In re Dahlin – S.D. Tex. Bankr. Ct. holds that unrecorded refinancing lenders not entitled to insurance proceeds from destruction of property

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A bankruptcy court in Texas has held that two individual refinancing lenders could not claim fire insurance proceeds stemming from the destruction of mortgage property because the trustee’s status as a hypothetical bona fide purchaser defeated the refinancing lenders’ unperfected deed of trust. [In re Dahlin, 2018 Westlaw 4154759 (Bankr. S.D. Tex.).]

FACTS: Following a contentious divorce, a financially distressed homeowner borrowed almost $200,000 from two individual lenders (her close friends) in order to pay off her home mortgage. After the payoff, the homeowner failed to execute a note and deed of trust in favor of the individual lenders, despite their continuing requests that she do so.

The day after the original lender recorded a lien release, the home was destroyed by fire. The homeowner filed an insurance claim. About a year later, the homeowner finally executed a note and deed of trust in favor of the individual lenders. However, unbeknownst to the individual lenders, the homeowner filed a Chapter 13 petition the next day, just before the deed of trust was recorded.

A little more than a month later, the homeowner (now a Chapter 13 debtor), received $333,000 in insurance proceeds. Both the individual lenders and the trustee claimed the money. The individual lenders asserted that they were entitled to be equitably subrogated to the lien of the original mortgage lender; the trustee argued that since the individual lenders’ deed of trust was recorded after the petition date, their security interest was unperfected and was avoidable under 11 U.S.C.A. §544(a)(3). Both parties moved for summary judgment.

REASONING: The court ruled in favor of the trustee. The court held that although the individual lenders may have had the right to be equitably subrogated to the position of the original mortgage lender, there was no recorded lien encumbering the debtor’s title on the date of bankruptcy. Further, there was nothing in the record to provide inquiry notice to a prospective bona fide purchaser showing a claim on the part of the individual lenders. Therefore, since the trustee is deemed to be a hypothetical bona fide purchaser, he and the bankruptcy estate took the property free of any claim held by the individual lenders.

The court also held that the recording of the deed of trust one day after the bankruptcy petition was filed was an unauthorized post-petition transfer under §549. Finally, the individual lenders claimed to be the beneficiaries of a constructive trust, but the court again reasoned that the trustee’s status as a bona fide purchaser meant that his right to the insurance proceeds trumped the claim of a constructive trust under Texas law.

AUTHOR’S COMMENT: This result is technically correct, but what an inequitable disaster! This unscrupulous debtor inveigled her dear friends to bail her out, strung them along without executing the required documents, and lulled them into a false sense of security by finally executing the key documents while secretly filing a bankruptcy petition, just before the deed of trust could be recorded. Making matters worse, she then grabbed all of the insurance proceeds. And what a coincidence that the property burned down the day after the mortgage was released.

Turning to the legal issues, the cases are mixed; but the trend is clearly in favor of trustees and against unrecorded refinancing lenders seeking equitable subrogation. The lessons are obvious. First, do not fund the payoff of the original mortgage until a deed of trust or mortgage is recorded in favor of the refinancing lender. Second, make sure that the refinancing lender is named as a loss payee on the property insurance. Third, do not try to arrange private lending transactions without professional help.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.