In In re O'Connor, the U.S. Bankruptcy Court for the Western District of Pennsylvania was called on earlier this year to decide whether information contained in the debtors' bankruptcy schedules could provide constructive notice to the trustee, thereby destroying the trustee's status as a bona fide purchaser under § 544(a) of the Bankruptcy Code.
According to the bankruptcy court's opinion in the case, Gregory and Kathryn O'Connor filed a Chapter 7 bankruptcy petition on Sept. 9, 2009, (the petition date). On the same day, the O'Connors caused O'Connor Contracting, Inc. and KOG, two entities wholly owned by the O'Connors, to file Chapter 7 bankruptcy petitions. The O'Connors owned their personal residence (their sole real property asset), which was also the address used for O'Connor Contracting Inc. and KOG.
Three years before the petition date, KOG borrowed $100,000 from Standard Bank. In return, the opinion said, KOG executed and delivered to Standard Bank an "Open-End Mortgage," which purported to grant a mortgage to the bank on the O'Connors' residence and which identified KOG as the sole mortgagor. Standard Bank recorded the mortgage on Oct. 4, 2006. As noted above, the O'Connors—not KOG—owned the realty on which the mortgage was granted, but Standard Bank alleged that the O'Connors had orally promised that they, on behalf of KOG, would grant a mortgage to Standard Bank to secure the $100,000 loan to KOG.
When the O'Connors filed the Chapter 7 petitions, they simultaneously filed bankruptcy schedules for themselves, O'Connor Contracting, and KOG. In Schedule D to their bankruptcy petition, the O'Connors listed the $100,000 debt that KOG owed to Standard Bank as a secured claim and identified their residence as the collateral for that debt. Additionally, in Schedule A to their bankruptcy petition, the O'Connors listed the residence as their only real property asset, the opinion said. At the same time, KOG's bankruptcy Schedule D listed as a secured claim the same $100,000 debt owed to Standard Bank and identified the residence as collateral for that debt: KOG's bankruptcy Schedule A did not list any real estate assets.
Standard Bank's Motion for Relief
Following the petition date, Standard Bank moved for relief from the automatic stay in order to permit it to reform or modify the mortgage agreement with KOG in order to identify the O'Connors as mortgagors. The O'Connors consented to the bank's motion. Both the bank and the O'Connors conceded that "(a) KOG . . . never owned the realty that [was] the subject of [the] mortgage agreement, (b) KOG thus could not possibly have granted a mortgage to Standard Bank, (c) the [O'Connors] owned such realty when such mortgage agreement was executed, and ... they still own such realty, and (d) the [O'Connors] are thus the only party that could have granted a mortgage to Standard Bank." The O'Connors' Chapter 7 trustee opposed the motion on the ground that the trustee's § 544(a)(3) strong arm powers precluded the mortgage reformation sought by Standard Bank and, therefore, cause did not exist for granting stay relief.
In analyzing the trustee's response, the court first addressed § 544(a)(3), which provides that the trustee may avoid any lien or transfer avoidable by a hypothetical bona fide purchaser of real property of the debtor as of the date of the commencement of the case. While the court then acknowledged that the extent of the trustee's rights as a bona fide purchaser of real property pursuant to § 544 were governed by state substantive law, the court also noted that where such state law is inconsistent with federal bankruptcy law, the state law will be pre-empted.
The court then acknowledged that "[o]ne such instance which state substantive law may be inconsistent with, and will thus be trumped by, federal bankruptcy law is with regard to the knowledge that may operate to negate one's status as a bona fide purchaser." The court continued that "even if a state's substantive law is such that actual knowledge will operate to prevent one from attaining the status of a bona fide purchaser, bankruptcy law renders a trustee's actual knowledge of a lien or defect irrelevant by virtue of the provisions of § 544(a)(3)," which establish the trustee as a hypothetical bona fide purchaser without knowledge.
Having addressed § 544(a)(3), the O'Connor court then turned to state substantive law governing the reformation of mortgages and Standard Bank's argument that the trustee's strong arm powers did not preclude reformation. The trustee argued that, under Pennsylvania law, "the equitable principles allowing the reformation of a mortgage are not applicable against a bona fide purchaser." In response, Standard Bank argued that the trustee could not be considered a bona fide purchaser because (i) any purchaser of the residence as of the petition date would have had constructive or inquiry notice of the mortgage in favor of Standard Bank by virtue of the information contained in the schedules appended to the O'Connors' and KOG's bankruptcy petitions, and (ii) the trustee had actual knowledge in any event.
Reliance Upon 9th Circuit Precedent
The court summarily dismissed Standard Bank's second argument, noting that the trustee's strong arm powers under § 544(a)(3) may be exercised irrespective of the trustee's actual knowledge. Addressing Standard Bank's first argument, the court acknowledged the authority upon which Standard Bank relied as standing for the proposition that "when a Chapter 7 debtor's bankruptcy schedules are filed concurrently with such debtor's bankruptcy petition, the disclosures contained in such schedules ... will provide the constructive notice that would operate to preclude a bankruptcy trustee from using such trustee's strong arm powers under § 544" (citing the court's 2007 opinion in In re Lauver). Notwithstanding the foregoing, the court rejected Standard Bank's constructive notice arguments for two reasons.
First, the court rejected the holding in Lauver that disclosures in a debtor's bankruptcy schedules provide constructive notice sufficient to abrogate the trustee's strong arm powers. Instead, the court cited to the 9th U.S. Circuit Court of Appeals' ruling in In re Deuel, which provides that "even if bankruptcy schedules are filed concurrently with a debtor's bankruptcy petition, such schedules cannot operate to provide the constructive notice that would serve to preclude a bankruptcy trustee from using such trustee's strong arm powers under § 544(a)." In Deuel, the court found that the timing of the bankruptcy petition was of critical importance on the issue and stated that a "case is 'commenced' by the filing of a petition . . . " and "[t]hus the bankruptcy trustee has the status of a bona fide purchaser at the instant the petition is filed."
Accordingly, the Deuel court reasoned that because bankruptcy schedules must be filed in a bankruptcy case, they cannot be filed until there is such a case in which to file them. Therefore, at the moment the bankruptcy petition is filed, the trustee has no knowledge of any information, constructive or otherwise, that is contained in the bankruptcy schedules. As such, the O'Connor court held that the schedules could not provide constructive notice precluding the trustee's use of its strong arm powers.
Application of § 558 and the Statute of Frauds
Second, the O'Connor court questioned that even had the bankruptcy schedules provided notice to the trustee, "To what do they provide constructive notice?" The court then emphasized that because the mortgage had purportedly been granted by KOG (which didn't own the O'Connors' residence), no mortgage had ever been granted to Standard Bank. Accordingly, the O'Connors' bankruptcy schedules, at most, provided constructive notice of an oral agreement between Standard Bank and the O'Connors.
The court reasoned that even were such an agreement to exist, because the agreement involved the conveyance of a mortgage, that agreement was required by the statute of frauds to be in writing. As such, under § 558 of the Bankruptcy Code, the trustee would have been able to assert the defense of the statute of frauds and render the oral agreement unenforceable. This defense would have been available to the trustee even though the O'Connors consented to Standard Bank's stay relief motion, as such consent could only have occurred post-petition and would not have bound the trustee.
Accordingly, the O'Connor court opined that even were it to hold that the O'Connors' schedules provided constructive notice of such an oral agreement, the trustee had the power to render that agreement unenforceable. Therefore, and in reliance upon Deuel, the O'Connor court denied Standard Bank's motion for relief from the stay and held that the trustee's strong arm powers operated to preclude the mortgage reformation sought by Standard Bank.
The Statute of Frauds Is Alive and Well
The O'Connor decision emphasizes the importance for a secured lender to assure (i) that a party granting a mortgage has the legal authority to do so, and (ii) that the mortgage so granted is properly recorded. Moreover, this decision serves as a reminder that the statute of frauds is alive and well and can serve to render oral agreements wholly unenforceable. Accordingly, secured lenders are well served to perform adequate title searches prior to accepting a mortgage, to properly record any mortgage received, and to require any subsequent amendments thereto to be in the proper form of writing signed by the mortgagor.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is chairman of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Blake D. Roth is a 2009 graduate of the Earle Mack School of Law at Drexel University and an associate in the business reorganization and financial restructuring practice group at Duane Morris.
Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.