Section 544(a) of the Bankruptcy Code - commonly referred to as the "strong arm clause" - gives a bankruptcy trustee special powers to defeat the status of certain creditors. It provides that "[t]he trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by a debtor" that could have been "avoided," or invalidated, by certain kinds of hypothetical judicial lienors, holders of unsatisfied executions or bona fide purchasers of real property. When complemented by the trustee's powers to avoid preferential or fraudulent transfers made (or obligations incurred) by a debtor prior to filing for bankruptcy, the strong arm powers give the trustee a formidable array of tools to generate the greatest possible pool of assets for administration in a debtor's bankruptcy estate.
Among the trustee's strong arm powers is the ability under section 544(a)(3) to assume the status of a hypothetical bona fide purchaser of real property. This allows the trustee to avoid any lien that is unrecorded or improperly recorded as of the bankruptcy filing date. However, the extent of the trustee's rights as a bona fide purchaser of real property is measured by the substantive law of the state governing the property in question.
For example, courts interpret the statutory language "without regard to any knowledge of the trustee or of any creditor" to mean actual, rather than constructive, knowledge. This means that when an otherwise bona fide purchaser of real estate would be subject to a claim because of constructive notice under state law, the trustee cannot avoid the claim. A hypothetical bona fide purchaser under section 544(a)(3) is a purchaser who under state law could have conducted a title search, paid value for the property and perfected his interest as a legal title holder as of the date of the commencement of the case. The trustee, just as a hypothetical purchaser, is amenable to state recording statutes and other non-bankruptcy laws which would prevent him from properly perfecting a transfer from the debtor at the time of the commencement of the case. Thus, although section 544 provides that a trustee's actual knowledge is not relevant, a trustee is still bound by the state law regarding recordation and constructive notice, as well as other state law limitations upon bona fide third party purchaser status.
The 6th Circuit Court of Appeals recently had an opportunity in Rogan v. America's Wholesale Lender (In re Vance) to address the distinction between actual and constructive knowledge in the context of section 544(a)(3). In Vance, a couple in Kentucky mortgaged a house to a lender and filed for chapter 7 bankruptcy protection a few months later. The bankruptcy trustee sought to avoid the mortgage based on a minor defect in the recording of the security interest.
Under the laws of Kentucky, a mortgage must contain a notary's acknowledgement certifying that the acknowledging individual appeared before the notary and acknowledged that he executed the instrument, and that the individual was known to the notary. The recorded mortgage did not contain the proper notary certification. Accordingly, the bankruptcy court held that the trustee could avoid the mortgage. The district court reversed on appeal. According to the court, although the mortgage was not properly acknowledged, the recorded mortgage served to give either actual or inquiry notice to anyone searching the title on the property. As such, the district court ruled, the trustee could not avoid the mortgage as a hypothetical bona fide purchaser.
A unanimous Sixth Circuit reversed that determination. Crediting the district court with having "followed a good, common-sense approach to resolve the problem," the Court of Appeals observed that "it is not the law of Kentucky." Although any title search would have provided actual notice of the mortgage, the Sixth Circuit emphasized, section 544(a)(3) of the Bankruptcy Code specifically prohibits trustees from having actual knowledge of security interests. Therefore, it ruled, a trustee can only be charged with constructive notice and, in Kentucky, an improperly recorded security interest fails to provide constructive notice. Thus, the improperly recorded mortgage could be avoided by the trustee.
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Rogan v. America's Wholesale Lender (In re Vance), 2004 WL 771484 (6th Cir. Apr. 8, 2004).
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