Daily Development for
Thursday, April 2, 1998

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

Today’s DD was written by Dale Whitman as “guest editor.” Dale - you’re pretty good at this. Have you considered a career?

MORTGAGES: PRIORITY: A junior mortgage is not entitled to any remedy as a result of the modification of a senior mortgage where the junior mortgage did not get its priority as a result of a subordination agreement.

Friery v. Sutter Buttes Sav. Bank, 72 Cal.Rptr. 32 (Cal. Ct. App. 1998).

Sutter made a loan of about $400,000 in 1986 on a commercial property in Yuba City, Cal., secured by a first deed of trust. Friery subsequently purchased the property in 1988, and resold it in 1991 to the Briones, taking back a second deed of trust for $68,000 as part of the purchase price. Later in 1991 Sutter discovered the sale. It asserted that the sale violated the due-on-sale clause in its deed of trust, and that the Briones were not creditworthy. It allowed the Briones to assume the first deed of trust, but only after they agreed to modify its terms by changing the maturity date from 2001 to 1996. (The court does not say whether the first note called for monthly payments, or whether the payments were increased as a result of the shorter maturity.) The Briones also were required to pledge to additional parcels of real estate as added security.

In 1995 the Briones defaulted on both debts. Sutter filed a judicial foreclosure action, naming Friery as a defendant. Friery moved the court to reverse the priorities, giving her priority over Sutter, because the modification had increased the probability of default on the first deed of trust, thus impairing her security interest. The trial court refused to grant this request, and the Court of Appeals agreed.

The court distinguished two prior California cases: Gluskin v. Atlantic Sav. & Loan Ass'n, 108 Cal.Rptr. 318 (1973) and Lennar Northeast Partners v. Buice, 57 Cal.Rptr.2d 435 (1996). Both of these cases involved modifications of the first deed of trust which arguably harmed the holder of the second deed of trust. In both cases, significantly, the second had become junior in priority as a result of an express subordination agreement. The court in the present case pointed out that no subordination agreement was involved here; Friery had become junior, not by subordinating a senior deed of trust, but simply by taking her deed of trust after the Sutter deed of trust had already been recorded.

The court conceded that both Gluskin and Lennar had been decided correctly, but only because the junior lienholder in both of those cases had become junior by subordinating. Those junior lienholders were entitled to a reversal of priorities to the extent of the harm they suffered from the modification. But the court saw this equitable reversal of priorities as a an application of the notion of the duty of good faith and fair dealing that is inherent in a subordination agreement. Here, by contrast, there was no subordination agreement, and hence no occasion to apply the duty of good faith and fair dealing. Hence Friery was not entitled to priority over Sutter to any extent at all.

Reporter’s Comment 1: In terms of prevailing U.S. law, this case is conceptually wrong. Restatement of Mortgages Sec. 7.3(b) states the majority view"...the senior mortgage, as modified, retains prority as against junior interests in the real estate, except to the extent that the modification is materially prejudicial to the holders of such interests..." The court cited no non-California law, and seems to have been unaware of the Restatement or of the prevailing view. Under the Restatement, a senior mortgagee can expressly reserve the power to modify with loss of priority, but there is no indication in the opinion in the present case that Sutter had done so.

The majority and Restatement view seems preferable. (Indeed, the court quotes Miller and Starr, the eminent California real property authorities, as advocating it, but the court is unmoved by their position.) If a senior mortgage contains no provision reserving the right of the mortgagee to make future advances or future modifications, a junior mortgagee should be able to rely on the fact that no such advances or modifications will occur to the junior's detriment. If a senior mortgagee wants to make future advances or modifications with impunity, it is a simple matter to include a clause reserving that authority in the senior mortgage. Such a clause will warn prospective junior lenders to stay away. In the absence of such a clause, they should be able to assume that the first mortgage will maintain its status quo.

Reporter’s Comment 2: Notwithstanding the above comment, the decision may be correct on its facts (though not on its reasoning). The reason is the type of modification that Sutter engaged it. The modification did not increase the interest rate or the principal amount of the first loan; it simply changed it maturity date from 2001 to 1996. If the loan did not call for regular installment payments, or if the payments were not increased (but instead, the loan was expected to "balloon" in 1996), it is very hard to see how the modification caused any prejudice to Friery. Even if the modification caused an increase in the monthly payments on the loan, it is arguable the the modification was actually beneficial to Friery, since it would result in the first loan's being paid off five years earlier. (In fact, Friery's loan was also due to mature in 1996, so she would experience no practical benefit from the acceleration of the maturity date.)

Friery's argument for "material prejudice" to her position, however, runs along a different line If the payments to be made by the Briones are increased, the probability of their defaulting (as indeed they did) is also increased; this, in turn, increases the risk that a foreclosure will wipe out Friery.

The difficulty with this argument is that it is impossible to quantify that increased risk. Indeed, it is obvious that Sutter believed the increased monthly payments (if such there were) were within the Briones' reasonable capacity to pay; otherwise it would not have required them, for obviously Sutter would not have wanted to "set up" the Briones to default. What is the monetary value of the increased risk, if any? It seems to me impossible to say, and I believe no reversal of prioritities in Friery's favor would have been warranted on these facts.

The Restatement, in Sec. 7.7, Comment c, takes the view that extensions of maturity of the senior mortgage are not sufficient to justify a promotion of the junior lender's priority. It notes that "extensions of maturity generally reduce the likelihood of foreclosure of the senior mortgage, and thus are beneficial, rather than prejudicial, to the interests of junior lienors." By comparison, reductions of maturity probably do increase the risk of default to some extent, but that extent is not quantifiable, and similarly should not justify an promotion of the junior lien. Under the Restatement, only increases in interest rate or in principal amount in senior mortgage debt will warrant a promotion of the junior lien; their prejudice is readily quantifiable, since the balance on the senior debt will be higher than it would otherwise have been by X dollars at the date of foreclosure as a result of the higher interest or balance. This seems a sensible rule.

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