Daily Development for
Monday, October 21, 1996

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

MORTGAGES; TRANSFER BY MORTGAGOR; SURETYSHIP; DISCHARGE: Mortgagor/surety who has transferred property subject to mortgage will be discharged completely if mortgagee releases lien of mortgage in favor of transferee, rather than just to the extent of the value of the property released, even if transferee had not assumed and agreed to pay the note.

Chrysler First Business Credit Corporation v. Kawa, 914 P.2d 540 (Colo.App. 1996).

In holding that the defendants in this case were sureties and entitled to all the protection that the law gives to sureties, the court relied on the general rule that when property is pledged or mortgaged as security for a debt, the land becomes the primary source for payment.

If real property is sold "subject to" an existing mortgage, the buyer acquires the property burdened with that mortgage. If the buyer does not also assume the mortgage, the buyer takes the land subject to the encumbrance without a personal obligation to pay the debt. The seller, having signed the note, usually remains bound by it. But typically, as between the buyer and seller, the parties expect the buyer to pay the note or lose the property to foreclosure, with the seller liable only in the event of a deficiency. When such a transfer occurs, a principal and surety relationship is deemed to arise between the land and the seller/mortgagor, with the seller/mortgagor being the surety and the land itself taking on the characteristic of the principal debtor.

Upon default in payment of the note in this case, under principles of suretyship, the defendants became primarily liable on the debt and were entitled to avail themselves of the designated source of repayment, which was the real property. As a surety, the defendants had the right of subrogation to the creditor's position when the debt went into default. The mortgagee, however, released its underlying security, the first deed of trust encumbering the real property, without the defendant's knowledge or consent. This release completely extinguished the defendants' subrogation rights in the real property, and, thus, materially altered the surety relationship between the parties by interfering with the defendants' access to their security. As a result, the court concluded that the defendants were fully released from personal liability on the note.

Comment 1: The court permits a complete discharge of the mortgagor/surety, rather than a discharge only to the extent of the value of the property at the time of its release. The court considers and rejects what is probably the majority rule, permitting discharge only to the extent of the value of the property. The "partial discharge" approach was the express rule as to instruments covered by the UCC under old UCC Section 3-606. The new UCC does not expressly cover the situation of mortgage debtors who transfer their property, but UCC 3-605, which replaced 3-606 in this area, would provide an analogy and would permit discharge only to the extent of the property released.

The new Restatement of Land Security also would permit discharge only to the extent of the land released by the mortgagee, arguing that a full discharge would give an inappropriate windfall to the mortgagor.

Comment 2: This was a large commercial loan. Properly drafted loan documents at this level probably should have included a waiver of suretyship discharge rights of this type, unless the mortgagor negotiated them out of the deal (a highly unlikely event). Such waivers are generally upheld.

Comment 3: Dale Whitman, a Reporter for the new Restatement of Land Security, comments:

Sec. 5.3(a)(3)(i) (found in Tent. Draft. No. 2, 1992) provides that:

"...the transferor is discharged from personal liability on the obligation secured by the mortgage ... to the extent that the transferor suffers loss caused by ... the mortgagee ... releasing all or part of the real estate from the mortgage."

The operative words are "to the extent that." [In the reported case], when the first deed of trust was released by Chrysler, the note-makers were injured to the extent of the value of the real estate; that's all the coverage that the first deed of trust could have given them. Hence, they should continue to be liable for the balance. The court's result gives them an unwarranted windfall by discharging them completely, rather than pro tanto.

The case law on this point is divided. As we said on p. 139 in the Reporters' Note: "In effect, the [Colorado court's view] presumes that the property was worth at least as much as the debt, a result which seems illogical and unjustified."

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