Daily Development for Monday, April 25, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

Another great contribution from Jack Murray, with a few comments of my own at the end.

MORTGAGES; SUBROGATION; PRIOR LIS PENDENS: The doctrine of equitable subrogation cannot be invoked to benefit a secured lender that paid off a senior lien without actual knowledge of a lis pendens that gave constructive notice of a possible lien on the party senior to the secured lender’s claim, even though final judgment on the matter was not obtained or recorded until after the refinancing lender had placed its mortgage of record.

Mortgage Electronics Registration Systems, Inc. v. Phylactos, 2005 U.S. Dist. LEXIS 6295 (N.D. Ill.  3/ 30/05)

On May 19, 2000, the debtors granted Fidelity Mortgage a mortgage on their home for $203,000, and on the same day granted Bank One a second mortgage on the subject property for $92,000.  Both mortgages were recorded on May 30, 2000. Fidelity subsequently assigned its mortgage to Delta Funding Corp., which assignment was recorded on June 12, 2000.  Delta, in turn, assigned the mortgage to Countrywide Homes, Inc., which assignment was recorded on September 17, 2001. On July 22, 2002, MERS ordered a title commitment on the subject property from Stewart Title Guaranty Co. The commitment showed a specific exception for a lis pendens notice against the property filed by Harris Bank on June 10, 2002, arising out of a complaint filed by Harris Bank on April 7, 2002 alleging that the debtors had breached the recorded Declaration of Covenants, Restrictions and Easements established by Harris Bank as the original fee owner of the subdivision of which the subject property was a part. Specific

ally, Harris Bank alleged that the debtors had failed to obtain the required architectural approval for a fence they had constructed on the subject property.

Harris Bank also alleged that on August 27, 2002, it had a series of telephone calls with an individual who said she represented a lender that was considering making a loan to the debtors, and that she inquired about the specifics of the lawsuit that was the subject of the lis pendens.  On August 28, 2002, Harris Bank's in-house counsel faxed a letter to this individual stating that although a judgment had not been obtained, the attorney's fees (in excess of $15,000) incurred by Harris Bank were a lien against the subject property regardless of when a final judgment might be entered. Nonetheless, on September 3, 2002, MERS paid and satisfied the prior mortgages of Countrywide and Bank One, which mortgages were subsequently released of record. On September 12, 2002, the debtors granted MERS a new mortgage on the subject property, which was recorded on the same day.

On March 14, 2002, Harris Bank obtained a judgment against the debtors for failure to remove the fence constructed on their property. The judgment ordered the debtors to remove the fence within fourteen days, and also awarded Harris Bank its attorney's fees and costs (later determined, by court order entered April 22, 2003, to total approximately $37,000).  On June 16, 2003, Harris Bank recorded a Memorandum of Judgment against the subject property related to the fees and costs awarded by the court.

MERS subsequently filed a foreclosure action against the subject property, naming Harris Bank as a subordinate mortgagee, and asking the court specifically to subordinate Harris Bank's claim to the MERS mortgage. Harris Bank countered with a motion for summary judgment, claiming that its lien was superior in time and right to the MERS mortgage. MERS argued that under Illinois law, the state court judgment in favor of Harris Bank only validly attached as a lien against the subject property on June 16, 2003, the date that Harris Bank recorded the Memorandum of Judgment. But the Federal District Court noted that the lis pendens notice had been recorded on June 10, 2002, three months before MERS recorded its mortgage, and that under the Illinois lis pendens statute, the filing of such a notice constitutes constructive notice to "persons subsequently acquiring an interest in or lien on the property affected thereby," and that all such parties "shall be bound by the proceedings to the s

ame extent and in the same manner as if he or she were a party thereto."  The court agreed with Harris Bank's argument that the fact that its judgment was recorded after the date that MERS recorded its mortgage against the subject property was irrelevant, because Harris Bank's lis pendens notice was already of record and MERS therefore was charged with constructive notice and was deemed to be a "subsequent purchaser" under the lis pendens statute.

The Federal District Court acknowledged that in Illinois the equitable-subrogation doctrine creates an exception to the "first in time, first in right" rule, but refused to apply the doctrine under the facts of this case. The court noted that in Illinois two types of subrogation exist: conventional and equitable. According to the court: "Conventional subrogation exists arises from an agreement between the parties that the subrogee pay a debt on behalf of a third party and, in return, be able to assert the rights of the original creditor."   The court noted that this type of subrogation would not apply in this case because MERS acknowledged that there was no express agreement between itself and the debtors that by paying off the prior mortgage liens, MERS would have a lien equal to the amounts paid off.

The court then addressed MERS's argument that the doctrine of equitable subrogation should apply. Noting that this doctrine is based on the equities of each particular case, the court reasoned that in those few Illinois cases that had applied the doctrine there existed evidence that even though no express agreement existed at the time of the new financing, the parties' intent was clear (e.g., by virtue of a stipulation that the parties' intent was that the mortgagee be subrogated to the rights of the paid-off mortgagee or by virtue of an "inquiry and demand that prior liens be paid out of the loan proceeds").  According to the court, MERS provided no evidence that it expressed such an intention or that MERS and the debtors had agreed to such an intention and instead MERS had satisfied and released the prior mortgages on the subject property "with actual notice that the Subject Property was involved in pending litigation, yet . . .  did nothing to establish its intended priority po

sition. The court will not allow MERS to claim a right of equitable subrogation when it had available an easy method to advance to first priority; namely, an express agreement to that effect."

Reporter’s Comment 1:  This decision should not be a surprise to anyone but MERS. Obviously someone on their end did not do a very good job of reviewing Illinois law regarding the effect of the recording of a notice of lis pendens. MERS was well aware of the existence of the recorded lis pendens and the underlying litigation between the debtors and Harris Bank, going so far as to request a specific statement of the amount that Harris Bank claimed was owing for attorneys' fees and costs. (Although the court notes that "MERS denies all of Harris Bank' allegations" in this regard.). Yet MERS went ahead and paid the prior mortgages, despite its knowledge of the recorded lis pendens and its failure to express any understanding with the debtors that it was MERS's intention to be subrogated to the claims of the existing mortgagees. MERS was forced to fall back on the elusive doctrine of equitable subrogation, and the equities were certainly not in its favor. Also, as the court noted, MER

S could have approached Harris Bank regarding the possibility of having it enter into a subrogation or intercreditor agreement, but chose not to so.

Reporter’s Comment 2:  Interestingly, the court states that on September 3, 2002, "MERs paid and satisfied the prior mortgages of Countrywide and Bank One," whose mortgage releases were, however, not recorded until September 25, 2002 and November 13, 2002, respectively.  Yet the court then states that, "On September 12, 2002, Debtors granted MERS a mortgage on the Subject Property . . . . The mortgage was recorded on September 12, 2002."   This is most peculiar: Why would MERS pay off the existing mortgages on the property nine days before it granted its own mortgage on the subject property?

Reporter’s Comment 3:  With respect to mortgage loans, the doctrine of equitable subrogation generally provides that when loan proceeds from a new loan are used to satisfy a prior lien, the new lender stands in the shoes of the prior lienholder, if there is no prejudice to other lienholders. It rests on the equitable maxim that no one shall be enriched by another's loss, and may be invoked when justice demands its application. The doctrine is designed to prevent an unjust forfeiture, on the one hand, and a windfall amounting to unjust enrichment, on the other. Recent Illinois appellate court decisions given subrogation claims new vitality by confirming and applying the doctrine of "conventional subrogation," a fraternal -- but not identical -- twin of equitable subrogation, and allowing claimants to bypass equitable defenses that have operated to defeat subrogation claims in the past.  In Aames Capital Corporation v. Interstate Bank of Oak Forest, 315 Ill.App.3d 700, 706 (Ill.App.

 2nd Dist. 2000), the appellate court explained subrogation as follows:

There are two broad categories of subrogation rights: contractual or conventional rights, and common-law or equitable rights. Schultz v.  Gotlund, 138 Ill.2d 171, 173 (1990). Equitable subrogation is a creature of chancery (a court  of equity) that is utilized to prevent unjust enrichment. There is no general rule that can be laid down to determine whether a right of equitable subrogation exists, since the right  depends upon the equities of each particular  case. (Citing Dix Mutual Insurance Co. v. Framboise, 149 Ill.2d 314, at 319 [1992].)  Conventional subrogation, on the other hand, arises from an agreement between the parties that the subrogee pay a debt on behalf of a third party and, in return, be able to assert the rights of the original creditor. See Home Savings Bank v. Bierstadt, 168 Ill. 618, 624 (1897).

The doctrine of equitable subrogation also has ancient origins and the law is well developed in this area (if not to a great extent in Illinois). But both the "conventional subrogation" and "equitable subrogation" doctrines are creatures of equity, and the court may be creating a distinction without a meaningful difference.

Reporter’s Comment 4:  The majority view of equitable subrogation in the United States is that the doctrine is only available if the party paying the prior lien has no actual knowledge of the intervening lien. The Restatement (Third) of Property (Mortgages) purports to expand the right of equitable subrogation, and provides that a refinancing lender is equitably subordinated to the priority of the first mortgage even where it has actual knowledge of the intervening lien:

“[U]nder this Restatement, however, subrogation can be granted even if the payor [the refinancing lender] had actual knowledge of the intervening interest; the payor's notice, actual or constructive, is not necessarily relevant.  The question in such cases is whether the payor reasonably expected to get security with a priority equal to the mortgage being paid. Ordinarily lenders who provide refinancing desire and expect precisely that even if they are aware of an intervening lien.  A refinancing mortgagee should be found to lack such an expectation only where there is affirmative proof that the mortgagee intended to subrogate its mortgage to the intervening interest.”  Restatement (Third) of Property: Mortgages § 7.6 cmt.e (1996)

The more liberal Restatement position is the minority view. In any event, there are prudent steps that an Illinois real estate practitioner who represents mortgage lenders can take to avoid the loss of priority of a new mortgage, where some or all of the proceeds from the mortgage are intended to be disbursed to pay off a prior recorded mortgage. Obviously, the mortgage loan documents should -- and almost always do -- clearly state the intention of both the mortgagor and the mortgagee that the mortgagee is to receive a properly perfected first mortgage lien against the property. If the parties are aware of an existing mortgage lien, it also would be beneficial to state in the loan documents that it is their intention that the new mortgagee is to receive the priority of that existing mortgage (if it is not to be released). The new mortgagee's attorney should obtain a title commitment to ascertain the status of title and to determine if there are any presently existing mortgage lien

s or other encumbrances against the property (and whether there are any subsequent liens or encumbrances appearing thereafter), and a title policy insuring the new mortgagee's security interest as a prior, valid and enforceable first mortgage lien on the property. (The availability, extent and scope of such coverage will depend on the facts and circumstances of each transaction, as well as underwriting considerations based on applicable case law and title insurance regulations). The refinancing mortgagee's attorney may also find it beneficial to have an existing mortgage lienholder, whose loan is to be paid off from the proceeds of the new loan, assign the existing mortgage to the new mortgagee (in those situations where there are intervening lienholders or encumbrancers) instead of releasing the mortgage from record (or at least leave the existing mortgage of record until the new mortgagee's loan is paid in full). Another prudent action would be to require, as a condition to the

new mortgage loan, that any known or identified intervening lienholder execute (and agree to have recorded) an intercreditor or subordination agreement, whereby the intervening lienholder would consent to the new mortgage lien and confirm that its lien would be subordinate to the new mortgage (at least to the extent of the outstanding amount of the prior lien being paid from the proceeds of the new loan).

Reporter’s Comment 5:  As to the key issue of the scope of equitable subrogation (and its offspring, "conventional subrogation"), litigation is often necessary to determine whether a mortgage lender who has paid off a prior lien is entitled to the priority of the earlier recorded lien. The goal of the actions mentioned above is to avoid, at all costs, a court challenge to the priority of the new mortgage. Decisions in Illinois in this area of the law are highly fact-specific and uncertain, and mortgage priority disputes can be time-consuming and expensive for mortgage lenders to resolve. The  resolution of such litigation often depends on off-record facts that are difficult to determine and prove -- and meanwhile, title to the property remains undetermined and "in limbo" until the litigation is concluded.  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.

Editor’s Comment 1: The editor agrees with Jack about the state of the law and, in general, believes that the current law, and not the Restatement, states the best policy.  Why should lenders be bailed out of the consequences of their own carelessness?  Lenders often are unwilling to cut the rest of us the same slack,  and we’re not professionals in this area.

Although, admittedly, the party benefitting from the refusal to subrogate gets a windfall improvement in priority, where a junior lender has actual knowledge of that party and still lends in the face of the claim, the junior lender obviously is making a concrete choice to take a junior position.  It has other options, such as taking an assignment of rights from the senior parties it pays.  In this case, MERS could also have required an escrow to deal with the lien reflected by the lis pendens.  It’s refusal to do any of these things reflects a business decision that MERS should live with now.

Editor’s Comment 2: The only problem with the above analysis by the Editor is the presence of the concept of “Conventional Subrogation,” which is said to arise when the debtor represents to the creditor that the creditor will enjoy the security position of the senior liens that it pays off.  This is fine in cases of fraud or good faith misunderstanding, but will courts enforce such an agreement where the borrower and lender simply execute a document between themselves providing for such priority?  The editor hasn’t seen that case.  If there are cases that would enforce such agreements for subrogation between borrower and new lender, then why not find that such agreements are implicit in every deal?  In short, the existence, if any,  of a broad conventional subrogation doctrine would render meaningless the policy distinction argued for by the Editor regarding equitable subrogation, and makes the Restatement position more appropriate.  The editor isn’t familiar enough with the cases

 and is too lazy to read the Restatement comments on the point, especially when he is hopeful that Dale Whitman, co-author of the Restatement, will make a posting explaining the Restatement reasoning.

Editor’s Comment 3:  Note also that there are a number of cases that would deny subrogation even where the lender had only constructive notice of the prior interest, unless the lender had some “special equity” that justified it in believing that there was no effective senior lien.

The Reporter for this item is Jack Murray of the Chicago office of First American Title Insurance Company.

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