Indiana Court Discusses Whether A Lender Was A “Bona Fide Mortgagee”

Imagine making a mortgage loan and later having a court determine that the mortgage is invalid.  What you thought was a secured debt suddenly becomes unsecured.  That’s what happened in Thomas v. Thomas 2010 Ind. App. LEXIS 389 (Ind. Ct. App. 2010). 

The story.  The Thomas case involved some pretty bizarre facts.  The case dealt with Lender, Father (who owned real estate) and Father’s two sons.  Father purchased the property in 1965 and lived there continuously and throughout the litigation.  For estate planning purposes, he deeded the property in 1977 to Son 1, with the oral understanding that Son 1 would deed the property back at any time upon request.  In 1995, Son 1 deeded the property to Son 2, and Son 2 knew that he must convey the property back to Father upon request.  In early 2001, Father asked Son 2 to deed the property back, but Son 2 refused.  In response, Father recorded a $200,000 mechanic’s lien notice on the property and also filed a quiet title lawsuit.  In late 2001, Son 2 obtained a $118,000 mortgage loan from Lender based, in part, on a forged and technically-flawed mechanic’s lien release.  In 2002, Father filed a foreclosure lawsuit with respect to the mechanic’s lien and named Lender as a defendant.  In 2003, Son 2 filed bankruptcy and ended up conveying the property back to Father.  In 2007, Lender had the mechanic’s lien rendered invalid in the mechanic’s lien foreclosure suit.  The mess thus boiled down to a battle, in the foreclosure case, between Father and Lender as to whether the mortgage was invalid. 

Bona fide mortgagee rule.  The Court’s opinion in Thomas surrounded whether Lender was or was not a “bona fide mortgagee.”  While I’ve previously discussed here (May 8, 2010 and October 4, 2009) the “bona fide purchaser” defense, I’ve not posted about the “bona fide mortgagee” doctrine.  The Court noted that the Indiana bona fide purchaser doctrine “applies with equal force to mortgagees.”  Although the Court did not articulate the test for how a lender/mortgagee would qualify as a bona fide mortgagee, application of the bona fide purchaser test suggests that the lender would have to acquire a mortgage in good faith, for valuable consideration, and without notice of the outstanding rights of others.  It follows that the defense is premised on the theory that every reasonable effort should be made to protect a lender who acquired a mortgage for valuable consideration without notice of a legal defect.

Duty to inspect?  Since Lender clearly acquired the mortgage for valuable consideration, the issues in Thomas were whether Lender (1) acted with good faith and (2) without notice of Father’s rights.  To my surprise, the Court sided with Father on both points and rendered Lender’s mortgage invalid.  The Court first focused on Father’s possessory rights.  In Indiana, generally speaking, “one who fails to examine land which he is about to purchase, and to inquire as to the rights of one in possession, is not acting in good faith and will not be treated as a bona fide purchaser.”  Furthermore, “possession of land puts the world on notice that the possessor may have a claim of ownership and right to possession.”  The Court utilized all these various legal principles to arrive at the following conclusion:

Quite simply, it is undisputed that [Father] was in possession of the property in question and that [Lender] nonetheless did nothing to ascertain his rights to it.  It is apparent that even a cursory investigation would have quickly uncovered both [Son 2’s] fraud and [Father’s] claims on the home.  Under the circumstances, [Lender] cannot have been a bona fide mortgagee, and we therefore affirm the trial court’s judgment in this regard.

Frankly, I’m still trying to wrap my head around what this holding means to lenders.  Remember, Son 2 had the deed and thus title to the property.  Beyond that, do lenders actually need to verify whether who is in possession of the property and determine his, her or its rights to title?  Hmmm . . ..  I welcome the posting of comments or emails about this matter.

Bogus lien release.  The Court seemed to back off of the notion that lenders must physically inspect their real estate collateral - - saying that, “even in the absence of a duty to inspect,” the “irregularities on the face of the forged release of mechanic’s lien” should have put Lender, as a reasonably prudent person, on inquiry notice that something was amiss.  Basically, the Court felt that anyone reviewing the mechanic’s lien release should have questioned the authenticity of it.  Lender “clearly had the means to discover that the lien the forged instrument purported to release did not exist . . . we believe that a reasonably prudent lender would have taken the simple steps necessary to verify that a superior $200,000 mechanic’s lien had indeed been released.”  All told, the Court held that Lender could not have been a bona fide mortgagee due to “its failure to investigate [Father’s] interest in the home.” 

Much more could be said about Thomas, particularly regarding the potentially scary proposition that under certain circumstances lenders may have some burden to physically inspect real estate before making a loan in order to verify the possessor is also the mortgagor/owner.  But allow me to conclude with this one piece of simple advice:  always get title insurance when you’re initially making a mortgage loan or later foreclosing on the mortgage.  Title work, including loan policies and owner’s policies, provide a critically-important level of protection for lenders.  Assuming the Lender/Son 2 closing was insured, presumably the title company and not the Lender ultimately will bear the loss in the Thomas case.   

“Service Of Process” Fundamentals For The Plaintiff Lender

Earlier this year, the Indiana Court of Appeals, on the same day, issued two opinions setting aside default judgments entered in favor of lenders in mortgage foreclosure actions.  The reason - inadequate service of process on the borrowers.  The two cases were:  Elliott v. JPMorgan Chase Bank, 920 N.E.2d 793 (Ind. Ct. App. 2010) (.pdf) and Yoder v. Colonial National Mortgage, 920 N.E.2d 798 (Ind. Ct. App. 2010) (.pdf).  As I reviewed the cases, it occurred to me that a blog post about service of process could benefit workout professionals. 

Job 1.  Service of process involves the delivery of a summons and the complaint to a defendant.  (Here is a form summons.)  Service of process is a necessary and critical initial step in any loan enforcement litigation.  “Ineffective service of process prohibits a trial court from having personal jurisdiction over a defendant, and a judgment rendered without personal jurisdiction over a defendant violates due process and is void.”  Elliott v. JPMorgan Chase Bank.  Constitutional law (notice and an opportunity to be heard) is at the heart of the service of process requirements. 

Types and manner of service.  In Indiana state law, “process” is governed by the Trial Rule 4 series, which starts with Rule 4 and ends with Rule 4.17.  Loan enforcement actions typically involve service upon adult individuals and/or organizations such as limited liability companies.  Service upon individuals is governed by Rule 4.1, and service upon organizations, such as LLCs, is governed by Rule 4.6.  Organizations can be served a number of ways, most notably by service on the “registered agent” designated  with the Indiana Secretary of State. 

Perhaps the simplest and cheapest way to serve either an individual or an organization is by certified mail.  A sometimes more effective approach is to have service of process accomplished by the county sheriff, which is an option available to plaintiffs in every county in the State.  Service by certified mail is covered by Rule 4.11.  Service by sheriff is covered by Rule 4.12.  Service by publication is covered by Rule 4.13.

Case study – copy service.  Elliott involved the Court’s reversal of a default judgment due to defective “copy service.”  Copy service typically refers to “leaving a copy of the summons and complaint” at an individual’s dwelling, house or usual place of abode.  Rule 4.1(A)(3).  In Elliott, the county sheriff’s office served the summons by leaving a copy at the defendant’s residence.  But, there was no evidence that the sheriff complied with Rule 4.1(B)’s second step (U.S. Mail) in the two-step copy service procedure:

the person making [copy] service also shall send by first class mail, a copy of the summons without the complaint to the last known address of the person being served, and this fact shall be shown upon the return.

Case study – publication.  In Yoder, the Court reversed the default judgment because service by publication pursuant to Rule 4.13 was insufficient.  Service by publication is just that – publication of the summons and related information in a newspaper circulated where the defendant resides.  This is a last resort method of service.  Plaintiffs in Indiana really cannot utilize the service by publication option unless they have used “due diligence to locate” the defendant first so as to actually deliver the summons.  In Yoder, the Court outlined how the plaintiff’s “cursory attempt to locate [the defendant did] not constitute a diligent search.”  Before turning to service by publication, it’s advisable to consider personal delivery by the sheriff or a private process server at any last-known address that can be reasonably found either in your files, through the Secretary of State’s office (if an organization) and/or an internet search tool, such as that offered by LexisNexis. 

Client’s decision.  The manner of service (certified mail, sheriff, private process server, etc.) may be dictated by the lender’s cost tolerance and/or sense of urgency to enforce the loan (or get the defendant’s attention).  Lenders and their counsel should discuss this issue around the time they are finalizing the complaint.  More often than not, certified mail service (handled by the clerk’s office) will work.  If, however, you don’t have a good mailing address and/or have reason to believe the particular defendant may avoid signing for the package, then the potential for delay may justify the costs of hiring a process server to get the job done. 

NOTE:  For more, see my 2-2-13 post.

Creditor May Repossess Collateral And Sue For Full Debt Simultaneously, And Generally Is Not Compelled To Accept Short Sale

If you work for a commercial lending institution and have ever wondered (1) whether you must accept a short sale of non-real estate collateral and/or (2) whether you first must obtain a  judgment before repossessing that collateral, then SFG v. N59CC, 2010 U.S. Dist. LEXIS 20931 (N.D. Ind. 2010) (.pdf) will be of benefit to you. 

Enforcement measures.  SFG involved the standard parties to a commercial loan enforcement action:  a lender (the plaintiff), and a borrower and guarantors (the defendants).  The loan was for $1,020,000, and the collateral was an aircraft.  Upon the loan default, the lender filed a lawsuit based upon the promissory note and security agreement.  While the suit was pending (before judgment), the lender repossessed the aircraft.  Later, the lender filed a motion for summary judgment seeking the entire amount of the debt.  The SFG opinion dealt with the borrower/guarantors’ objection to the motion.

Parallel tracks fine.  The UCC, which governed the lender’s remedies, did not require the lender to choose between two remedies of money judgment and repossession.  The lender was “well within its authority to pursue a judgment against [borrower and guarantors] for the default while simultaneously repossessing the aircraft.”  Ind. Code § 26-1-9.1-601 states that, after a debtor defaults, a secured party may “reduce a claim to judgment, foreclose, or otherwise enforce the claim.”  The secured party’s rights are “cumulative and may be exercised simultaneously.”  (But be sure to check your security agreement for self-help and repossession rights and/or limitations.) 

Double recovery?  Theoretically, the pursuit of multiple remedies could give rise to the recovery of more than the original debt.  However, SFG reminds us that the “check on a plaintiff’s right to pursue multiple remedies . . . is the requirement that a plaintiff proceed in a commercially reasonable manner and apply the proceeds of the disposition to the amount owed by the defendant.”  See I.C. § 26-1-9.1-608 through 610.  This means, among other things, that the lender in SFG must later account to the defendants for any proceeds of the sale of the aircraft. 

Short sale lost.  While the motion for summary judgment was pending, a “short sale” offer for the aircraft surfaced that would have netted $570,000 to the lender.  The defendants conceded that the aircraft was worth more but were inclined to move forward anyway, assuming the lender committed to structure a settlement for the payment of the remaining balance (the deficiency).  For a variety of reasons, the lender allegedly failed to “seal the deal,” so the sale never occurred.  The defendants claimed that, to their detriment, the lender failed to act in a commercially reasonably manner.  The defendants contended that any judgment amount should therefore be reduced by $570,000.

Commercially reasonable?  Judge Simon devoted a substantial portion of his opinion to a discussion of whether the contemplated short sale was “commercially reasonable” or whether the lender’s alleged failure to agree to the short sale was “commercially reasonable.”  In the end, Judge Simon overruled the defendants’ objection to the motion for summary judgment on the grounds that issues of commercial reasonableness were not ripe for adjudication. 

If [lender] fails to conduct its sale of the plane in a commercially reasonable manner, [borrower or guarantors] may then bring an action to recoup any loss.  In the meantime, because [borrower and guarantors] concede liability and the amount of damages under the agreements, summary judgment in this action is proper. 

Short sale not mandated.  The defendants’ only chance of making any hay out of the lost short sale in SFG will be if, post-judgment, the lender fails to liquidate the aircraft for more than $570,000.00.  Conceivably, the defendants in SFG could then pursue a claim against the lender to recover the difference - by establishing that the lender failed to act in a commercially reasonable manner for not accepting the prior short sale.  Even then, however, there would be a multitude of factors that will go into the validity of such a claim, including an examination of the proposed short sale terms and conditions as compared to those of the subsequent liquidation sale.  Under the circumstances in SFG, the creditor was not initially compelled to accept the short sale. 

2011 Indiana County Sheriff's List

Thanks to Cindy Edmiston of SRI, Incorporated for circulating the attached list of Indiana sheriffs for 2011.  Sheriff's sale documents, such as the notice, clerk return and deed, should identify the county sheriff.  Evidently, there will be forty-six new sheriffs in 2011.  Mortgagees and their foreclosure counsel should update certain forms accordingly.