In re Woods – a Cautionary Tale for Kentucky Lenders

Although litigation is society’s mirror, it’s a mirror that reflects only with a certain lag time. Now that we are three years into the housing bust, and over two years into the Great Recession, the published case law is finally beginning to suggest that yes, we have had a credit crisis. That’s not surprising. Today’s post, however, concerns In re Woods, 422 B.R. 102 (Bankr. W.D. Ky. Jan. 28, 2010), a case that moves beyond mere taxonomy into the area of theory, to suggest why the credit crisis happened. Although there are surely other reasons, In re Woods tells a story of astonishingly lax lending procedures.

Admittedly, some may claim the loan diligence and documentation process is ministerial, but it does matter — at least when it’s time to get paid…and…you don’t get paid, which is what happened to the bank in Woods. Because this story isn’t going to be flattering for the bank in question, for purposes of our discussion, let’s call the bank “Sad Bank”. “Sad”, that is, because they’re not going to get paid. “Sad”, because if the situation in Woods is anything more than an isolated instance (odds on that, anyone?), then the bank’s shareholders are sad, too. “Sad” because depositors at all banks are paid less interest so all banks can pay increased FDIC insurance fees to cover systemic risk presented by the Credit Crisis All Stars, like Sad Bank.

Woods involved a bankruptcy debtor, a revocable trust, and a purported mortgage on property owned by the revocable trust. Its analysis is a useful reminder that revocable trusts do not provide asset protection.

Let’s explore the case….

The debtor, Mr. Woods, was married to Mrs. Woods in 1995. Two years later, the debtor became a co-owner with his brother of a business, Autosource, Inc. Around the same time, Mr. and Mrs. Woods had prepared and signed estate planning documents, including what seems to have been a joint revocable living trust.  (Although KYEstates believes that on balance, joint revocable living trusts for Kentucky residents cause more problems than they solve, and generally aren’t advisable, they are used with some frequency in Kentucky.)  As part of their estate planning, they each had a springing power of attorney (effective only in the event of their incapacity) prepared in favor of the other.  As part of the estate planning process, Mr. and Mrs. Woods conveyed their residence to the revocable trust (the “Trust”).

Mr. and Mrs. Woods were co-trustees of the Trust.  The Trust contained several provisions regarding the trustee’s powers.  First, it provided that either trustee could conduct business and act on behalf of the Trust without the consent of any other trustee.  The Trust also provided that the trustee had the power to borrow funds from any person, and to secure any such obligation by mortgage.  Nonetheless, the Trust did not specifically grant the trustees the power to encumber Trust property to secure loans made to third parties.

Readers, you may be able to sense where this fact pattern is going.  By March 2006, Mr. Woods needed working capital for the business.  Because most of Mr. Woods’ assets were probably held in the Trust, a mortgage on Trust property was needed to secure the working capital loan.  Mr. Woods had sought his wife’s permission to mortgage the house in the Trust (the “Property”), but she refused.

Mr. and Mrs. Woods had previously sold other parcels of vacant land owned by the trust.  When they had done so, each of them had signed the transaction documents and deeds as co-trustee.  Mr. Woods believed both his signature and his wife’s were necessary to mortgage the Property.

Without his wife’s consent or knowledge, Mr. Woods approached Sad Bank, which at that time was Happy Ready To Lend Bank, seeking a home equity line of credit secured by a mortgage on the Property.  Sad Bank’s loan officer took the loan application over the phone, and later informed Mr. Woods that the loan had been approved.

After the loan was approved, the loan officer was notified that a copy of the Trust Agreement was required.  Mr. Woods provided one, and it was forwarded to the Sad Bank underwriting department, but also told the loan officer his wife would not sign the loan application.  Sad Bank wanted to close the loan (of course), so they discussed other options.  One option was they considered was the springing power of attorney from Mrs. Woods in favor of Mr. Woods, which Sad Bank decided it could use to close the loan.

The closing occurred in April 2006.  The mortgage had four signature lines, two for each of Mr. and Mrs. Woods individually, and two for each of Mr. and Mrs. Woods to sign as co-trustee.  Mr. Woods signed all four signature lines.  A Sad Bank employee notarized the signatures.  The notary bloc attested that Mrs. Woods had duly signed the documents.  (This, of course, wasn’t exactly true….)

Upon execution of the loan documents by Mr. Woods, Sad Bank transferred to Mr. Woods a $400,000 line of credit under the mortgage on the Property.  Mr. Woods used the loan proceeds for his business, Autosource, or for his personal account.  The parties stipulated that at no time did Sad Bank inquire whether Mr. Woods was Mrs. Woods’ attorney-in-fact, or whether Mrs. Woods was incapacitated.  In reality, Mrs. Woods was not incapacitated, and the loan documents were executed without her authorization or consent.

Another bank (“Mega Bank”) recorded a judgment lien against Mr. Woods in February 2008.  In April 2008, the IRS filed tax liens against Mr. and Mrs. Woods.  In May 2008, Mrs. Woods became aware of the mortgage on the Property.  In June 2008, Mr. Woods filed a Chapter 7 bankruptcy petition.  Later that same month, the Trust and Mrs. Woods brought an action against Sad Bank seeking a declaratory judgment to have the mortgage against them declared null and void.  In November 2008, Mega Bank brought an adversary proceeding to determine the priority and extent of liens against the Property.

(For readers who lost track: the score is now: 1 Stressed Marriage, 1 Angry Wife, 1 Busted Husband, 1 Nonplussed Bankruptcy Trustee, 3 Unhappy Lienholders, and only 1 Property.)

In the litigation, Mega Bank, the Trust, Mrs. Woods, and the bankruptcy trustee argued that the mortgage obtained by Mr. Woods through Sad Bank on the Property was invalid because Mr. Woods did not have authority to mortgage Trust property under the terms of the Trust, and because the notarial attestation of the mortgage was invalid under KRS 382.270.  Sad Bank argued that the mortgage was valid because Mr. Woods did have authority under the terms of the Trust to mortgage the Property, and that the Property was never property of the bankruptcy estate.

The bankruptcy court found that the Property was part of the bankruptcy estate.  Under 11 U.S.C. Sec. 541(a)(1), the bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case”.  Because the Trust was a revocable trust (with the consent of Mrs. Woods) and because Mr. Woods had a beneficial interest in the trust, the court, citing In re West, 2009 WL 2713331 (Bankr. W.D. Ky. Aug. 25, 2009), found that the Property was includible in the bankruptcy estate.  (It seems as if the fact that the Trust was revocable only by joint action of Mrs. Woods and Mr. Woods was immaterial….)

The court then evaluated all of the provisions of the Trust agreement, as well as the intent of Mr. Woods and Mrs. Woods in creating the Trust, under a contract-type analysis.  it determined that that Mr. and Mrs. Woods intended that each Trustee’s consent was required to encumber the Property.  Reviewing the facts, the Court also determined that Sad Bank knew that Mrs. Woods’ signature was necessary in order to mortgage the Property, and was aware that Mrs. Woods had to be incapacitated in order for Mr. Woods to act as her attorney-in-fact under the document, but that Mrs. Woods was not incapacitated when the loan documents were signed.  The court also found that Sad Bank “was also aware at the time [Mr. Woods] signed the mortgage that [Mrs. Woods] was not present, that she did not consent and either knew or with careless disregard failed to determine whether she was incapacitated.”

Accordingly, the court held that Sad Bank “should not now be allowed to profit from its own negligence by having its mortgage take priority over the other creditors.”

The court also found that the mortgage had been defectively acknowledged under KRS 382.270, and that a “defectively acknowledged security interest or mortgage does not provide constructive notice of the mortgage.”

Significantly for readers interested in fiduciary and trust law matters, the court also found that “it is undisputed that the proceeds of the loan went to [Mr. Woods and his business].  In other words, [Mr. Woods] used Trust property for his own benefit.”

Kentucky case law provides that a trustee owes a “duty of utmost fidelity and loyalty to the beneficiary and if it appears that the trustee is guilty of such self-dealing, the courts will not hesitate to declare such a transaction void.”  Hutchings v. Louisville Trust Co., 276 S.W.2d 461, 464 (Ky. 1955)  Consequently, the court found that Mr. Woods’ actions with regard to the mortgage were invalid, as he had violated his fiduciary duty to the beneficiaries of the Trust by acting in his own self-interest.  Because Mrs. Woods (the other beneficiary) did not benefit from the mortgage, the transaction was void.

The bankruptcy court held that Sad Bank’s mortgage was avoided as a matter of law.

The lessons of Woods aren’t subtle.  Don’t loan funds against real property that doesn’t belong to the borrower, and that the mortgagor doesn’t have authority to mortgage.  Don’t accept an agent’s authority to act under a springing power of attorney without proof that the principal is incapacitated.  And if you’re a bank shareholder, a taxpayer, or a depositor, expect better from your banks, so at least the next financial crisis will involve new negligence, not the same missteps all over again.

Taking a moment away from the law, KYEstates notes that today is the 234th birthday of our Nation, and that this year we find our Nation weary, worn-out, and indebted. The Nation’s underlying architecture, however, has been and remains solid. Putting aside ephemeral politics, and concerns of the moment, consider how F. Scott Fitzgerald spoke through Nick Carraway at the end of The Great Gatsby:

…for a transitory enchanted moment man must have held his breath in the presence of this continent, compelled into an aesthetic contemplation he neither understood nor desired, face to face for the last time in history with something commensurate to his capacity for wonder.

Carraway then mused on Gatsby’s ceaseless striving for the “green light at the end of Daisy’s dock,” a dream that “must have seemed so close that he could hardly fail to grasp it,” but a dream that was “already behind him, somewhere back in that vast obscurity beyond the city, where the dark fields of the republic rolled on under the night.”

On this July Fourth here in Kentucky, where the dark fields of our Republic roll on under the night, let’s pause to appreciate with our own full sense of wonder what a privilege it is to live our common destiny together on this great continent, come what may.  Happy Birthday, America.

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