Daily Development for Wednesday, January 10, 2001

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

MORTGAGES; PRIORITY; VENDEE'S LIEN: In the future, unrecorded vendee liens for payments voluntarily made by a contract purchaser after a mortgagee properly records its mortgage will not have priority over the mortgage.

Cox v. RKA Corporation, 164 N.J. 487, 753 A.2d 1112 (N.J. 2000)

According to the court, this case is not only one of first impression for New Jersey, but appears to raise factual issues not considered before by any court.

A home buyer entered into a contract with a contractor to purchase property and construct a home on it. A deposit of $12,000 was paid and the balance of the purchase price was due "at settlement."

Without the buyer's knowledge, the contractor obtained a construction loan from a bank. In doing so, it provided the bank with a copy of the contract and the bank relied on the fact that the property was "presold" in making its lending decision. The buyer, however, was unaware of the construction loan. (You can see where this is going.)

The construction loan was secured by a mortgage and two advances were made before the contractor defaulted on the loan. After the mortgage was recorded, and after the advances were made, the buyer made several additional voluntary payments to the contractor. The contractor defaulted on the construction contract and the buyer filed suit seeking specific performance.

The contractor then defaulted on the loan and the buyer then amended its complaint, seeking to void the mortgage or, alternatively, to obtain a ruling that it had a lien in the amount of its total payments to the contractor and that its lien was superior to the recorded mortgage. The lower court found that the lender was on notice of the buyer's interest in the property prior to recording the mortgage and therefore the buyer had an equitable lien superior to the recorded mortgage for the entire sum paid to the contractor.

The Appellate Division affirmed, adding that the bank should have made further inquiry when it accepted an affidavit from the contractor to the effect that no other persons had legal rights to the property, while at the same time it was aware of the contract. "Balancing the 'unusual equit[ies]' at issue," the Appellate Division found in favor of the buyer.

The New Jersey Supreme Court upheld the result, but ruled that this would not be the outcome in the future. Fundamentally, the Supreme Court held that "[u]nrecorded vendee liens for payments voluntarily made by the vendee after the mortgage lender properly records its mortgage do not have priority over the mortgage. This decision will be applied prospectively; therefore, [the buyer's] lien will be accorded priority over [the lender's] mortgage interest for the full amount of all payments advanced by [the buyer] against the contract price." In New Jersey, under common law, a buyer's lien on property occurs when a seller "is in some default for not completing the contract ... and the vendee is not in default so as to prevent him [or her] from recovering the purchasemoney paid."

Also, under the doctrine of equitable conversion, a buyer is vested with certain equitable interests in the property. The Court also considered New Jersey's recording statutes which established that "as between two competing parties the interest of the party who first records the instrument will prevail so long as that party had no actual knowledge of the other party's previouslyacquired interest." Here, the lender had notice only of the buyer's initial deposit by way of its copy of the contract between the contractor (its borrower) and the buyer. On the other hand, the buyer had constructive notice of the mortgage lien before it made its further, voluntary payments to the contract.

Because no prior New Jersey case had resolved the issue of respective priorities of the buyer's lien and a recorded mortgage, the Court looked to other jurisdictions. It conceded that the majority rule apparently held that a buyer's lien had priority to the extent that the recorded party had notice of the buyer's equity in the property. Nonetheless, it rejected the holdings of other jurisdictions that permitted the buyer to recover the deposit money where a lender is aware of a contract but does not know its terms, the identity of the buyer, or the amount of the down payment. By extension, the Court rejected any contention that the buyer should recover all payments, even payments voluntarily made, so long as the lender has knowledge of an underlying contract.

Fundamentally, the Court ruled in favor of the recording statutes, "which must be enforced to preserve the integrity of the conveyance system," which would be impaired by a holding to the contrary. Consequently, the priority of a buyer's lien will, in the future, not extend to payments voluntarily made by a buyer after a mortgage is recorded. Nonetheless, "[b]ecause of the uncertainty in the law at the time of this transaction, this holding will be applied prospectively." Consequently, this particular buyer received priority for its initial deposit and subsequent advances, but in the future, buyers will follow the rule of law espoused by the Court.

The opinion is lengthy and thoughtful, followed by an equally lengthy and thoughtful concurring/dissenting opinion, arguing that the best rule ought to be that the lender has the responsibility to protect itself from advances made by a prior contract vendee of whom the lender has notice. The dissent analogized to the "optional/obligatory" rule for future advances, under which optional advances made by a future advance lender are subordinated to interests intervening between the mortgage and the advance only where the lender has actual knowledge of them (some states apply a constructive knowledge rule here as well).

Comment 1: If you've read this far, you probably agree that this is a fascinating issue and a close question. The dissent tends to focus on the notion of equitable conversion to argue that the vendee under the contract already has established a right to obtain title to the property by paying the price, and argues that vendee's payments pursuant to that right ought to have priority as of the execution of the contract so long as the mortgagee has knowledge of the contract. The majority opinion focuses on the significance of the recording acts and stresses that the vendee ought to check the recording act for a mortgagee prior to making any voluntary payments under the contract.

Comment 2: The editor sides with the dissent, for three reasons: First, the argument by the court that the vendee can protect itself by simply checking the record is simply wrong. In many jurisdictions, recording provides constructive notice even though the recorded instrument may not be indexed and findable for a substantial period of time. Of course, the vendee can always get title insurance, but this does not seem to be a situation in which the vendee, undoubtedly making advances subject to "poor mouthing" by the contractor and anxious to get the project completed, is likely to be thinking about getting title insurance protection.

Comment 3: The editor's second problem with the decision is that it imposes the risk of providing clarity and avoiding problems on the wrong party. The lender, coming to the transaction second and having actual knowledge of the contract vendee, certainly is in a position to protect itself against being primed by a vendee's contract advances any number of ways. Further, most lenders in this situation will be institutional lenders with the wherewithal to protect themselves easily from being hurt by a priority in favor of the contract vendee. This decision de facto encourages lenders to lie in wait with undisturbed priority and permit the contractor to defraud its vendees.

Comment 3: The third reason is that if the court found in favor of the vendee, the lender would be no worse off than the deal that it made. It seems clear that the only loss of priority for the vendee's lien is as to voluntary payments. If the lender had paid the contract according to its terms, the lender would be primed by those payments. It's already taking the risk that the contractor will abscond with the funds and not pay off the mortgage. It's interests are always well served by involving the vendee in the overall process and insuring that payments by the vendee go to reduction of the mortgage. Given this situation, why permit the gross inequity that happened in this case, where the vendee lost priority as to $80,000 in advances?

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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