Daily Development for Monday, August 23, 1999

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

 Here is a little puzzle that's got it all: omitted junior lienholders, merger doctrine, deed warranty liability, a dollop of laches, a dash of equitable reinstatement. For genuine gourmands only.

MORTGAGES; FORECLOSURE; OMITTED JUNIOR LIENHOLDER: Property remains encumbered by second mortgage after holder of first mortgage forecloses upon without giving notice to holder of second mortgage.

Patel v. Khan, 970 P.2d 836 (Wyo. 1998).

In 1986, a bank that held a first mortgage on a home foreclosed upon that home, but did not join the holder of a second mortgage (Green) as a party to the foreclosure even though it was aware of his interest. The bank purchased the home at the foreclosure sale and the previous owner did not redeem the property. The bank then conveyed the home by warranty deed to the Patels, who later transferred it by contract for deed to other parties named Patel (presumably relatives). The warranty deed did not mention the existence of the Green mortgage, even though that mortgage had been properly recorded. Green gave the second Patels purchasers actual notice of the existence of the mortgage in his favor, but they did not pay off that mortgage. Instead, both sets of Patels conveyed the property to the Khans through a warranty deed that did not mention the existence of the Green mortgage.

The sale to the Khans occurred six years after the original foreclosure from which Green was omitted. Although Khans obtained a bank mortgage loan on the property, it does not appear that any title search was done for the Khans or their bank.

Green then brought a judicial foreclosure action against the Khans, the Khans filed a third party complaint against Patel and the bank for breach of implied covenants in their warranty deeds.

The Khans entered into a settlement agreement with Green, and the remaining parties filed crossmotions for summary judgment. The trial court entered judgment in favor of the Khans for the amount of their payment to Green, and the bank and the Patels appealed.

The Wyoming Supreme Court affirmed. The bank's mortgage terminated when it became the owner of the property, leaving Green as holder of a first mortgage. The bank's failure to give notice to Green of its earlier foreclosure meant that Green's interest survived that foreclosure. Thus, the bank and the Patels were liable for breach of the implied covenant in the warranty deed that the property was free from encumbrances. The proper measure of damages was the amount the Khans had to pay Green to prevent loss of their home.

Comment 1:  Veteran real estate lawyers will hardly be surprised by the sad story related above, save for the fact that the Khans were able to obtain a bank mortgage loan without Green's mortgage being revealed and paid. But they may wonder why Patel and the foreclosing bank even bothered to litigate this case, apparently a loser from the start.

The answer lies buried in the court's discussion of the arguments, in the course of which it discusses generally the doctrine of merger and its impact upon the foreclosing bank's mortgage. It states that, although merger typically is a found only when the parties so intend, the transfer of property by warranty deed free of stated liens generally is viewed as a merger of any mortgage interest held by the grantor/fee owner.

This analysis in the opinion suggests that the foreclosing bank had argued that its original mortgage, although theoretically terminated at its foreclosure, ought to be preserved and equitably reinstated with priority over Green's mortgage for purposes of dealing with Green's mortgage. This is a relatively common approach taken by many courts. Some reinstatement the senior mortgage in the case of omitted junior lienholders all the time, others only when the facts suggest good faith mistake in the omission of the junior in the first foreclosure.

Here, however, the bank had proceeded to sell the property to Patels by warranty deed, apparently representing to them by the warranty that the property was clear of mortgages.  The court concludes that this event constituted a "merger" terminating any residual interest that the bank had.

Comment 2: In many of these cases, the holders of junior liens are barred by laches when they wait six years to assert their rights. But in this case Green did notify Patels, albeit several years after the original foreclosure, and Patels, rather than responding, resold the property to Khans without revealing Green's interest. This is hardly a good case on the equities for Patels.

Comment 3: Still, is it proper to conclude that the bank's "mortgage reinstatement" claim was merged away because of the warranty deeds by Bank and Patels? The result is that Green gets a windfall and now is in first priority a position he never really had the expectation that he would enjoy.. We could reinstate the lien in favor of Khans, saying that if Green forecloses we would treat Green as subordinate to an equitable mortgage in favor of Khans.

Perhaps the short answer to this is that Khans elected not to raise that defense for themselves, and instead settled. Their settlement was rationale behavior on their part equitable reinstatement of mortgages six years after foreclosure is a dicey thing at best. Anything they did reasonably to protect their title ought to be recoverable in damages for breach of warranty deed.

The first bank and Patels, both of whom had actual knowledge of te Green mortgage, and both of whom gave warranty deeds without disclosing that mortgage, perhaps lack equitable standing to argue for reinstatement of the mortgage themselves.

But, to repeat a mantra the editor has recited a number of times in the past why in the world do we have to describe this result as "merger?" Once again, the court reduces a very sophisticated analysis of a complex equitable balancing exercise to a plumbing analogy.

 Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 16, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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