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.