Daily Development for Wednesday, August 9, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGES; PRIORITY; SUBROGATION: Refinancing loan on FNMA/FHLMC paper qualifies for "conventional subrogation" and therefore refinancing mortgage takes priority over recorded judgment lien that was present at the time that the original senior mortgage was paid off.

Aames Capital Corp. v. Interstate Bank of Lake Forest, 2000 WL 1051860 (Ill. App. 2nd Dist. 7/31/00))

The facts of this case are quite simple as subrogation cases go. Some time after the borrowers granted a first mortgage lien, a judgment lienholder recorded a substantial judgment against the borrower. Thereafter, the borrowers obtained a refinancing loan, executing standard form FNMA/FHLMC documents, including a mortgage to the refinancing lender. Apparently the new lender had no actual knowledge of the judgment lien, and the parties certainly made no provision for it. The terms of the refinancing lien required that the entire loan proceeds be used to pay off the first lien and no proceeds went directly to the borrower.

Later, of course, the holder of the judgment lien foreclosed and claimed priority over the later recorded refinancing mortgage. The refinancing mortgagee, of course, claimed subrogation ,to the original first lien mortgage, which, in the end the court granted.

All of this is really quite predictable, based upon the precedents. The judgment lienholder would have been unjustly enriched by denial of subrogation, since its original lien was subject to the outstanding first mortgage debt, which in effect had never been paid off by the mortgagor. So the mortgagor's "true" equity in the property had never increased for purposes of legitimately covering the judgment lien claim.

The court, however, chooses this case to go through an extended analysis of the difference between equitable subrogation and conventional subrogation (both of which are equitable doctrines), and to conclude that equitable subrogation applies in this case. As the court describes conventional subrogation, the concept arises when a lender and borrower agree that the lender will retire a secured claim against the borrower's property and that the lender will have the lien of that secured claim. When there is such an understanding, of course, typically the refinancing lender actually takes an assignment of the prior secured claim, and equitable doctrines like subrogation never enter the picture. In some cases, however, after the refinancing lien is made, the necessary assignment never takes place, and course have granted what is in essence an equitable completion of the planned assignment.

But in many circumstances the parties intend and believe that the lien of the refinancing lender will replace the lien of the loan being refinanced, and thus will occupy prime position, because the parties erroneously assume that there are no other liens on the property. That appears to have been the case here. Is this mistaken assumption the same as an "agreement" that the refinancing mortgagee will have the priority of the loan paid?

The court here says "yes." For reasons that are somewhat unclear, the court seems uncomfortable using equitable subrogation, and elects instead to try to pound this case into the hole marked "conventional subrogation.

     "[The refinancing loan agreement] specifically provides that the   [borrowers] were to discharge any lien that had priority over the   mortgage. The Uniform Instrument further provides that Pacific   may pay any sums secured by a lien that had priority over its   mortgage and that any such sum paid would become additional   debt secured by the mortgage.

     Although there is no provision in the Uniform Instrument that   specifically states that the mortgage is a first mortgage, we   believe that the abovereferenced provisions, when read together,   indicate that the agreement of the parties was that the mortgage   held by Pacific would be a first priority mortgage, and that any   other prior mortgages of record would be paid off by Pacific, with   the new mortgage securing that debt. In addition, we do not   believe that such a specific provision in the mortgage document   regarding the assumption of the first priority position is required .   . . ."

The court goes on to conclude that policy supports application of subrogation here, but does not really make clear why the technical concept of "conventional subrogation" is the necessary form:

     "There are numerous policy reasons to apply the doctrine of   conventional subrogation to a case involving a refinancing   mortgage. A debtor in bankruptcy, who has outstanding judgments   and has defaulted on his mortgage, may find relief in refinancing his   home, albeit under less favorable loan terms. Similarly, any time a   mortgage note is accelerated or matures is a prime opportunity for   a debtor to enter into a refinancing agreement. Absent subrogation   of the original mortgage lien, these consumers would be hard   pressed to find a lender willing to refinance. In addition, if   subrogation were not applied in cases of mortgage refinancings,   then the intervening lienor . . . would receive a windfall from the   payoff by the refinancing mortgagee."

Comment 1: The editor has no quarrel with the outcome. It fits the precedents. Further, the editor is not sufficiently clear as to the reason for differentiating between conventional and equitable subrogation in the first place to be overly concerned about the use of conventional subrogation here. Finally, contrary to the court's analysis, there is the argument, overlooked by the court, that the warranty of title that undoubtedly was contained in the FNMA/FHLMC mortgage in fact did constitute a contractual undertaking that the refinancing mortgagee would have first priority, so the facts fit more closely to the conventional subrogation model than the court admits.

Comment 2: Having taken into account all of the considerations in Comment 1, however, the editor still prefers to view this case as one of equitable subrogation. The real understanding of the parties was not that the mortgagee would have the rights of the old mortgagee, but that the refinancing mortgagee would have a new loan, with new terms and conditions.

Subrogation does not imbue the new refinancing loan with the priority of the old one. It merely slips the refinancing lender into the shoes of the old lender for the amount of the old lien. This includes interest rate, foreclosure rights, and every other provision of the original mortgage. Thus, it is not accurate to say that the parties to a refinancing lien have an understanding that the lender will have the lien of the original lender quite the opposite is true. It is only true to say that the parties believe, in most cases that the new lender will have the priority that the original lender enjoyed. Even here, however, it likely is their expectation that the new lender will have the priority of the old one as to all sums the new lender advanced, and not just as to the amounts of those prior liens that the new lender paid off.

In short, to say that the subrogation in these cases is based upon any real understanding reached by the borrower and lender is a sham. It seems sufficient to the editor to look at the situation as one involving general equitable principles, and not to try to hammer the refinancing loan into an illfitting category just to take advantage of some favorable precedent. Comment 3: In any event, the recent massive increase in recordings of refinancing mortgages has strained many recorder's offices, leading to substantial indexing delays in many areas, and creating a danger of "blind recordings" that threaten to prime refinancing mortgages even though they can't be identified by title searchers and don't appear in title plants.

Jack Murray Comments:

Jack Murray sent me this case, and after writing it up, I sent my comments back to Jack, who volunteered these comments of his own:

The Doctrine of Equitable Subordination: Aames Capital Corp. v. Interstate Bank of Oak Forest

By John C. Murray  2000

Some additional thoughts:

1) It appears that the appellate court is straining mightily (and not at all convincingly) to fit this set of facts into the "conventional subrogation" box. This is so because it likely believes the "equitable subordination" doctrine is nebulous and not well (if at all) developed under Illinois case law. The court apparently fears its decision may be overturned by the Illinois Supreme Court unless it shoehorns this case into the "conventional subordination" doctrine, which at least has some case law support. Methinks the court worries too much. The doctrine of equitable subordination is ancient and the law is well developed in this area (if not to a great extent in Illinois). As Pat Randolph correctly notes, both the "conventional subrogation" and "equitable subrogation" doctrines are creatures of equity, and the court may be creating a distinction without a difference.

2) This is clearly a "results oriented" decision; the court knew what it wanted to do from an equitable standpoint, and then looked for some way (strained, in this case) to justify its ruling ("Absent subrogation of the original mortgage lien, these consumers would be hardpressed to find a lender willing to refinance"). Id. at *7.

3) This case clearly illustrates the danger in relying on the Fannie Mae/Freddie Mac "Uniform Instrument," with no modifications to take into account the fact that the priority of the loan may be called into question. The form does not state that it is a "first mortgage," nor was any language added that it was the parties' intention that the refinancing mortgagee (to comply with the Illinois "conventional subrogation" doctrine) would succeed to the interests of the prior mortgagees who were paid from the proceeds of the new loan. The refinancing mortgagee was fortunate that the prior mortgages were not released of record before the judgment lien was placed of record; even this court would have denied the refinancing mortgagee the protection of equitable or conventional subrogation if this situation had occurred. The most effective approach, of course, would have been to take an assignment of the prior mortgages to clearly maintain priority (the appellate court notes that Illinois case law is clear that the mere act of assignment would preserve priority).

4) The appellate court remanded the case to "determine the extent to which [the new lender] is subrogated," which, according to the court, could only be "up to the amount that the original mortgages secured at the time of perfection." The court states that "after searching the record for evidence of the value secured by the [prior] mortgages, . . . we have been unable to locate the necessary information." Id. at *8. Questions: Didn't the refinancing mortgagee request payoff letters from the prior mortgagees before making its loan? Why weren't such letters introduced into evidence?

5) The appellate court did not cite or discuss a recent Illinois bankruptcy decision, In re Pearce, 236 B.R. 261 (Bankr.S.D.Ill. 1999), that is pretty much on point. Maybe that is because, on facts somewhat similar to those in Aames, the bankruptcy court (applying Illinois law) reached the opposite conclusion. In this case, the refinancing mortgagee sought to take advantage of the Illinois equitable subordination doctrine in order to avoid the bankruptcy trustee's claim that its lien was an avoidable preferential transfer that had been perfected within 90 days prior to the borrowerdebtors' bankruptcy filing.

According to the bankruptcy court, "There are two types of subrogation under Illinois law: conventional subrogation, which is founded upon an express or implied agreement, and legal subrogation, which arises by operation of law... . Conventional subrogation differs from legal subrogation in that the parties' agreement takes away the character of a mere 'volunteer,' fulfilling that requirement for subrogation." Id. at 264 65 (citing Illinois cases). The court found that to assert a right of subrogation under Illinois law, a "potential subrogee" must satisfy the following requirements: the prior debt must be have been paid in full; the subrogee must have paid a debt for which a third party and not the subrogee is primarily liable; the subrogor must possess a right that he could enforce against a third party; and the subrogee must not have acted as a mere volunteer in paying the debt.

Also, according to the court, "Generally, when a creditor advances funds to a debtor to pay an existing debt and takes a new mortgage to secure the loan, there is no subrogation, because the new security manifests the creditor's intent to rely upon it, rather than upon the old security, which was discharged (citation omitted). In this case, [the refinancing mortgagee's] taking of new security to collateralize its loan underlines the fact that [the refinancing mortgagee] is not an innocent party needing the protection of equity to undo the fraud or mistake of another, but a sophisticated creditor in the business of making loans for a profit. Despite [the refinancing mortgagee's] delay in recording the debtor's mortgage, it is apparent that [the refinancing mortgagee] intended to rely on its own mortgage with the debtors rather than that of the previous mortgagee of the property. On these facts, the Court finds that the doctrine is inapplicable to entitle [the lender] to the status of a perfected mortgagee in the debtors' real estate." Id. at 266.

The bankruptcy court also rejected the refinancing mortgagee's argument that its "expectation" of assuming the prior mortgagee's status and priority was sufficient to fulfill the requirement that payment be made pursuant to an agreement or understanding. The court stated that "allowing [the refinancing mortgagee] to take on [the prior mortgagee's] status as perfected mortgagee based solely on the "expectation" of acquiring such status would prejudice the debtors' other creditors, who would share proportionately with [the refinancing mortgagee] in the distribution of the debtors' estate if [the refinancing mortgagee's] lien were avoided." Id.

Finally, the court held that even if the refinancing mortgagee was acting to protect its legitimate interests and not as a "volunteer," it had paid a debt for which third parties were primarily liable (the borrowerdebtors had taken title subject to the existing mortgage on the property owed by the sellers). According to the court, "A subrogee has no greater rights than the subrogor and can enforce only the rights of the subrogor (citation omitted). In this case, [the prior mortgagee] had no rights against the debtors under its mortgage, and [the refinancing mortgagee] could not, by stepping into [the refinancing mortgagee's shoes], enforce this mortgage against the debtors or the trustee as representative of the debtor's estate." Id. at 26667. (Note: this was not the case in Aames, where the borrowers were fully liable under the prior mortgages).

The only certainty is that there is uncertainty as to how Illinois courts will rule on this issue. As the bankrupt court in Pearce correctly notes, "[e]quitable subordination is, quintessentially, a factual inquiry, and its application is dependent on the facts and circumstances of each case (citations omitted." Id. See generally, David H. Cox and Vernon W. Johnson III, "State Equity Doctrine Helps Title Insurers," The National Law Journal, p. B17, Feb. 7, 2000.

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