Daily Development for Wednesday, September 15, 2009
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

Here is another Ira Meislik Contribution:

MORTGAGES; SUBROGATION: Even if a refinancing lender's lack of knowledge of existing contractually subordinated encumbrances is due to its own neglect, when its borrower accepts a mortgage whose proceeds are used to pay the superior loan, the refinanced loan remains superior to the subordinate encumbrances.

UPS Capital Business Credit v. Abbey, 2009 WL 2046157 (N.J. Super. Ch. Div. 2009); June 26, 2009.

A homeowner borrowed $800,000 from a bank. The loan was secured by a mortgage. The borrower then took $187,450 from a second bank, and the first bank agreed to subordinate its mortgage to the later recorded mortgage. The borrower then borrowed $185,000 from a third bank, the successor-in-interest to the second bank. Those funds were used to pay the second loan. The title insurance commitment obtained at the time of the refinancing did not reference the $800,000 mortgage. Neither did the borrower's affidavit of title.

When the borrower defaulted, the third bank filed a foreclosure complaint but, through mistake and inadvertence, it did not list the first bank in the foreclosure complaint. The first bank then claimed that its lien had priority. The first bank argued that when it executed a subordination to the $187,450 loan, it only agreed to be subordinate to that mortgage and any renewals or extensions. It argued that the $185,000 mortgage loan from the third bank, as successor to the second bank, was neither a renewal nor an extension, but was a new loan. The first bank claimed that once the $187,450 mortgage had been satisfied, its $800,000 mortgage regained first lien priority.

The Court disagreed, finding that the $185,000 loan, which was from the holder of the superior loan, was in effect a modification and renewal of the $187,450 mortgage because it served to extend its term for a lower interest rate. Therefore, the Court found that first bank's subordination agreement applied to the $185,000 mortgage "modification" and its $800,000 mortgage was inferior.

It further found that, pursuant to the doctrine of equitable subrogation, the successor-in-interest bank had priority notwithstanding the fact that it was negligent in failing to discover the existence of the $800,000 mortgage. The Court pointed out that equitable subrogation is favored and is applicable as long as the third bank did not know of the first bank's mortgage even if it was the result of negligence. Therefore, the Court found that the third bank's mortgage had priority over the $800,000 mortgage.

The Court looked for the appropriate remedy to mitigate the first bank's exclusion from the foreclosure proceedings. In actions for strict foreclosure, the senior lien holder can force the junior lien holder to either redeem the senior mortgage debt or forfeit the lien. Strict foreclosure cannot be used to extinguish a junior lien if the lienholder was intentionally excluded from the foreclosure action. However, in this case, the failure to list the first bank in the foreclosure action was by mistake. Nonetheless, the Court found that the application of strict foreclosure in this case to compel the first bank to either redeem the third bank's mortgage or lose its lien was inappropriate based on the fact that the first bank never had the opportunity to bid at the sale. Therefore, the Court vacated the sheriff's sale and required the third bank to refile its reforeclosure complaint to extinguish the first bank's lien.

Editor's Comment 1:  Although essentially mooted by the court's ruling on equitable subrogation here, the question of whether a replacement loan from a new lender is an "extension or renewal" of the original loan is a nice one.  The editor suspects that most in the industry believe an "extension or renewal" is an agreement between the mortgagor and the holder of the mortgage.  But does it really make any difference?  The subordinating lender typically would not have the power to prevent the senior lien from being sold to another lender, so why should it care if another lender comes in and pays of the old loan?  The subordinating lender would argue "injury or no - that's not the deal."  Would it be right?

Comment 2:  As indicated above, the issue in comment 1 becomes moot when the court concludes that anyone who refinances a senior lien and takes and records a new loan is subrogated to it as against junior lienholders.  The Restatement of Mortgages rule is that a such a party is entitled to such benefit even if it has knowledge of the junior lien and, perforce, if it doesn't have knowledge, but this is due to culpable negligence.

Note that New Jersey rule doesn't move to the Restatement approach, at least not yet.  Subrogation is available only where the refinancing lender is unaware of the "sandwiched" loan, albeit through negligence.  Note that missing an $800,000 lien here when you are lending only $180,000 is a pretty big mistake.  New lender got very lucky.    

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