Daily Development for Wednesday, October 24, 2001

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

MORTGAGES; MODIFICATION: Modification agreements to senior lien loan that increase interest rate, cross collateralize with other loans, or increase costs secured by mortgage in event of default will be disallowed versus interest of subordinate mortgagee. Extensions of time for payment of the senior lien note, however, will not automatically lead to loss of priority.

Burney v. McLaughlin, 2001 WL 1143226 (Mo.App. S.D. 9/28/01)

Burneys owned two adjacent parcels. They constructed a motel on Parcel One, and sold that parcel to C&J. In this deal, C&J paid $1 million cash, to Burneys, paid off Burneys' $1 million construction loan, replacing it with a new loan from Bank, secured by Parcel One, and gave a note to Burneys for another $1 million, also secured by Parcel One.

Burneys executed an express subordination of the priority of their purchase money deed of trust to Bank's deed of trust on Parcel One.

Subsequently, C&J acquired Parcel Two from Burneys with money borrowed from Bank, and constructed an addition to the motel on Parcel Two. The acquisition and construction loans were at first secured only by Parcel Two. Later, however, C&J gave Bank a new deed of trust on Parcel One securing this loan. This new deed of trust, everyone agreed, was subordinate to both the Bank's original deed of trust on Parcel One and to Burneys' deed of trust on Parcel One.

Soon thereafter, the project got into trouble, and there ensued a series of modifications and extensions of the C&J loans as the parties attempted to accomplish a workout of the project's difficulties. These modifications at first were simply extensions of the payment structure of the C&J structure. Later they included increases in the interest rate, and, in the last few adjustments, the Bank also added a cross collateralization clause, linking the Parcel One and Parcel Two loans, and provisions adding additional "closing fees, appraisal fees and provisions relating to bankruptcy [unspecified]."

Ultimately, C&J just surrendered and notified Bank that it would not reopen the motel following the traditional winter closing. The Bank filed for foreclosure, intending to sell Parcel One and Parcel Two at foreclosure together as a single operation. Burneys obtained a temporary restraining order enjoining the foreclosure pending resolution of priority. Burneys claimed that Bank had lost its priority over the Burney lien through its frequent modifications of the secured loan on Parcel One.

The trial court granted the injunction and found that the Bank lien was subordinate to Burneys'. The Court of Appeals here reversed, at least in part, holding that the foreclosure could proceed as to Parcel One. The Bank did not lose its priority merely because it had extended the date of payments under its Parcel One secured loan. But the court held that the modification agreements that altered the interest rate and other terms (aside from payment date) would not be effective as against Burneys.

The court virtually incorporated the provision of the Restatement of Mortgages Section 7.3(b), which establishes that, even absent any language in the instruments, the parties to a mortgage loan may modify the terms in ways that do not injury interest of junior lienholders and retain the priority of the original secured position. The Restatement indicates, as does the weight of authority, that a simple extension in terms of payment will not normally do injury to the interests of juniors, but does allow for the possibility that this might not be true in a particular case. The Restatement is quite clear that cross collateralization, increase in the interest rate, or increase in the secured amount are all changes that would detract from the status of junior lenders, and will not enjoy priority.

Comment 1: The case is correct, and consistent with authority. The editor's only caveat is that there may in fact be a case in which an alteration in a payment schedule would work to the disadvantage of the junior interest.

Further, the editor believes that a junior lender who is interested in restricting the mortgagee from making any changes in the terms of the senior lien could easily do that. The editor hasn't seen the case in which this has been done. Certainly any such changes could be made an event of default. The bigger question might be whether such an agreement really could inhibit the ability of the senior to make a deal with the mortgagor anyway, retaining priority. The junior might not find out about such a deal until it is too late (of course, in theory, if the junior can show injury, then it will not be subordinate, but this may not solve every problem - especially in cross collateralized loans and interdependent projects). Perhaps a better approach would be for the junior to notify the senior of its contractual inhibitions and rely upon a potential tort claim for interference with contractual relations as a deterrent to the senior's proceeding to make any changes.

Comment 2: Needless to say, the senior can dodge all these problems by placing a provision in its mortgage permitting it to modify the senior lien.

The Restatement Section 7.3(c) validates such provisions as preserving priority, but the editor notes that the discussion in the Restatement acknowledges that there may be some policy argument running contrary to this position in jurisdictions that attempt to preserve the junior's ability to deal with its equity in the case of, say, the future advance mortgage. A jurisdiction that follows the "optional/obligatory" test in that area may feel it appropriate to place some inhibitions on the ability of the senior lender to completely tie up the property by authorizing unlimited modifications.

The instant case specifically refused to consider or approve Restatement Section 7.3(c), since there was no contract provision in the senior Bank note or deed of trust here that authorized modifications.

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

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