorded, except as against such subsequent judgment creditors, purchasers and mortgagees.”

 

The recording statue was not intended to protect parties privy to the transaction in question, nor was it intended to strip mortgagees of their secured status by mortgagors who executed on the mortgage itself. 

 

Recording and perfecting of security interests are, in essence, methods that creditors utilize when seeking to put all other creditors on notice of their interest in property.   As Debtors cannot argue they had no notice of a mortgage which they themselves executed, the recording statute itself is superfluous.

 

If a Debtor was able to reclassify an unrecorded mortgage as unsecured, the incentive for all mortgagees would be to execute on a mortgage, then undertake the proverbial “race to the courthouse” to file for Chapter 13 protection before the mortgage can be recorded.  This would allow mortgagees to treat that mortgage as unsecured.  Surely that cannot be the result intended by either the Bankruptcy Code or the New Jersey Recording Statute.

 

Even assuming that Debtors would not race to the Bankruptcy Court to file for Chapter 13 protection, the state of the recording offices in New Jersey is such that mortgages are often not recorded for three months or longer despite being sent for recording the day of closing.  In other situations, an error on the mortgage document itself, a miscalculated realty transfer fee or recording fee check, or any other mistake that may occur at closing, results in mortgages being returned and not getting recorded for an extended period of time.

 

If a completely forthright debtor was to purchase a home and then was unable to make a mortgage payment for the first few months, a secured creditor could begin a foreclosure action, and learn that its interest was not recorded only after a debtor filed for bankruptcy in response to the foreclosure.  The Bankruptcy Court should not allow debtors to avoid mortgage obligations in any of these situations.  If a Debtor can propose a viable Chapter 13 Plan, then there is little argument that treating unrecorded mortgages as secured will inure to the detriment of the Chapter 13 estate.   In view of a bankruptcy court’s primary calling as a court of equity, one final observation is in order.  If a debtor is permitted to employ the Bankruptcy Code to deprive a creditor of a property right for their personal benefit, with no benefit inuring to the estate, an inequitable result ensues.  A debtor should not therefore, in equity be permitted to step into the shoes of the trustee in order to use the strong-arm powers to avoid a consensual lien on his or her homestead.

 

The equitable doctrine of waiver also dictates that a Debtor should not be able to reclassify unrecorded mortgages as unsecured.  After the mortgagor relied on the Debtor being bound by the terms of the mortgage it would be unjust to allow a Debtor to later act as if the mortgage never existed.

 

Summary:

Some mortgages do not get recorded, for whatever reason.  When this happens, the arguments outlined above support the view that these mortgages should not be deemed as unsecured by debtor’s in Chapter 13 proceedings.  Any finding to the contrary is both inequitable and flies in the face of public policy.

 

This Article is a service of the Creditors’ Rights Department of Fein, Such, Kahn & Shepard, P.C., 7 Century Drive, Suite 201, Parsippany, NJ 07960.  Phone: 973-538-4700. Website: www.feinsuch.com.  It does not constitute legal advice nor create an attorney-client relationship.  For more information contact Shareholder Alan F. Such at afs@feinsuch.com.

 

© 2003, Fein, Such, Kahn & Shepard, P.C., all rights reserved.  Permission is granted to reproduce and redistribute this article so long as (i) the entire article, including all headings and the copyright notice are included in the reproduction, and (ii) no fee or other charge is imposed.