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
randolphp@umkc.edu
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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