Tales of WHOA!: Failure to Monitor Compliance Leads to Preferential Transfer Challenge

RMA Journal, The, Feb, 2001 by Michael L. Weissman

In re Jones 226 F.3d 917 (7th Cir. 2000) (decided under Ohio law), the question before the court was whether a trustee in bankruptcy could challenge the validity of a prepetition mortgage foreclosure decided in favor of the mortgagee.

Robert and Margaret Jones executed a mortgage in favor of Key Bank in November 1987 to secure a $500,000 note. The mortgage was recorded in Cuyahoga County, Ohio, on December 7, 1987. The mortgage did not satisfy the statutory requirements of Ohio law in order to be valid against third parties. Ohio law called for the execution of a mortgage to be acknowledged before two witnesses, who were to attest to the signature of the mortgagor and, thereafter, to be acknowledged by the mortgagor before a judge, clerk of court, county auditor, county engineer, notary public, or mayor. The mortgagors in this case did not sign the mortgage in the presence of two witnesses.

In January 1994 a mortgage foreclosure proceeding was initiated that resulted in the sale of the property An order was entered in June 1994 confirming the sale and directing distribution of the proceeds. Key Bank received $221,295.50.

The debtors went into bankruptcy in June 1994, and two years later, the trustee in bankruptcy of their estates filed an adversary proceeding against Key Bank. The suit contended that the estate was entitled to the $221,295.50 paid to Key Bank from the proceeds of the sale. The trustee asserted that the mortgage was invalid under Ohio law and that consequently the payment to Key Bank was a preferential transfer.

Key Bank responded that issue preclusion prevented the bankruptcy trustee from attacking the mortgage because the validity of the mortgage had already been decided in Key Bank's favor in the Ohio state court foreclosure case. (Issue preclusion means that the same issue has previously been litigated and determined by a final judgment that involved the same parties or other persons in close association with them.)

The Seventh Circuit Court of Appeals held that the trustee in bankruptcy was not precluded from challenging the validity of the mortgage, despite the Ohio state court foreclosure proceeding, because the trustee in bankruptcy represented unsecured creditors and the unsecured debtor's creditors were not parties to the foreclosure, nor were they in close association with the debtor.

The court also held that, under the Bankruptcy Code's definition of a preferential transfer, the fact that a transfer of funds was made pursuant to a state court judgment did not immunize it from attack by a bankruptcy trustee. Furthermore, finding that Key Bank was an unsecured creditor because the mortgage did not comply with Ohio law, the court had no difficulty in concluding that Key Bank received more as a result of the prepetition receipt of funds than it would have in a Chapter 7 liquidation. Thus, all the elements of a preferential transfer were found to be present.

What's the point? Lenders that fail to monitor the proper execution of their mortgages may find themselves challenged by a trustee in bankruptcy should the debtor file bankruptcy within 90 days after the confirmation of a foreclosure sale and distribution of the sale proceeds, notwithstanding the regularity of the prepetition foreclosure proceeding.

Weissman is a partner in the Chicago law firm of McBride Baker & Coles and is chairman of the firm's Financial Services Group. His practice is devoted to financial and business transactions including the structuring of a wide variety of financing transactions. He also actively prosecuted civil and bankruptcy matters on behalf of financial institutions and defended them in lender liability lawsuits.