Callen J. Bair, Twisting the Trustee?s ?strong Arm?: Constructive Notice in Section 544(a)(3) Adversary Proceedings

• Publication year: 2011

TWISTING THE TRUSTEE’S “STRONG ARM”: CONSTRUCTIVE NOTICE IN SECTION 544(a)(3) ADVERSARY PROCEEDINGS

INTRODUCTION

At the close of the last century and in the early years of this century, mortgage companies and other institutional lenders originated home loans1 at a breakneck pace to borrowers with marginal credit and to borrowers without documentation of their income levels or assets.2 The statistics documenting the rise of the subprime3 and Alt-A4 mortgage markets are abundant and staggering. To cite a few: “Between 1994 and 2006 the volume of subprime

1. The terms “home loan,” “security interest,” and “mortgage” are used interchangeably herein. A mortgage is defined as:

   the transfer of an interest in land as security, usually for the repayment of a loan, but occasionally for the performance of another obligation. The typical mortgage transaction is relatively uncomplicated. A landowner borrows money from an institutional lender and enters a written agreement with the lender that the landowner’s real estate is collateral for the loan. In legal terminology the landowner-borrower is a mortgagor, the lender is a mortgagee, and the agreement is a mortgage.

   JON W. BRUCE, REAL ESTATE FINANCE IN A NUTSHELL 1 (6th ed. 2008).

2. See, e.g., Chris Arnold, Economists Brace for Worsening Subprime Crisis, NPR (Aug. 7, 2007), http://www.npr.org/templates/story/story.php?storyId=12561184.

3. A joint report of the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision provides

   definitions of both “subprime” and “subprime loan”:

   
   

   The term “subprime” refers to the credit characteristics of individual borrowers. Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers.

   Press Release, Fed. Deposit Ins. Corp., Subprime Lending: Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001) (on file with author).

4. Candidates for Alt-A loans generally had better credit than those for sub-prime loans, but were unable

   to provide documentation of all of their income or assets. See Mike Hudson, IndyMac: What Went Wrong?: How an “Alt-A” Leader Fueled its Growth with Unsound and Abusive Mortgage Lending, CTR. FOR RESPONSIBLE LENDING (June 30, 2008), http://www.responsiblelending.org/mortgage-lending/research- analysis/indymac_what_went_wrong.pdf.

   
   

   lending grew from $35 billion to $600 billion a year . . . .”5 By 2006, subprime loans accounted for 20% of the mortgage market, compared with 9% just a decade earlier.6 The Alt-A mortgage market grew from $85 billion in 2003 to

   $400 billion in 2006.7 This growth was “explosive.”8

   
   

   But by the third quarter of 2007, 24% of all subprime mortgages and 30% of sub-prime adjustable rate mortgages9 were delinquent or in foreclosure.10 The “serious delinquency” rate for Alt-A mortgages issued in 2007 reached 10% twice as quickly as those issued a year earlier.11 The subprime mortgage crisis ensued.12 This crisis wreaked havoc on the American economy, leaving us in what Chairman of the Federal Reserve Ben Bernanke called the worst financial crisis since the Great Depression.13 The subprime-mortgage crisis, and the economic downturn for which it is at least partially responsible, forced many Americans into bankruptcy.14 Consumer bankruptcy filings in October 2009 jumped 27.9% from filings in October 2008 and 8.9% from filings in

   September 2009.15

   
   

   The “mortgage mills” and other institutional lenders that made the origination of so many home loans—prime, sub-prime, and Alt-A—possible in headier economic times did not always execute and perfect their security

   
   

5. Alan M. White, The Case for Banning Subprime Mortgages, 77 U. CIN. L. REV. 617, 618 (2008) (citing Ellen Schloemer et al., Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners, CTR. FOR RESPONSIBLE LENDING, 7 (Dec. 19, 2006), http://www.responsiblelending.org/pdfs/ foreclosure-paper-report-2-17.pdf).

6. Arnold, supra note 2.

7. Sumit Agarwal & Calvin T. Ho, Comparing the Prime and Subprime Mortgage Markets, FED. RESERVE BANK OF CHI., 2 (Aug. 2007), http://chicagofed.org/digital_assets/publications/chicago_fed_letter/ 2007/cflaugust2007_241.pdf.

8. Yuliya S. Demyanyk & Otto Van Hemmert, Understanding the Subprime Mortgage Crisis (Dec. 5, 2008), available at http://ssrn.com/abstract=1020396.

9. An adjustable rate mortgage (“ARM”) is one “in which the interest rate rises and falls over the term of the loan in accordance with prevailing market conditions.” BRUCE, supra note 1, at 87.

10. White, supra note 5 (citing MORTG. BANKERS ASS’N OF AM., NATIONAL DELINQUENCY SURVEY Q307 (2007)).

11. Dan Levy & Bob Irvy, Alt-A Mortgages Next Risk for Housing Market as Defaults Surge, BLOOMBERG (Sept. 12, 2008, 12:01 AM), http://www.bloomberg.com/apps/news?pid=20601109&sid=arb3xM3SHBVk.

12. See Ben S. Bernanke, Chairman, Fed. Reserve Sys., Speech at Morehouse College: Four Questions About the Financial Crisis (Apr. 14, 2009).

13. See id.

14. Jessica Dickler, Personal Bankruptcies on the Rise, CNNMONEY.COM (Oct. 28, 2008, 11:41 AM), http://money.cnn.com/2008/10/24/pf/bankruptcy_filings/index.htm.

15. Rolfe Winkler, Consumer Bankruptcy Filings Increase, REUTERS (Nov. 4, 2009, 10:48 AM), http://

    blogs.reuters.com/rolfe-winkler/2009/11/04/consumer-bankruptcy-filings-increase/.

    interests in accordance with applicable law.16 As Wall Street firms bundled mortgages into securities and sold them to investors, they often failed to record each link in the title chain properly.17 As a result, bankruptcy courts nationwide handle adversary proceedings18 to avoid these interests brought by Trustees pursuant to 11 U.S.C. § 544(a)(3).19 This provision of the Bankruptcy Code (the “Code”), a subsection of what is colloquially known as the “strong- arm clause,”20 allows the Trustee to avoid any transfer of or interest in the debtor’s real property that a hypothetical bona fide purchaser of the debtor’s property would be able to avoid under non-bankruptcy law.21 The Trustee invokes his status as a hypothetical bona fide purchaser to avoid unperfected or otherwise defective transfers of security interests in the debtor’s real property.22

    
    

16. See, e.g., Mortg. Elec. Registration Sys., Inc. v. Agin, No. 09-CV-10988-PBS, 2009 WL 3834002, at

    *2 (D. Mass. Nov. 17, 2009) (holding that the omission of the name of the mortgagor in the certificate of acknowledgment attached to the mortgage rendered the mortgage defective and, therefore, avoidable by the Trustee pursuant to § 544(a)(3) of the Bankruptcy Code). In an interview published after the district court had issued its opinion, the lawyer for the Trustee said that he did not think cases concerning defective acknowledgments of a mortgage were rare, and that they were appearing before federal courts in other jurisdictions “largely due to pushing mortgages through the system”—that is, due to the sloppy execution of mortgage documents. Sheri Qualters, Defective Paperwork Strips Mortgage Holder of Foreclosure Rights, NAT’L L.J., Nov. 19, 2009, http://www.law.com/jsp/article.jsp?id=1202435636327 (internal quotation marks omitted). In fact, the lawyer for one mortgage company has, however unwittingly, admitted the sloppy practices of parties operating in the secondary market: “In the secondary market, there are many cases where assignment of mortgages, assignment of notes, don’t happen at the time they should. It was standard operating procedure for many years.” Gretchen Morgenson, If Lenders Say, ‘The Dog Ate Your Mortgage’, N.Y. TIMES, Oct. 24, 2009, http://www.nytimes.com/2009/10/25/business/economy/25gret.html?_r=3&partner=rss&emc= rss (internal quotation marks omitted). The secondary mortgage market is “[t]he national market in which existing mortgages are bought and sold, usu[ally] on a package basis.” BLACK’S LAW DICTIONARY 1034 (8th ed. 2004).

17. Gretchen Morgenson, Massachusetts Ruling on Foreclosures Is a Warning to Banks, N.Y. TIMES, Jan.

    7, 2011, http://www.nytimes.com/2011/01/08/business/08mortgage.html.

18. In the context of bankruptcy, an adversary proceeding is “[a] lawsuit that is . . . governed by special procedural rules, and based on conflicting claims usu[ally] between the debtor (or the trustee) and a creditor or other interested party.” BLACK’S LAW DICTIONARY, supra note 16, at 58.

19. See Qualters, supra note 16 (explaining that cases involving defective acknowledgments have “cropped up . . . ‘largely due to pushing mortgages through the system’”).

20. See, e.g., ELIZABETH WARREN & JAY LAWRENCE WESTBROOK, THE LAW OF DEBTORS AND CREDITORS

472 (6th ed. 2009).

21 11 U.S.C. § 544(a)(3) (2006); 5 COLLIER ON BANKRUPTCY ¶¶ 544.01–.03, –.06 (Alan N. Resnick &

Henry J. Sommer eds., 16th ed. 2010).

1. See COLLIER ON BANKRUPTCY, supra note 21, ¶ 544.02[2] (“The purpose of the strong arm clause is to cut off unperfected security interests, secret liens and undisclosed prepetition claims against the debtor’s property as of the commencement of the case.”); Thomas H. Jackson, Avoiding Powers in Bankruptcy, 36

   STAN. L. REV. 725, 733, 737 n.32 (1984) (“[T]he ability of the trustee to avoid unperfected security interests [is] surely the property right most frequently avoided under the strong-arm power. . . . ‘The main applications of 11 U.S.C.A. § 544(a) are the cases in which the Trustee seeks priority under U.C.C. § 9-301 over a security

   In theory, § 544(a)(3) renders the Trustee a formidable opponent to a party that holds an unperfected or otherwise defective security interest in a debtor’s real property. In...