Daily Development for Thursday, November 13, 2003 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 The Reporter for this DD is Jack Murray of First American Title Insurance, Chicago Office. MORTGAGES; EQUITABLE SUBROGATION: Where a bank lender refinances a loan and pays off the prior note after a writ of attachment has been recorded against the property, the bank will nonetheless be equitably subordinated to the position of the original lender where there was no evidence of prejudice and the intervening party would be in no worse position because the bank had paid off the prior deed of trust. Houston v. Bank of America, 2003 Nev. LEXIS 69 (Nev. Sup. Ct., Oct. 28, 2003) Appellants, husband and wife, filed a complaint against Boone based on conversion of $740,000 they had transferred to him in his capacity as their investment advisor. At approximately the time this action was filed by the appellants, Boone and his wife obtained a divorce and Boone quitclaimed his interest in certain real property owned by him to his wife as part of the divorce settlement. The appellants recorded a lis pendens against the property on June 1, 1998 and subsequently obtained a prejudgment writ of attachment against the property, which was recorded on June 26, 1998. Subsequently, a bank refinanced the property and recorded a mortgage from Mr. Boone's wife on June 26, 1998 (apparently right after the appellants' writ of attachment was filed and recorded in the county recorder's office). The appellants ultimately obtained judgment on their action against Boone. Mr. Boone then filed for bankruptcy, but acknowledged that the money he owed the appellants was a nondischargeable debt. The lower court directed a writ of execution against the property and scheduled a sale. The bank brought an action to enjoin the sale, which the lower court granted (the lower court further granted summary judgment in favor of the bank on its equitable subrogation claim). The bank had hired a local title company to conduct a search of the property, which search was conducted on May 29, 1998, more than one month before the bank refinanced the loan. The bank argued that it had succeeded to the priority position of the original lender, but the appellants argued that the bank was negligent in failing to discover its interest and that they would suffer an injury if the bank were permitted to succeed to the interest of the prior lender. (The Nevada Supreme Court noted, however, that "the [appellants] did not provide the district court with the terms of the former deed of trust or any other evidence of prejudice.") The Nevada Supreme Court affirmed the holding of the lower court. The Nevada Supreme Court noted initially that, "We have previously applied the doctrine of equitable subrogation, but not in the context presented by this case." The court then described the "three different approaches" to equitable subrogation adopted by other courts (citing numerous cases in support of each position), to-wit: 1) The "majority rule," i.e., that "actual knowledge of an existing lien precludes the application of equitable subrogation, but constructive knowledge does not." However, the court refused to adopt this approach, finding that it "promotes willful negligence and encourages prospective mortgagees to avoid conducting title searches." 2) Prohibiting a party from invoking the doctrine when "a lien holder possesses either actual or constructive notice of an existing lien." The court also declined to adopt this approach, reasoning that equitable subrogation is an equitable doctrine and that even if the refinancing lender had actual or constructive knowledge the intervening creditor/lienholder would receive an "unjust windfall," and also finding that the lender still should reasonably expect to "step into the shoes" of the lender whose loan it paid in full. The court stated (somewhat surprisingly) that, "Neither negligence nor constructive notice of an existing lien is relevant to whether the junior lien holder will be unjustly enriched or prejudiced." (The court notes, in a footnote, that "some courts hold a sophisticated party [presumably an attorney, or a bank] to a higher standard in determining whether to apply equitable subrogation.") 3) The view adopted by the Restatement (Third) of Property, Mortgages, i.e., the approach that "disregards actual or constructive notice if the junior lien holder is not prejudiced." According to the court, "Because the "Restatement approach is the most persuasive, we adopt the view expressed by it." The court ruled that notice of an intervening lien (either actual or constructive) is simply irrelevant except only where there is proof that the lender specifically intended that the lien of the refinancing mortgage be subordinate to the intervening lien/judgment. The court agreed with the Restatement comment that in such a case the intervening lienholder would be no worse off and remain in the same position as if the original mortgage were still in place. The Nevada Supreme Court noted that the lower court had found specifically that the bank had paid off the prior mortgage with "the intention and belief" that it would succeed to the position of the original lender. The court stated that "the record does not contain any evidence that [the bank] intended to subordinate its mortgage to the [appellants]." The court further noted that the appellants had not offered any evidence that they would be prejudiced by permitting the bank to succeed to the priority position of the first loan; the appellants had not even provided the court with the terms of the prior loan to ascertain if there were any substantial modifications in the new loan that could materially prejudice the appellants. The court did, however, state that because the bank's loan was $5000 more than the amount of the prior mortgage, the bank was not entitled to equitable subrogation in excess of the amount of the original loan. The court also found that although (as a result of Mr. Boone's divorce) the mortgagor changed from Mr.Boone to Mrs. Boone, no evidence was presented that this change resulted in any prejudice to the appellants. Reporter's Comment 1: The court did not pay much attention to the fact that the bank had obtained a title search for the property, which was obtained more than a month before the bank made its refinancing loan. Obviously the title report did not disclose the appellants' recorded lis pendens or writ of attachment, both of which were recorded after the title report was issued. (The case does not indicate whether a final title policy ever was issued, or whether the bank merely relied on the preliminary report.) The appellants argued that there was a triable issue of fact as to whether the bank was "reasonable in relying on a twenty-seven day old title report." However, the court brushed this argument aside, reasoning that "since we adopt the Restatement view, [the bank's] negligence in discovering the lis pendens and writ of attachment or its knowledge thereof is irrelevant." Reporter's Comment 2: In a recent case from the State of Washington Supreme Court, Kim v. Lee, 31 P.3d 665 (2001), the judgment lien holder filed to execute on his judgment lien and the title insurer intervened to protect its insured lender. The title company had failed to discover the judgment lien when it searched title, and even though Kim made the company aware of it prior to closing, the title company closed without paying off Kim's judgment lien. The majority opinion states: "Under the Restatement [of Property 3d: Mortgages], a modification of a mortgage will ordinarily cause it to lose priority to junior interests to the extent that the modification is materially prejudicial to those interests. Absent an increase in the principal amount or the interest rate of the mortgage, such modifications normally do not jeopardize the mortgagee's priority as against intervening interests." The court also found that the modification of the loan repayment term from 6 years to 30 years and the fact that this was a new mortgage were materially prejudicial to Kim, the junior lien holder. The Kim court also refused to allow equitable subrogation where, as here, the party seeking subrogation had actual knowledge of the intervening interest. The court then described the role of the title insurer, saying: "Generally, the role of the title insurer is relied upon by the lender, judgment creditor, and other lienors. Just as a lender relies on the title insurer to commit that title is vested in its borrower, subject only to known exclusions, judgment creditors and other lienors rely on title insurers to prevent a debtor from conveying real property without first satisfying a perfected lien. In the instant case, legal remedies and equity suggest that the loss should fall on the title company rather than the innocent judgment creditor." The court summarized its discussion of the equitable subrogation doctrine by saying: "Although the doctrine of equitable subrogation may be applied, this case is controlled by Coy v. Raabe, 69 Wn.2d 346, 418 P.2d 728 (1966), which allows equitable subrogation to a bona fide purchaser (or refinance lender) to the extent they were entitled to rely on others to guarantee title. However, equitable subrogation should not apply in favor of a title company, which guaranteed title while on constructive, or actual notice of a prior judgment." Wrong, wrong, wrong! A title insurer does NOT "guarantee" title. It insures the title to the property subject to the terms, conditions, exceptions and exclusions contained in the policy. Furthermore, in Kim, the title insurer itself did not have a lien on the property, its insured lender did, and the lender and not the title insurer would be the direct beneficiary of any right to equitable subrogation! Also, it is to say the least a stretch to say that title insurers owe duties to third parties with whom they are not in privity or bound by any contractual relationships. Finally, the court's assertion that permitting equitable subrogation when the title insurer has actual or constructive notice effectively prevents any lien holder (or judgment lien creditor or any other party with an interest in property) from being entitled to the benefits of equitable subrogation whenever that party has title insurance, while those that do not have title insurance will be allowed such benefits. The court in Houston v. Bank of America specifically rejected this approach, noting that "precluding equitable subrogation when a mortgagee discovered or could have discovered a junior lien runs contrary to the purposes underlying the doctrine." Reporter's Comment 2: In a recent Illinois appellate decision, Union Planters Bank v. FT Mortgage Co., 341 Ill. App.3d 921 (2003), the court was faced with the issue of the applicability of the doctrine of "conventional subrogation." Union Planters Bank ("Bank") was the holder of a note and recorded mortgage (which was subordinate to two other prior recorded mortgages) on the borrowers' residence, in the amount of $138,068. Subsequently the borrowers obtained another mortgage loan from FT Mortgage Co. ("FT"). This subsequent mortgage from FT was a "cash-out refinancing," whereby the proceeds would be used to pay off all prior mortgages and provide the borrowers with a small amount of cash. FT hired a title company to conduct a title search on the property. The title company, in error, only disclosed two prior mortgages against the property. FT's instructions to the title company were to pay off all subordinate liens on the property. The title company took the proceeds from the new loan and paid off the first and second mortgages, but not the Bank's loan. The borrowers ceased paying the amounts owing on the Bank's loan, and the Bank commenced a foreclosure proceeding against the borrowers. FT then filed a counterclaim seeking a declaration that its mortgage, which was recorded subsequent to the Bank's mortgage, should have priority over the Bank's mortgage based on the doctrine of conventional subrogation. The court proceeded to discuss the difference between equitable subrogation and "conventional subrogation," as set forth in Aames Capital Corporation v. Interstate Bank of Oak Forest, 315 Ill. App.3d 700, 734 N.E.2d 493 (Ill. App. 2nd Dist. 2000): "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. 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." [citations omitted] The Bank argued that FT had no express agreement allowing it to assert the rights of the original creditors, but the court found that the generic contract language contained in the Bank's loan documents (providing that no subordinate liens were to remain of record) was sufficient and stated that, "We find that the form of the language at issue is not nearly important as the intent of the parties to the contract." According to the court, "The intent was clear - FT intended, by its actions, to receive equal priority in its lien and to be able to assert the rights of [the mortgagees paid from the loan proceeds]." The court also ruled that the fact that the borrowers received some cash in excess of the amounts necessary to pay off the prior mortgages was inconsequential, as FT could only be subrogated to the amounts of the debts extinguished in its refinancing. Finally, the court also ruled that the Bank was not guilty of "gross negligence," which would have prevented it from benefiting from the doctrine of conventional subrogation. The court found that the negligence of the title company retained by the Bank to do the title search could not be imputed to the Bank because the title company was not FT's agent. This was so, the court held, because there was no evidence reflected "no express or implied authority for FT to have exercised control over the manner in which [the title company] performed and reported its title search." Reporter's Comment 3: For other recent cases on equitable subrogation (which tend to go all over the map with respect to application of the doctrine), see Centreville Car Care, Inc. v. North American Mortgage Co., 263 Va. 339 (2002) (denying equitable subrogation to third lender where third lender paid off first mortgage loan and title examiner failed to discover second lender's mortgage, even though second lender was undersecured. The court found that equities did not favor third lender because of its negligence and the fact that second lender had the right to expect to advance to first mortgage position upon payoff of the prior loan and was entitled to receive balance of funds from new lender that were instead paid to the sellers, and obligors had no further incentive to pay debt because they no longer had equitable ownership in the property); Bank of New York v. Nally, 790 N.E. 2d 1071 (Ind. 2003) (bank claimed equitable subrogation because earlier mortgage was not recorded in grantor-grantee index; but the court denied equitable subrogation because bank was sophisticated party purchaser and was required, in Indiana, to search both mortgagor-mortgagee index and grantor-grantee index; therefore bank had constructive notice of documents recorded in both indexes and was negligent in not searching both indexes); Harms v. Burt, 30 Kan. App. 2d 263 (2002) (title company failed to discover judgment liens on property before sale of property; court disagreed with "majority rule" and held that parties are charged with constructive notice of public records and are negligent when they fail to discover a lien or interest in property that is a matter of public record); Picker Financial Group LLC v. Horizon Bank, 293 B.R. 253 (Bankr. M.D. Fla. 2003) (third lender paid off first lender, receiving and perfecting UCC security interest in debtor's assets, but third lender failed to conduct UCC search that would have disclosed second lender's interest; court ruled that under "traditional view" third lender was not entitled to conventional subrogation because its failure to check public records constituted constructive - though not actual - knowledge of second lien); First Union Bank v. Harmon, 2002 Ohio 4446 (Ohio App. 2002) (although general rule in Ohio is that first mortgage recorded has priority over subsequently recorded mortgages, equitable subrogation applied where intervening lender did not bargain for or expect first lien position; but equitable subrogation would apply only to extent of amount secured by first mortgage loan). Editor's Comment: Jack Murray, the leading commentator for the title insurance industry in America, has long been a strong advocate of the broad application of the subrogation concept to transfer to parties who pay off mortgage liens the priority held by those liens, even when the parties have actual knowledge of the liens. The editor has been more careful in endorsing such a remedy in the case of actual knowledge, since of course the paying off liens in such cases have any number of methods to formalize their claim of priority, and the editor is uncomfortable in permitting sophisticated parties to be given equitable relief when they should have contracted for protection. Dale Whitman and Grant Nelson, in the Restatement of Mortgages, take the position that the correct answer is not "Why should a professional lender get the benefit of equity when it fails to document its priority?" but rather "Why not?" To the editor, it would appear that there are many situations in which parties who deliberately elect not to document the nature of their interest are denied the ability alter or modify that interest later, even when there are no "competing equities." The motivation for lenders paying off senior liens and taking no assignment or otherwise documenting their expectation for priority may be obscure, but apparently some lenders in fact see a reason for doing this. The editor continues to be skeptical as to why equitable principles should be used to later resolve the issue in their favor when the fan starts to run. Readers are encouraged to respond to or criticize this posting. Items reported on DIRT and in the ABA publications related to it are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data provided and opinions expressed by the DIRT editor the sole responsibility of the DIRT editor and are in no sense the publication of the ABA. 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