The Bankruptcy Code does no favors for a bank holding an unrecorded mortgage at the time the bankruptcy petition is filed. The Code allows a trustee to avoid the bank’s lien and pursue the lien for the benefit of the estate, leaving the bank as a general unsecured creditor.1 But, what happens if the Trustee does not take advantage of the generosity of the Code and closes the case without taking affirmative action to avoid the lien? The answer under Kentucky law may surprise you. In some instances, the bank may record the mortgage after closure of the case and exercise its rights to foreclose on the mortgage.2 A lien not otherwise avoided for the benefit of the estate is not discharged, but passes through the bankruptcy and is enforceable in rem against the collateral.3
In 2003, Debtor, Charles Williams, filed his first bankruptcy.4 Holding an unrecorded mortgage executed by the Debtor in 2001, CIT Group likely waited for the trustee’s suit to avoid its interest. The action never came. The debtor received his discharge, and the trustee abandoned the property and closed the case in 2004 without ever filing a motion to avoid CIT Group’s lien. In 2011, well after case closure, CIT Group recorded its mortgage executed in 2001, and assigned the mortgage to a third party bank.
The debtor filed bankruptcy again in 2012, and a more diligent trustee was appointed. The second trustee filed an adversary proceeding challenging the bank’s lien and bringing before the bankruptcy court the issue of whether a mortgage recorded after personal liability of a debtor is discharged can be avoided in the debtor’s second bankruptcy case.5
The Court rejected the trustee’s argument and allowed the bank to enforce its mortgage against the real property. “In Kentucky, an unrecorded mortgage is not void, but valid between the parties to such transactions, but not against purchasers who had no knowledge thereof.”6 The reasoning is that the failure to record the mortgage affects only the priority of the creditor’s claims against the property. Id. Since no action was taken against the lien during the first bankruptcy, the bank’s right to foreclose on the mortgage in rem passed through the bankruptcy. Id. The bankruptcy court reasoned that upon abandonment by the trustee in the first bankruptcy, title revested in the debtor who was subject to the contractual mortgage lien with the bank. Since the case was closed, there was no automatic stay violation resulting from the recordation because the action was in rem only.7
When unrecorded mortgage threatens the bank’s interest, options may exist to salvage the bank’s lien. Never assume the interest is lost. Monitor the bankruptcy. The bank’s interest may pass through the bankruptcy, leaving the bank with the opportunity to exercise its rights in rem.
1See 11 U.S.C. § 547(b); 11 U.S.C. §551.
2Johnson v. Williams (In re Williams), 490 B.R. 236, 239-240 (Bankr. W.D. Ky. 2013).
3Id. at 240.
4Id. at 238.
5Id. at 239.
7Had the bank sought personal liability against the debtor under the contractual mortgage, a violation of the discharge order would have occurred and subjected the bank to possible sanctions.