Mortgage
Modification and Alteration of Priorities Between Junior and Senior Lienholders
Patrick A. Randolph, Jr.
Edwin F. Pierson Professor of Law
University of Missouri, Kansas City School
of Law
Of Counsel
Blackwell Sanders Peper Martin
Kansas City, Missouri
This paper discusses the basic rules
and recent developments concerning the right of senior mortgagee and their
borrowers to modify loan or mortgage terms
or to substitute new mortgages
for existing liens while still preserving the senior mortgagee’s
priority versus junior lienholders.
Remarkably, the rights of the parties in this area has not been fully
worked out in the common law, even though the issue is well known and frequently
addressed in loan documentation.
The general developing rule appears
to be that provisions in senior lien documents conferring a right upon a senior
lienholder to vary the term or the interest rate of a mortgage are deemed valid
and binding upon junior lienholders with actual or record notice. In addition, even where there is no
provision in the senior mortgage, courts have upheld the priority of changes in
the senior mortgage terms that do not “materially prejudice” the rights of the
junior mortgagee. Generally speaking,
alterations in the payment schedule of the senior lien, even dramatic changes
in the term and payment amounts, have not been viewed as prejudicial to the
junior lienholder. Alterations in the
basic amount of interest payable, on the other hand, generally are viewed as prejudicial,
and the alterations will not have priority unless the mortgage has so provided.
The right of a senior lienholder to
modify the senior lien extends even to replacement of the senior mortgage with
an entirely different mortgage, so long as there is no express intent of the
parties to enter into an accord and satisfaction that would have the effect of
eliminating the first mortgage.
Equitable courts have even recognized the priority of the replacement
mortgage as against existing junior liens
where the original mortgage was cancelled of record and the new mortgage
recorded with record priority after the existing juniors, so long as the
juniors did not rely upon the record in extending additional credit in the
expectation that the senior lien had been discharged.
A more difficult problem arises if
the nature of the changes in the senior mortgage could lead to increases in the
amount of the principle secured by that mortgage. This could happen in a number of ways, either
through a simple increase in the secured debt, through cross collateralizing
other debts through the mortgage in question, or through changing provisions of
the mortgage, such as prepayment premium language or language conferring a new
or revised right on the senior mortgagee
to protect its collateral by advancing certain sums to repair the property, buy
insurance, complete construction. In
this circumstance, a reserved right to modify the mortgage would operate as a
“future advance clause,” and special rules have been applied by the common law
courts to such agreements.
The common law rule has been that
provisions to advance additional funds, and thus increase the loan principle,
primed junior lienholders if they were obligatory, but not if they were
“optional” with the senior lender and the advances were made with knowledge of
the existence of junior liens. This
“optional/obligatory” test has proved difficult for courts to interpret, and
consequently has been revised in many jurisdictions by statute. Nevertheless, it is the rule most often
applied when courts are called upon to review future advance clauses.
The recent Restatement of Property,
Third, Mortgages, proposes abandonment
of the common law “optional/obligatory” test in those jurisdictions that have
not yet altered it by statute, and replacing it with a new common law rule that
permits senior mortgages to provide for additional advances with the priority
of the senior lien so long as there is a fixed limit on the amounts to be
advanced and so long as the borrower may terminate the future advances right by
notice to the senior mortgagee. Senior
mortgagees could make advances to protect security without provisions in the
mortgage and without a right of the mortgagor to terminate that right, and the
Restatement defines the concept of advances to protect security quite
broadly. No jurisdiction, to the
author’s knowledge has yet adopted the Restatement position in toto absent statute.
1.
Contract Provisions Permitting Revisions to Senior Liens:
1.a.
Background Law:
It is possible, of course, that a
mortgagee would demand the unilateral right to alter certain basic provisions
in the mortgage unilaterally. In fact,
to a limited degree, this is done. In
jurisdictions using the deed of trust device, for example, lenders normally
reserve the right unilaterally to substitute trustees, and it is not uncommon
for the mortgagee to reserve relatively broad rights relating to
insurance. For the most part, however,
post closing changes in the loan and security instruments are carried out only
with the concurrence of the lender and borrower. The real focus of this article is on the
impact of such chances, whether made unilaterally or bilaterally, on the junior
lienholder. Typically, even of the
mortgagor concurs in alterations to the mortgage instrument, junior lienholders
are not consulted, and often would not easily consent.
Under the Restatement of Mortgages,
a provision in a senior mortgage generally permitting the parties to alter the
terms of the senior mortgage without loss of priority will be upheld, even if
the changes materially alter the security position of junior lienholders. The logic, of course, is that the junior
lienholders really never had a security position other than one made subject to
the possibility of modification of the senior’s rights. See, generally, Restatement of Law 3d,
Property 3d, Mortgages (ALI 1996) (the “Restatement of Mortgages”) Sec. 7.3 (
c).
The common law treatment of such
clauses is less clear. In comment d, the
Restatement authors note that there is little judicial authority discussing the
validity of such provisions, and in fact scholarly commentary is somewhat
divided. Kratovil and Werner, authors of
a respected treatise on the law of mortgages, propose that such provisions
should not be upheld where they materially prejudice junior lienholders. 8 Creighton Law Review 595, 610 (1975). Another commentator, consistent with
Restatement authors Nelson and Whitman, takes the position that junior
mortgagees necessarily take their liens at peril of an increase in the interest
rate of senior liens.
Where the provision permits
alteration of the loan instruments that
results in an increase in the principal amount secured by the loan, the
common law courts likely will view such a provision as a “future advance clause,” and will apply
specially restrictive rules, as discussed below. The Restatement, however, does not draw such
a distinction, and would permit the parties to the original loan instrument to
agree that they later can increase the principal amount directly or indirectly
without loss of priority.
The Restatement authors note that
the senior mortgagee’s right to modify the terms of the senior lien is not
significantly different than a provision stating that the interest rate on a
senior secured note may adjust over time.
There seems to be little challenge to the priority of an adjustable rate
term in a senior mortgage. Although, of
course, the junior lienholder might argue that the adjustable rate varies
according to a set of objective factors, while a naked provision permitting
revision exposes the junior to whatever might arise from the bargaining between
the senior mortgagee and the borrower, the fact is that in either case the
security position of the junior can be altered through operation of factors
that the junior can neither predict nor control.
In a number of states, as noted
above, legislatures have provided for a right on the part of mortgagors with
future advance provisions in their loan agreements to deliver a notice to the
mortgagee that terminates the ability of
the mortgagee to make further advances with priority. The notion is that otherwise the senior
lienholder can “freeze” the borrower’s equity in the property by threatening
away junior lienholders while the senior lienholder has no obligation actually
to fund the loan. The statutes generally
provide that the mortgagor cannot terminate the mortgagee’s right to make
advances with priority where the senior mortgagee is committed to make
additional advances, such as in
connection with a line of credit arrangement, or where the advances are
necessary to protect security. See, e.g.
Mo. Rev. State. 443.055.
The Restatement authors view
provisions giving the mortgagee the right to alter the terms of the existing
indebtedness as representing the same danger to the borrower’s available
borrowing power, since a threat of unlimited revisions in the interest rate on
a senior lien or other important terms might also deter potential junior
lenders. Consequently, they provide in
the Restatement for a right on the part of the borrower to terminate the loan
modification right by notice.
Restatement of Mortgages Section 7.3 (d). The Restatement even requires the mortgagee
to provide a recordable instrument so that the mortgagor can “clear the record”
in a way that makes junior lenders (and their title insurers) most comfortable.
One of the problems with this
“notice right” is that a senior lender might not feel as comfortable itself
with the loan if it does not have the power to negotiate revised terms with
priority. It’s own ability to workout
difficulties in the loan would be hampered if it could not make such
revisions. Consequently, the author is
of the view that the mortgagee ought to be able to bargain for a term in the
original mortgage that gives the lender the right to accelerate the loan should
the borrower file such a notice.
1.b.
Practice Tip:
Since the Restatement might be
adopted at some future time, and in any event, since the Restatement generally
makes good sense in this area, it would be wise for parties negotiating new
commercial mortgages to consider providing expressly for modifications as
follows:
1. Mortgagees ought to consider bargaining for a
general right on the part of senior mortgagees to modify or replace the
mortgage without loss of priority. The
modification right ought to expressly state that modifications might be carried
out that would change the interest rate, payment schedule and other significant
terms of the mortgage without regard to prejudice to junior lienholders. The parties should take into account the
concerns expressed below relating to proposed revisions that might result in
increases in the interest rate and be viewed as “future advance” provisions.
2. Mortgagors, in response, ought to bargain
specifically for a right to terminate the priority loan modification provision
when they conclude that it is prejudicial to their ability to seek junior
financing. Of course, the nature of the
notice and the provisions for a recordable instrument clarifying the status of
the loan following such notice ought to be spelled out expressly.
3. Mortgagees, in response to the mortgagors
bargained for right to terminate the priority modification provisions, might
wish to provide a right to accelerate the loan in the event that the mortgagor
provides such a notice. In the author’s
view, this right to accelerate, if it exists, should not arise automatically
upon receipt of the notice, but rather the mortgagee ought to have the right to
respond to the notice by stating that it rejects the mortgagor’s request, but
that if the mortgagor insists upon terminating the priority modification right,
the mortgagee will accelerate the loan.
Of course, the parties may further negotiate as to whether prepayment
premiums will attend such acceleration, and to what extent.
It might be argued that the
mortgagee could accomplish the same result simply by providing in the mortgage
that the mortgagor has no right to terminate the priority modification right by
notice, anticipating the possible enactment of the Restatement. The author has devised the more complex
system described above to deal with the possibility that a court, in adopting
the Restatement, might conclude that the notice right cannot be waived. Notwithstanding a non-waiver rule, courts
might be convinced that mortgagees could have a correlative right to accelerate
in response to the notice of termination.
The author acknowledges that both routes lead to the same destination,
but a court might be more inclined to recognize the acceleration right on the
notion that it has a little more control over it (through good faith and fair
dealing principles) than it would over a
simple contract nullification of the mortgagor’s notice right.
1.c.
Modifications as Future Advances:
Although the Restatement of
Mortgages treats modifications and future advance clauses in basically the same way, the common law in a
number of jurisdictions, as indicated, applies the “optional/obligatory” test
for increases in the loan amount pursuant to a provision in the loan agreement,
and does not permit such increases to prime junior liens of which the lender is
aware unless the lender was obligated to make them. Courts have been careful about granting
priority to unlimited future optional future advance clauses because of the
distinct danger of “freezing” any equity the borrower might subsequently have
available to provide security for future loans.
Under an optional provision, the senior mortgagee has no duty to make a
loan against this security, but the possibility that it may later do so, and
enjoy the priority of the original loan, would drive away any other potential
secured lenders.
The priority concern, then, arises
where the parties to the senior loan have agreed at some time after the
original mortgage was executed to modify the terms of the loan, and that
neither the mortgagor nor the mortgagee
had any obligation to enter into such modifications. Thus, it is quite possible that an agreement
that significantly increased the secured balance of the loan would be construed
as a future advance and made subject to the priority rule even where the
mortgage specifically authorized loan modifications. An example might be, of course, an increase in
the loan amount, but other examples would include the adoption of a prepayment
premium that was different from the earlier terms (where the premium, as is
typical, is secured by the mortgage) or new terms providing that the lender can
take steps to improve or protect its security position - such as by completing
construction - where the common law of the jurisdiction would not give priority
to monies so expended absent language in the mortgage.
As indicated, the Restatement, although it
purports to abolish the “optional obligatory test” for future advance priority,
does recognize this policy concern, and addresses it with the device of
permitting the borrower to “opt out” of future advance arrangements by simple
notice to the lender, which can be recorded to clear the record for future
lenders. This device is the same device
the Restatement uses for other loan modifications, as discussed above.
A thorough discussion of future
advance clause considerations is beyond the scope of this Article. But we should note that parties who
contemplate modifications under a general modification clause,, must be very
wary if the modifications have the potential to increase the secured mortgage
amount where there is no future advance clause provision in the mortgage. Here we do not only have a question of
priority of the modification. There may
be a question of validity as well..
A recent Alabama case drew an
important distinction between a general modification right and a “future
advance” provision. In Cottingham v. The Citizens Bank, CV-01-14,
2003 Westlaw 133246 (Alabama 1/17/03), the borrower executed a mortgage in
1988 containing a general right to modify or replace the mortgage in the
future. In 1992, the borrower later
alleged, the balance secured by this mortgage was paid down to zero, but it was
never cancelled of record. In 1998, the
lender alleged, the borrower executed a guarantee of certain debts related to
the original purposes of the loan and agreed that the 1988 mortgage, among
other things, would secure that guarantee.
Shortly thereafter, the loan went into default and the mortgagee
foreclosed privately on the mortgage. In
a suit for wrongful foreclosure, the borrower alleged that when the secured
balance was paid down to zero in 1992, the underlying mortgage was cancelled
automatically as a matter of common law, and that therefore it did not exist
when the 1998 guarantee was executed.
Consequently, the reference to the mortgage in that guarantee was
meaningless. The Alabama Supreme Court
agreed, and the result is generally consistent with the common law that when a
mortgage is fully paid it is deemed cancelled.
Therefore, in order to avoid inadvertant cancellation of a debt where
the parties really intend that the terms might subsequently amended to add to
the principal, even after the original debt is repaid, the parties cannot rely
upon a general right to modify the instruments, but must include a specific
future advance clause.
2.
Background Law Where Senior Mortgage is Silent as to Modification:
2.a.
Basic Legal Principles:
The
basic common law rule seems well established that a senior lienholder can make
such modifications in the loan agreement
to which it and its borrower agree without concern about loss of priority
to the extent that such modifications do not result in significant prejudice to
the interests of junior lienholders.
Restatement of Mortgages Section 7.3 (a). (Using the term “substantially prejudicial.”)
Where junior lienholders would be
prejudiced, however, their stake in the priority position as it existed at the
time they took their lien is entitled to protection. Normally the remedy is simply a reversal of
priority with respect to the claims that are in excess of those that existed
under the original mortgage.
Occasionally, sue to special equitable considerations, courts have in fact granted a complete
reversal of priority.
As was stated in the recent case of Burney v. McLaughlin, 63 S.W.3d 223 (Mo. App. 2001):
"It is well established that while a senior mortgagee can enter into
an agreement with the mortgagor modifying the terms of the underlying note or
mortgage without first having to notify any junior lienors or to obtain their
consent, if the modification is such that it prejudices the rights of the
junior lienors or impairs the security, their consent is required."
Shultis v. Woodstock Land Dev.
Assocs., 188 A.D.2d 234, 594 N.Y.S.2d 890, 892 (N.Y.App.Div.1993); see Fleet Bank v. County of Monroe Ind. Dev.
Agency, 224 A.D.2d 964, 637 N.Y.S.2d 870, 871 (N.Y.App.Div.1996); Empire Trust Co. v. Park-Lexington Corp.,
243 App. Div. 315, 321, 276 N.Y.S. 586, 592 (1934); Shane v. Winter Hill Fed. Sav.
and Loan Ass'n., 397 Mass. 479, 492 N.E.2d 92, 95 (1986). "Failure to
obtain the consent in these cases results in the modification being ineffective
as to the junior lienors and the senior lienor relinquishing to the junior
lienors its priority with respect to the modified terms." Shultis, 594 N.Y.S.2d at 892 (citations
omitted). "While this sanction ordinarily creates only the partial loss of
priority noted above, in situations where the senior lienor's actions in
modifying the note or mortgage have substantially impaired the junior lienors'
security interest or effectively destroyed their equity, courts have indicated
an inclination to wholly divest the senior lien of its priority and to elevate
the junior liens to a position of superiority." Id. (citation omitted); see cases cited in FRIEDMAN, CONTRACTS
& CONVEYANCES, 6th ed., Vol. 2, § 6.5 n. 13 (1998).”
The same is true as to junior
lienholders who take a lien position without actual or record knowledge of
prior modifications in the senior lien.
One might argue that junior lienholders ought to have a duty of inquiry
to determine whether the recorded mortgage reflects the current understandings
of their mortgagor and the senior lienholder, but the law does not seem to have
extended the inquiry duty of the junior lender this far, and in the author’s
view it should not do so. There is
little injury to the right of senior lienholders to modify their instruments if
we require that they also provide notice to the world through recording of
those modifications, and there is a great benefit to property transactions if
the record status of senior liens is kept up to date.
In
one extraordinary California case, the California Court of Appeals appears to
completely reject the general authority on this point. It remains to be seen whether the case will
stand up as good law. In Friery v. Sutter Buttes Savings Bank, 72
Cal. Rptr. 2d 32 (Cal. App. 1998), a property owner sold property subject to an
existing mortgage and took back a a junior mortgage securing part of the
purchase money. Thereafter, the buyers
were notified by the senior lender that it was accelerating its loan on the
basis of the “due on sale” clause.
Negotiations ensued, and the buyers
and the lender agreed to modify the terms of the loan. Later, the junior purchase money lender
argued that there should be a reversal of priority because the senior loan was
modified without its knowledge or consent.
The modification involved only a modification of the payment terms,
albeit a relatively pointed one (see discussion of the case below in section
2.b.1. Perhaps more importantly,
however, the court strongly criticized the position taken by a leading
California real estate law treatise in favor of some protection of juniors from
prejudicial modification of senior liens.
The court failed to cite significant out-of-jurisdiction authority and
the leading treatise writers, and seemed to view the issue as one of good faith
and fair dealing,
2.b.
What Constitutes a “substantially prejudicial” modification?
2.b.1.
Modifications in term.
Most courts state categorically that
mortgagees and their borrowers can modify payment schedules, including
extending or shortening the schedules, without loss of priority. This is on the notion that a change in the
payment terms of senior debt rarely will impair
significantly the legitimate expectation of the junior lender. It must be acknowledged that the junior
lender always takes subject to the senior lender’s discretion to invoke
acceleration and foreclosure remedies when the mortgagor does not pay on time. Permitting the parties to the senior mortgage
to agree on a set revised payment schedule is not seen as a significant change
from that position. A frequently cited
case discussing these considerations is Guleserian
v. Fields, 351 Mass. 238, 218 N.E.2d 397 (1966).
The Restatement of Mortgages
comments that “[a]bsent an increase in the principal amount or the interst rate
of the mortgage, such modifications normally do not jeapordize the mortgagee’s
priority as against intervening interests . . . Extensions of maturity
generally reduce the likelihood of foreclosure of the senior mortgage, and thus
are beneficial, rather than prejudicial, to the interest of junior
lienors. Restatment of Mortgages Sec.
7.3, comment c . See also: Shultis
v. Woodstock Land Dev. Assoc., 594 NYS 2d 890, 892 (N.Y,. App 1993), Lennar Northeast Partners v. Buice, 57
Cal. Rptr. 2d 435 (Cal. App. 1996).
But to say that the senior lenders
can alter the payment schedule with complete impunity, as many courts do,
probably overstates the case. Some
authorities and commentators recognize that a radical change in payment
schedule may indeed be beyond the expectation of the junior lender and can lead
to prejudice. Id. This is particularly
true where the payment schedule is dramatically foreshortened. In Gluskin v. Atlantic Savings & Loan Ass’n,
108 Cal. Rptr. 318), a 30 year payment schedule was changed to a balloon
mortgage due within one year, and the court refused to permit such change to be valid as against a
subordinating lienholder.
A subsequent decision, however,
casts some doubt on the authority of Gluskin
outside of the case of a subordinating lender. In Friery
v. Sutter Buttes Savings Bank, 72 Cal. Rptr. 2d 32 (Cal. App. 1998), the
senior lender modified the note by moving the maturity date five years earlier,
and fifteen days before the due date on the second mortgage. Obviously this had the effect of focussing
the borrower’s attention more on the senior lien debt and less on the junior
lien debt at the critical time when
the junior lien debt had been due.
Nevertheless, the court distinguished Gluskin in part on the grounds that Gluskin involved a subordinating purchase money lender, while in Friery the objecting junior lienholder
had always been junior to the modified loan.
The author submits, however, that the same principles ought to apply in
both cases. If Friery is correct, it is correct simply because the alteration in
the payment schedule was not significantly different from what the junior
lender legitimately should have expected would occur, and Friery therefore does place the authority of Gluskin in some doubt.
Citizens
& Southern National Bank of South Carolina v. Smith, 284 S.E. 2d 770
(1987), another case involving a subordinating lender, also voided the
subordination on the basis of a change in the payment schedule, in this case an
extension of the schedule.
Another case that suggested that an
alteration in the payment date might result in prejudice to the junior lender
is Remodeling & Construction Corp. v.
Melker, 65 N.Y.S. 2d 738 (Sup. Ct. 1946), where the court appears to have
entirely reversed the priority in a case in which it concluded that the
modification of the senior loan was made “for the sole purpose of wiping out
the second mortgage.” In this case,
however, the parties also changed the interest rate as well as the payment
schedule, so it is difficult to isolate the change in term as supporting the
holding alone.
2.b.2.
Modification in Interest Rate:
Courts are far more loathe to
conclude that an increase in the interest rate is not prejudicial. They
conclude that such a change would make it more difficult for the junior to
avoid foreclosure of the senior lien and protect its interest. Consequently, they generally tend to
conclude that, absent language in the senior mortgage authorizing such a
change, the change in interest rate is ineffective as against the junior, even
though it remains effective against the mortgagor. Restatement of Mortgages Sec. 7.3 comment
c. See,
e.g., Fleet Bank of New York v.
County of Monroe Industrial Development Agency, 637 N.Y.S.2d 870 (N.Y. App.
Div. 1996); Shultis v. Woodstock Land
Dev. Assoc., 594 N.Y.S.2d 890 (N.Y. App. Div. 1993) ("Any prejudice
visited upon [junior lienor] as a result of the interest increase was
successfully abated by giving it priority over the amount representing the
increased interest due and owing plaintiffs as a result of the unauthorized
second modification.").
Nelson and Whitman, in their fine
treatise on mortgage law, discuss this issue, with authorities (which are
omitted here):
“The basis for pro tanto loss of priority has been explained as
follows: This result is premised on the
assumption that such transactions prejudice the interests of such junior
lienholders. Suppose, for example, that a modification agreement results in an
increase of the interest rate on a $10,000 mortgage balance from 11 percent to
14 percent. If, as is likely, this increases the mortgage payments, this
enhanced debt burden increases the risk of default and foreclosure as to both
senior and junior mortgagees. Moreover, the junior lienor's margin of
protection in the real estate is reduced to the extent that the higher interest
rate increases the amount of the senior debt. Similarly, if the principal
balance of the senior debt is increased from $10,000 to $12,000, prejudice to
the junior lienor is obvious. The mortgagor's higher total debt burden could
increase the likelihood of default and foreclosure for all liens on the
property, and the junior's margin of protection in the mortgaged real estate is
reduced. Moreover, in both of the above modifications, if the junior lienor is
forced to satisfy the senior mortgage in order to protect his or her position,
the amount required for such a satisfaction will be more than could have been
contemplated at the time the junior interest was acquired. 1 G. Nelson & D. Whitman, Real Estate
Finance Law 816-17 (3d ed. 1993).
A few cases have found that there
was no prejudice resulting from interest rate increases: Strong v. Stoneham Co-op. Bank, 310 N.E.2d 607 (Mass. Ct. App.
1974) (apparently distinguishing Guleserian,
supra, on the ground that the senior lender had no knowledge of junior
lienholders, either actual or constructive, at the time it entered into the
loan modification. The distinction is
dubious and the case seems contrary to general authority); Commerce Sav. Lincoln, Inc. v. Robinson, 331 N.W.2d 495 (Neb. 1983)
(cross-collateralization and increase in interest did not affect priority where
lender ignorant of junior liens and substituted mortgages - case may involve
special considerations of purchase money mortgages).
A decrease in the senior mortgage
interest rate is not deemed to prejudice the interest of junior lienholders. See Big Land Inv. Corp. v. Lomas &
Nettleton Fin. Corp., 657 P.2d 837 (Alaska 1983).
2.b.3.
Other Loan Terms: The Burney
Case:
A recent Missouri case, Burney v. McLaughlin, 63 S.W.3d 223 (Mo. App. S.D. 9/28/01),
provides a good example as to how the principles discussed here apply in the
context of loan workouts, and is discussed in detail.
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 an
injunction against the foreclosure 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.
3. Subordinating Lenders:
As indicated above, some cases
apparently have taken the view that lienholder who becomes subordinate as a
consequence of a subordination agreement is entitled to special protection
against modification of the senior mortgage, apparently on the notion that the
subordination agreement contemplated specific terms to which the subordination
would occur. In this case, of course, it
might also be possible to argue that the subordination agreement ought to be
voided entirely, leading to a complete reversal of priority, as opposed to the pro tanto alteration that is most often
seen in cases that do not involve subordinated lienholders.
Lennar
Northeast Partners v. Buice, 57 Cal. Rptr. 2d 435 (Cal. App. 1996),
concluded that there is no warrant for the complete reversal of priority even
in this case, and even in a jurisdiction in which subordinating lenders receive
extraordinarily delicate consideration.
Note that the Burney case, above, did not address the problem as one of the scope
of subordination, but rather as one involving the rights of junior lenders
generally.
4.
Substitution of Mortgages:
4.1.
The Basic Rules:
The
same Restatement provision discusses the concept of replacements substitutions of loans by the same
lender. Where the same parties to the
original mortgage, or their assigns, are involved, there really is no reason to view the
replacement of a mortgage as any different conceptually from the modification
of the mortgage. Although the
replacement of a mortgage involves the recording or a new instrument and the
discharge of the original instrument, where the parties intend to maintain the
existing secured credit relationship, there is no reason to treat the recording
act formalities as affecting the substance of the transaction, so long as no
junior lenders are prejudiced by relying upon an open record in extending new
credit. Consequently, the Restatement
supports a broad right of substitution and replacement without loss of
priority:
Restatement Section 7.3 (a)
provides:
If a senior mortgage is released of record and, as part of the same
transaction, is replaced with a new mortgage, the latter mortgage retains the
same priority as its predecessor, except (1) to the extent that any change in
the terms of the mortgage or the obligation it secures is materially
prejudicial to the holder of a junior interest in the real estate, or (2) to
the extent that one who is protected by the recording act acquires an interest
in the real estate at a time that the senior mortgage is not of record.
As the Restatement notes, the common
law approach is reasonably well established that senior mortgagees do not lose
priority simply by replacing a record mortgage with another, citing, e.g., Stephens
Wholesale Bldg. Supply Company, Inc. v. Birmingham Fed. Sav. and Loan Ass'n, 585
So. 2d 870 (Ala. 1991); Home Federal
Savings & Loan Association v. Citizens Bank of Jonesboro, 861 S.W.2d
321 (Ark. Ct. App. 1993); Farmers &
Merchants Bank v. Reide, 565 So. 2d 883 (Fla. Dist. Ct. App. 1990); Rebel v. National City Bank, 598 N.E.2d
1108 (Ind. Ct. App. 1992); Jackson &
Scherer, Inc. v. Washburn, 496 P.2d 1358 (Kan. 1972); Financial Acceptance Corp. v. Garvey, 380 N.E.2d 1332 (Mass. Ct.
App. 1978); Piea Realty Co. Inc. v.
Papuzynski, 172 N.E.2d 841 (Mass. 1961); Greenfield v. Petty, 145 S.W.2d 367 (Mo. 1940); Mackiewicz v. J.J. & Associates, 514
N.W.2d 613 (Neb. 1994); Resolution Trust
Corp. v. Barnhart, 862 P.2d 1243 (N.M. Ct. App. 1993) ("where a senior
mortgagee discharges its mortgage of record and contemporaneously takes a new
mortgage, the senior mortgagee's lien is not subordinated to intervening liens
in the absence of (1) evidence of an intent to subordinate, or (2) paramount
equities in favor of junior lienholders that justify subordinating the senior
mortgagee's lien."); Norstar Bank v.
Morabito, 607 N.Y.S.2d 426 (App. Div. 1994); Kellogg Bros. Lumber v. Mularkey, 214 Wis. 537, 252 N.W. 596 (1934);
Marine Bank Appleton v. Hietpas, Inc., 439
N.W.2d 604 (Wis. Ct. App. 1989) ("It is a well-accepted rule that a new
mortgage that secures an old debt does not extinguish the original lien absent
evidence of the parties' intent to do so or of paramount equities that would
require that result"); In re Earl, 147
B.R. 60 (Bankr. N.Y. 1992); Annots., 98 A.L.R. 843 (1935); 33 A.L.R. 149
(1924). Of course, a loss of priority is even more unlikely where the original
mortgage is not discharged of record. See
Hummel v. Hummel, 896 P.2d 1203 (Okla. Ct. App. 1995); Skaneateles Savings Bank v. Herold, 376 N.Y.S.2d 286 (N.Y. App.
Div. 1975), aff'd 359 N.E.2d 701 (N.Y. 1976).
The Restatement advises a
presumption that when a mortgage is discharged but replaced by another between
the same parties, intent on the part of the senior mortgagee to subordinate to
intervening liens will not be inferred. Only express and unambiguous evidence
of such intent will suffice. Indeed, courts frequently deal with the intent
issue by recognizing a presumption that the mortgagee intended a result that
would be most beneficial to its security interest. See, e.g., Commercial Fed. Sav. & Loan Ass'n v. Grabenstein, 437
N.W.2d 775 (Neb. 1989).
Needless to say, prudent mortgagees obviate the intent issue
by carefully spelling out in the new document the parties' intent that the
replacement mortgage retain the same priority as its predecessor.
4.2.
Distinguishing Subrogation:
Courts sometimes confuse
substitution principles with the concept of equitable subrogation. They are quite different. Substitution simply continues an existing
relationship between mortgagor and mortgagee, and is the equivalent of a loan
modification. It can be addressed under
the same principles as loan modification.
Where, however, a new lender
provides funds to a borrower, who uses the funds to retire an existing loan,
the new lender has entered into a new contractual relationship, and there is no
particular reason to assume that the new lender is stepping into the shoes of
the old except when special equitable hardship might result. For instance, where a new lender is providing
funds in the good faith belief that the record is clear of junior lenders, but
in fact there is a junior lender of record whom the lender’s title search
missed, courts commonly have granted subrogation of the new lender to the old
lender’s mortgage. Note, however, that
the new lender is stuck with whatever terms and conditions the old lender had
negotiated for itself, and does not enjoy priority for its new loan (if the old
loan had modification provisions, however, presumably the new lender would be
subrogated to those as well).
An example of a case in which the
court became wholly confused about the two concepts is Suntrust Bank v. Riverside Nat. Bank of Florida, 2001 WL 980819
(Fla. Ap. 4th Dist. 8/29/01), where the court cited the Restatement
provisions on equitable subrogation and applied subrogation principles in a
case in which an existing lender had discharged an earlier mortgage and agreed
to a substitute mortgage. A strong
dissent argued that equitable subrogation was inappropriate because there had
been no equitable foundation laid justifying the failure of the mortgagee to
address the rights of the recorded junior lenders. Both majority and dissent, however, neglected
to note that the case involved a simple substitution arrangement. There was no new lender.
In the author’s view, when a third
party lender makes a loan and knows or should know of existing liens on the property,
that lender’s rights ought to be subordinate to those existing liens unless
special equities justify a different result.
The author here would require the lender to demonstrate why it should
not be entitled only to the priority that its objective actions entitled
it. The author is concerned that any
other rule could lead to unscrupulous manipulation of the credit record by
lenders, perhaps in collusion with borrowers,
to secure inappropriate advantage over existing liens. Normally it is a simple matter to obtain an
assignment of the senior lender’s rights if the take out third party lender
indeed expects the priority of that party’s lien, and needs of regularity in
real estate documentation suggest that when the parties do not use an assignment,
they should not be treated as having made an equitable assignment unless there
are affirmative equitable reasons to do so.