Daily Development for Monday, September 24, 2007
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGE LOAN PARTICIPATION: COURT MAY MODIFY PRIORITIES AMONG PARTICIPANTS TO ACHIEVE EQUITY. If a group of parties receive partial assignments or participation shares in a note and mortgage, and if they do not specifically agree among themselves as to their priority, the court is not bound to treat them as pro-rata participants, but instead can assign priority among them based on the equities of the case.

Carbon v. Spokane Closing & Escrow Co., 147 P.2d 605 (Wash. App.2006).

This case involves the creation of a set of partial assignments (participations) in a $2.5 million note and deed of trust. The facts are complex, and it isnt clear that the court understood them perfectly, but heres what seems to have happened.

Mr. & Mrs. Carbon sold a parcel of land to A&P Properties for $930,000. A&P gave them a note for $330,000, secured by a deed of trust on other property (which was never paid to them), and they also received $30,000 from one of the promoters of the deal. They were supposed to receive the remaining $566,000 by way of a 15-day note from A&P, but that note was never paid to them. Instead, A&P gave a note and deed of trust to Solid Rock for $2.5 million; this deed of trust was a lien on the land the Carbons had sold to A&P. (A&P never received anything of value for the $2.5 million note). Solid Rock then issued five partial assignments of the $2.5 million note to five individuals, one of which was a partial assignment to the Carbons in the amount of $566,000. The deed to A&P, the deed of trust from A&P to Solid Rock, and the partial assignments were all duly recorded.

Thus, the partial assignment received by the Carbons was evidently intended to represent payment of the remaining purchase price owed to them for their land, and they evidently accepted it in lieu of payment of the 15-day, $566,000 note. However, of the $566,000 they were to receive on the partial assignment, they were paid only $150,000; at that point, the $2.5 million note went into default and payments on it ceased.

This transaction was ill-thought-out, to say the least. Why would the Carbons have accepted a one-fifth share of a note for $2.5 million in partial payment for, and secured by, land that they had just sold for less than $1 million? Why did they not insist on receiving immediate payment of the $566,000 note, and sue on it when it was not paid? There are no clear answers to these questions. The trial court concluded that the escrow officer who prepared the document breached a fiduciary duty to the Carbons.

In effect, the Carbons were holders of about a 23% participation share of the $2.5 million note and deed of trust, although there was no participation agreement. When the note went into default, the Carbons brought a suit against all of the other parties, demanding among other remedies that they be given first priority in the payout of the foreclosure proceeds on the deed of trust.

Ordinarily, when there is no contrary agreement, the parties to a participation share pro-rata in the proceeds of a foreclosure if a shortfall occurs. But here, the court granted the Carbons the first priority as they had requested. In doing so, it applied equitable principles: The Carbons were entitled to first priority, in essence, because they had provided the real estate that made the whole deal possible. Their priority would extend, the court held, to let them recover up to the full purchase price they had originally agreed to accept.

The court found that the $2.5 million note and deed of trust were fraudulent conveyances, by which it presumably meant that they were executed without receipt of equivalent value, and that their issuance left A&P, which issued them, insolvent. Nonetheless, the court refused to set the note and deed of trust aside on the basis of the fraudulent conveyance statute, because the Carbons and each of the other holders of the partial interests had contributed value to the deal, and hence all were BFPs.

Not only did the Carbons receive first priority, but the court prioritized at least some of the other parties interests as well. One party who made a cash investment in the property received second priority, and another party, who did not provide any cash but who renegotiated existing security interests in other properties, was given third priority.

Reporters Comment 1: The fact that the Carbons were given first priority is not surprising when we remember the principle that a purchase-money mortgage to a vendor is presumed to have priority over other security interests that come into effect in connection with the purchase. While the Carbons interest was not, strictly speaking, a purchase-money mortgage, it was in effect granted to them in lieu of a purchase money mortgage. Hence, the priority they received makes sense.

Reporters Comment 2: The purchase-money mortgage doctrine, however,  doesnt explain the allocation of priorities among the other partial assignees. That was done on the basis of pure equity. The lesson is clear: if the parties to a participation want a particular priority, they had better spell it out. They cant assume that the court will treat the participants as all as pro-rata if their agreement is silent on the point.

Reporters Comment 3:   There was no participation agreement or other contract regarding the priority of the partial assignments here. Its interesting to think about what the court might have done if there had been. It is likely that the court would have enforced the agreement. After all, the purchase-money mortgage doctrine is only a presumption, and can be reverse by specific language of subordination. There is every reason to suppose the court here would enforced a specific priority agreement as well.

Reporters Comment 4:   In one paragraph, near the end of the opinion, the court goes off on a tangent concerning UCC Article 9. It points out (correctly) that the perfection provisions of Article 9 apply to security interests in a note, even one secured by a mortgage. This is true but irrelevant, since the partial assignments in this case were (so far as one can tell from the opinion) outright assignments rather than security assignments. (Article 9 provides that outright assignments of instruments such as promissory notes are automatically perfected, without the necessity of either delivery of the instrument itself or of filing a UCC-1; see UCC 9-309(4). And perfection as to the note automatically perfects as the real estate security the mortgage or deed of trust as well; see UCC 9-308(g)). The court concludes by saying that since none of the partial assignees perfected, none of them had secured interests in the note. Again, true but completely irrelevant, since their
interests were outright shares of fractional ownership, rather than security interests in the $2.5 note. The paragraph does no ultimate harm, but illustrates how confused judges and lawyers can become when faced with the interaction of Article 9 and real estate interests.

The Reporter for this item is Professor Dale Whitman of the Missouri, emeritus professor of the Missouri,  Columbia Law School.

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