In Secured Lending 101, we learn that the general rule is "first in time, first in right." Well, how does one determine who is "first in time"? Generally, secured lenders may rely on state and county recording offices to determine the priority of their lien against a borrower’s property. If public records show no existing liens on the property, the lender’s lien generally will have top priority.

Can a diligent lender’s lien lose its priority position despite good-faith reliance on the public records? Recently, in In re Rag East LP, No. 12-2454-CMB (Bankr. W.D. Pa. Mar. 4, 2013), U.S. Bankruptcy Judge Carlota M. Böhm of the Western District of Pennsylvania was asked to decide which lien had priority: a lender whose properly recorded liens were fraudulently released by recording of lien "satisfaction" documents filed with state and county recorders’ offices without its permission, or subsequent lenders who relied on the forged satisfaction documents and believed they were getting first priority liens? Faced with this difficult situation, the court held the forged statements were nullities and the first lender retained its first priority position.

Three Innocent Lenders and Two Bad Documents

The opinion contains the following stipulated facts. In the spring of 2011, Rag East LP and its principal borrowed $750,000 from Primerock Real Estate Fund LP to buy a vacant building. As security for the loan, Rag East executed and delivered a mortgage and a separate security agreement to Primerock. The Primerock mortgage was recorded with the commissioner of records and a UCC-1 financing statement was filed with the secretary of state.

Approximately six months later, Rag East obtained a construction loan from MileStone Bank in the principal amount of $350,000, secured by a mortgage on the property. Rag East later obtained another construction loan from MileStone for a principal amount of up to $1.5 million. Rag East was permitted to make draws against this second loan to pay certain expenses. While MileStone knew of Primerock’s mortgage when it made the first loan, it relied on the existence of a satisfaction piece document and would not have made the loans unless it was provided a first lien on the property.

After the MileStone mortgage was filed, the satisfaction piece allegedly executed by Primerock prior to the first MileStone loan was filed with the commissioner of records. The satisfaction piece ostensibly released Primerock’s liens and security interests granted under the Primerock mortgage. A UCC-3 termination statement was later filed with the secretary of state. The UCC-3 termination statement purported to terminate the liens and security interests granted under the Primerock security agreement. The parties stipulated that both the satisfaction piece and UCC-3 termination statements were forged.

After the forged documents were filed, Rag East and certain of its affiliates borrowed $600,000 from a third lender, Zhuang Zhong. Like MileStone, Zhuang was unaware that Primerock continued to assert liens against Rag East’s property, and Zhuang believed Primerock’s liens had been satisfied based on the filed satisfaction piece and UCC-3 termination statement. MileStone and Zhuang were not involved with the satisfaction piece or UCC-3 termination statement, and they had no reason to suspect either was a forgery when they made their loans.

As to Primerock, the lender discovered the existence of the forged satisfaction and termination filings after the MileStone and Zhuang loans were made and Primerock began collection proceedings by confessing judgment against Rag East on March 16, 2012. In fact, Rag East executed and delivered a mortgage to Zhuang on April 24, 2012, over a month after Primerock confessed judgment against Rag East.

The court concluded its recitation of the stipulated factual background by writing, "What is readily apparent from the stipulated facts is that Primerock, MileStone, and Zhuang are the innocent victims of the forged satisfaction piece and unauthorized termination statement. Unfortunately, the hardship must inevitably fall on one of these parties." With that in mind, the court turned to the lien priority issues.

Finding the Most Innocent Victim and Equitable Result

Zhuang filed an involuntary bankruptcy petition against Rag East in May 2012. Primerock commenced an adversary proceeding seeking a declaratory judgment striking the forged mortgage satisfaction and UCC termination statements, a determination of its lien priority and security interests, and to quiet title with respect to its mortgage. Primerock and Zhuang filed a motion and cross-motion for summary judgment, respectively.

The court began by considering the impact of the forged satisfaction piece. Under Pennsylvania law, a recorded satisfaction piece is prima facie evidence that the debtor has fully satisfied the note and the creditor has released the mortgage lien. However, a lender may prove the lien was improperly discharged with evidence that the borrower was not entitled to have the mortgage satisfied. The court found the satisfaction piece was unauthorized and invalid as to the debtor and relief was appropriate against Rag East. That being said, the rights of third parties needed to be addressed.

Primerock, who had recorded first, would maintain priority only if the forged satisfaction piece was ineffective against third parties. The decision set forth what the court called "two important principles: the invalidity of forged and unauthorized filings and the interests of bona fide mortgagees for value … one must take precedence over the other."

The court began its analysis by discussing Brown v. Henry, 106 Pa. 262 (1884), a Pennsylvania Supreme Court case in which a mortgage satisfaction was mistakenly filed by another mortgagee. There, the purchaser had relied on a wrongly filed satisfaction piece and believed he took the property free of liens. The Brown court held that the satisfaction piece had been entered without the authority of the mortgagee, and was therefore ineffective. The opinion notes that Brown has been cited in other jurisdictions for the proposition that a wrongfully satisfied mortgage survives notwithstanding the existence of a subsequent bona fide purchaser or mortgagee for value.

Next, the court turned to Leedom v. Spano, 647 A.2d 221 (Pa.Super.Ct. 1994), in which the Pennsylvania Superior Court ruled that property sold to innocent homeowners continued to be encumbered by a mortgage despite the filing of a forged mortgage release. The opinion notes the homeowners in that case, while innocent as to the forged satisfaction, would have had to make a claim on their title insurance policy for their remedy.

Zhuang cited cases involved liens obtained through fraudulent inducement or negligent conduct, not a forged satisfaction piece, for the proposition that innocent mortgagees are not bound by unknown liens. The court distinguished these cases because they involved situations where the interested party knew its interests were being affected, and because of "the fundamental principle that where one of two innocent persons must suffer, he whose neglect made the injury possible should bear the loss."

The court emphasized the importance of reliance upon the public records and the policy of protecting bona fide purchasers and mortgagees for value. The court also acknowledged the need to discourage secret liens held by entities that failed to give proper notice to those who subsequently deal with the property. In this case, the court reasoned the purpose of this rule was not served by invalidating Primerock’s mortgage. Primerock had properly recorded its mortgage, thereby giving notice of its interest to the public. The harm to MileStone and Zhuang was not made possible by Primerock’s neglect. The court concluded Primerock’s mortgage was entitled to priority status despite the harm to MileStone and Zhuang.

The court then turned to the forged UCC-3 termination statement. Section 9510 of the UCC adopted in Pennsylvania provides that in order to be effective, a termination statement must be filed by certain authorized persons. Here, only Primerock was entitled to file a termination statement. The decision recites that although no reported decisions were cited interpreting the Pennsylvania statute on these facts, the court relied on court decisions interpreting other states’ UCC statutes and held the forged UCC-3 termination statement was ineffective and had no effect on Primerock’s original properly filed financing statement.

In the end, the court observed while all three parties were innocent, Primerock was the most innocent. MileStone made its first loan with knowledge of Primerock’s prior mortgage. Zhuang did not record his mortgage until over a month after he made his loan and after Primerock confessed judgment against Rag East.

Innocence and Diligence Are Not Always Enough

Secured lenders routinely rely on the state and county recording systems to learn about the properties they desire to be pledged as collateral for loans in order to be notified of their respective interests. Unfortunately, as this case reminds us, all systems can fail when fraud is involved. Perhaps the lesson here is simply to make sure title insurance will cover these situations. Alternatively, the lender is left with the burden to contact prior filed mortgagees and confirm the filed satisfaction pieces and UCC termination statements were in fact authorized and prior loans have been paid. One thing is certain — as the economy strengthens and lending credit standards weaken, unusual situations involving competing claims for limited collateral will occur. •

Andrew C. Kassner is the chair of the corporate restructuring practice group of Drinker Biddle & Reath, practicing in the firm’s Philadelphia and Wilmington, Del., offices. He can be reached at andrew.kassner@dbr.com or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington offices. He can be reached at joseph.argentina@dbr.com or 215-988-2541.