Equitable Subrogation: The Missed Mortgage
Articles from The Massachusetts Focus
Newsletter of Stewart Title Guaranty Company, Massachusetts Offices
Spring 2005, Volume 4, Number 2
Equitable Subrogation: The Missed Mortgage
by Gary F. Casaly, Special Counsel
The relative positions of a prior second mortgage that was missed in connection with either a sale of the property and a pay-off of an existing first mortgage, or the refinance of the existing first mortgage was discussed in East Boston Savings Bank v. Ogan, 428 Mass. 327, 701 N.E.2d 331 (1998). This case can be a “life saver” to an attorney or title examiner who happens to miss the second mortgage in a rundown of title.
The basic rule is this: if, in connection with the payoff of a first mortgage, you miss an intervening lien, the interest of the transferee(s) of the owner (e.g., new purchaser or mortgagee) will enjoy a priority over the position the intervening lien, at least to the extent of the amount of the first mortgage that was paid off.
The doctrine of equitable subrogation governs the above result. The East Boston Savings Bank case discusses the doctrine in detail. The facts in that case are straight-forward and, unfortunately, familiar to many conveyancers. Steven and Jeffery Kline purchased a condominium unit as tenants in common for $227,000 on September 19, 1988, and financed their purchase, in part, with a $187,500 mortgage loan from Eastern Savings Bank. On February 9, 1989, Steven Kline granted a second mortgage in his one half undivided interest in the property to Ogan. (Why a lender would grant a mortgage on a one-half interest is the topic for another newsletter article altogether.) This mortgage indicated that it was “subject to a mortgage to the Eastern Savings Bank.” Accordingly, after the purchase and the two mortgage transactions, the property was subject to the first mortgage to Eastern Savings Bank, and the second mortgage to Ogan (at least as to Steven’s half interest).
Steven and Jeffery Kline then sold the property to Toner on November 10, 1994, for $183,000. As consideration, Toner gave a mortgage secured by the property for $130,000 to East Boston Savings Bank, and he provided $54,407.63 from his own funds toward the purchase. The balance of the mortgage then held by Eastern Savings Bank at the time was $176,948.65, and the conveyancing attorney for the new lender, East Boston Savings Bank, secured a payoff figure from Eastern Savings Bank, paid the mortgage off and recorded a discharge. Unfortunately, in connection with the transaction the closing attorney never discovered Ogan’s intervening mortgage. Accordingly, after the sale, on the record the property was subject to the mortgage to Ogan followed by the new mortgage to the plaintiff, East Boston Savings Bank.
Upon learning of the situation and in an effort to determine the status of its mortgage, East Boston Savings Bank brought an action against Ogan in the Land Court for a declaratory judgment, praying that the mortgage to East Boston Savings Bank be determined to actually be a first mortgage, having priority over the mortgage held by Ogan, based upon the doctrine of equitable subrogation. The new owner, Toner, also joined in the lawsuit to determine the status of his equity in relation to Ogan’s mortgage. The Land Court held that Ogan’s mortgage was subordinate to both the equity interest held by Toner and the mortgage interest held by East Boston Savings Bank. Ogan appealed to the Appeals Court but the Supreme Judicial Court, on its own motion, transferred the case to that court.
The court began its opinion with an observation that courts have “broad powers over mortgages.” Some of the examples that the court cited with respect to this rule were these: (i) the power to reform mortgages (General Bldrs. Supply Co. v. Arlington Coop. Bank, 359 Mass. 691, 696 697, 271 N.E.2d 342 (1971), discussing reformation of mortgages, and cases cited), (ii) the power to restore once-extinguished mortgages (Childs v. Stoddard, 130 Mass. 110, 112 (1881), and Bruce v. Bonney, 78 Mass. 107, 12 Gray 107, 112 (1858) where mortgagees sought to have a discharge of mortgage set aside), and (iii) the power to adjust priorities among existing mortgages (Worcester N. Sav. Inst. v. Farwell, 292 Mass. 568, 574, 198 N.E. 897 (1935), where subrogation was applied to adjust priorities among mortgages).
The court characterized the case as one of first impression, not on account of the application of the doctrine of equitable subrogation, which had been applied many times before, but rather because it was being asked for the first time to apply the doctrine to a sale, as opposed to simply a situation involving the refinancing of a mortgage.
We have not previously addressed the question whether, and to what extent, equitable subrogation applies where a mortgage is extinguished as part of a sale. We have applied subrogation to a refinancing transaction. See Provident Coop. Bank [v. James Talcott, Inc., 358 Mass. 180 (1970)] supra; North Easton Coop. Bank [v. MacLean, 300 Mass. 285 (1938)], supra at 292, [15 N.E.2d 241]. Because we find that the equities are substantially similar in refinancing and sales transactions, and that application of equitable subrogation to a sale is consistent with our precedent, we hold that equitable subrogation applies in this case.
The court stated the elements of the doctrine of equitable subrogation by citing the Restatement (Third) of Property (Mortgages), §7.6(a) (1997):
One who fully performs an obligation of another, secured by a mortgage, becomes by subrogation the owner of the obligation and the mortgage to the extent necessary to prevent unjust enrichment. Even though the performance would otherwise discharge the obligation and the mortgage, they are preserved and the mortgage retains its priority in the hands of the subrogee.
The court noted that the effect of this rule would be that the new mortgage given by a mortgagor, who used the proceeds of the new mortgage to extinguish an earlier mortgage, may receive the same priority once given to the earlier mortgage. The court noted, however, that the application of the doctrine of equitable subrogation was dependent upon the determination of certain factors:
(1) the subrogee made the payment to protect his or her own interest;
(2) the subrogee did not act as a volunteer;
(3) the subrogee was not primarily liable for the debt paid;
(4) the subrogee paid off the entire encumbrance; and
(5) subrogation would not work any injustice to the rights of the junior lienholder.
The court, in applying the doctrine of equitable subrogation must ensure that the intervening mortgagee is not unjustly enriched by succeeding to first priority, but it also must ensure that the intervening mortgagee does not receive a lower priority as a result of the subrogee’s mistake. This “balancing act” requires that subrogation apply only to the extent that it does not prejudice the intervening mortgagee and is accomplished by permitting subrogation to occur only to the extent that funds are owing on the original mortgage when the mistake is made. Citing Provident Coop. Bank, the court stated, “The payor is subrogated only to the extent that the funds disbursed are actually applied toward the payment of the prior lien. There is no right of subrogation with respect to any excess funds.” (This rule, though cited by the court, seems curiously applied in the case. The court upheld the Land Court in declaring that both the mortgage to East Boston Savings Bank ($130,000) and Toner’s equity ($54,000) enjoyed a priority position over Ogan’s mortgage, when in fact the amount paid to Eastern Savings Bank, to which the parties’ rights had been subrogated, had an outstanding balance of only $177,000.)
The court discussed the question of the subrogee’s knowledge or notice of the intervening lien when the mistake as to its existence was made. It noted that some courts subrogate without regard for the subrogee’s knowledge (citing Klotz v. Klotz, 440 N.W.2d 406, 409 410 (Iowa Ct.App.1989); Trus Joist Corp. v. National Union Fire Ins. Co., 190 N.J.Super. 168, 179, 462 A.2d 603 (App.Div.1983), rev’d on other grounds, 97 N.J. 22, 477 A.2d 817 (1984); Providence Inst. for Sav. v. Sims, 441 S.W.2d 516, 520 (Tex.1969), while others deny subrogation where the subrogee has actual knowledge, but will permit it where the subrogee has constructive knowledge (citing Smith v. State Sav. & Loan Ass’n, 175 Cal.App.3d 1092, 1098, 223 Cal.Rptr. 298 (1985); United Carolina Bank v. Beesley, 663 A.2d 574, 576 (Me.1995)), while still other courts deny equitable subrogation to a subrogee who has mere constructive knowledge of the intervening lien (citing Independence One Mtge. Corp. v. Katsaros, 43 Conn.App. 71, 74 - 75, 681 A.2d 1005 (1996)). The court said, however, that it would not adopt a “bright line” concerning the subrogee’s knowledge and would decide each case on a case-by-case basis.
Ogan made some interesting arguments as to why equitable subrogation ought not apply in cases of a sale. The point that Ogan was making regarding this argument was that when a mortgage is refinanced, the intent of the parties is that the new mortgage will be a substitute for the old mortgage with its priority being unchanged and that when that intent is not realized and the original mortgage is discharged a “mistake” occurs, but that no such mistake occurs in the case of a sale because the new mortgagee has no intention of substituting its mortgage for that of the existing mortgagee. For example, in Worcester North Savings Institution v. Farwell, 292 Mass. 568, 574, 198 N.E. 897 (1935), when an owner found it onerous to keep up the payments on a first mortgage held by a cooperative bank, the second mortgagee suggested that the owner “substitute a mortgage to a mutual savings bank for the mortgage held by the cooperative bank,” and thereby obtain some financial relief. When the “substitution” was made—and a second mortgagee’s mortgage was not discovered by the mutual bank’s attorney—the court characterized the situation as one of “mistake,” and realigned the respective priorities between the new mutual bank mortgage and the second mortgagee, since the intention of substituting one mortgage for another and retaining the original priorities had not been realized. Similarly, in Provident Co-operative Bank v. James Talcott, Inc., 358 Mass 180, 260 N.E.2d 903 (1970) a mortgage was refinanced with the same lender, with the new mortgage being recorded and the old mortgage being discharged. In that case the court held that the discharge by the mortgagee of its original mortgage was a “mistake,” since it never would have given the discharge if it had known of an intervening lien that existed at the time. Ogan argued that the cited cases supported the notion of a mistake and that it was proper in those cases to apply the doctrine of equitable subrogation because they all involved refinances of existing mortgage. Ogan distinguished the present case, involving a sale, as one where no mistake existed, at least in the nature described in the cases, although admittedly there clearly was negligence. However, although it is true that all the cases previously decided in Massachusetts on the issue have dealt with refinanced mortgages and have decided the matter based on the fact that the mortgagee’s intention to retain a priority position based on the substitution of one mortgage for another has been thwarted, the court in East Boston Savings Bank dismissed Ogan’s the argument simply by stating that in either case—a refinanced mortgage or a sale financed by a new mortgage—the facts yield the same result.
Next, Ogan argued that equitable subrogation has been applied based on the theory that the original mortgage to which the subrogee is subrogated is deemed “assigned” to the subrogee. It is this assignment of the rights of the original mortgagee that permits the subrogee to succeed to the rights of the original mortgagee. However, Ogan argued, when there is a sale the original mortgage is paid with the intention of extinguishing it, so that there are no rights remaining that could be the subject of such an “assignment.” The court dismissed this argument, claiming that it was misplaced in that Ogan had cited only cases that had addressed the distinction between an assignment and a release, a distinction, the court pointed out, that was not at issue in the case.
One of the most persuasive, although rejected, arguments that Ogan posed was that the application of the doctrine of equitable subrogation in the case of a sale would undermine the recording system and would create doubt about every discharged mortgage on record where an intervening mortgage or other lien existed. The court rejected this argument.
[T]he court could deny equitable subrogation to a mortgagee who unnecessarily delays before demanding subrogation because this could prejudice the intervening mortgagee, or one who purchases the intervening mortgagee’s interest.
This point is important. The application of the doctrine of equitable subrogation does not occur automatically. That is, the refinancing of a mortgage or the recording of a mortgage which funds a purchase, where an intervening encumbrance has been overlooked, does not automatically result in the new mortgage gaining priority over the intervening mortgage. A demand for such relief must be made to and granted by the court. Moreover, there is authority that where equitable subrogation would otherwise be applied and granted, it will be denied if the holder of the new mortgage elects to enforce its mortgage. After such election the court may deny a request by that mortgagee to be placed in a priority position. Childs v. Stoddard, 130 Mass. 110 (1881) and Houle v. Vallieres, 281 Mass. 123, 183 N.E. 259 (1932).
The doctrine of equitable subrogation has also been applied in the case of intervening federal tax liens that would otherwise take priority over a newly recorded mortgage when a prior encumbrance has been paid. Mort v. United States, 86 F.3rd 890 (9th Cir.1996) and Han v. United States, 944 F.2d 526 (9th Cir.1991).
1 In this regard the court cited Heller Financial v. Insurance Company of North America, 410 Mass. 400, 573 N.E.2d 8 (1991). In Heller Financial a developer had given a first mortgage to Guaranty Bank and Trust Company and a second mortgage to Heller Financial. The mortgage to Heller Financial went into default and the mortgagee threatened to foreclose. Insurance Company of North America, which had bonded the project, was fearful that the foreclosure would interrupt the project resulting in liability under its bond. To prevent liability Insurance Company of North America deposited funds in an escrow account out of which, under an arrangement between it and the developer, the developer kept the mortgage to Heller Financial current and caused the first mortgage to Guaranty Bank and Trust Company to be purchased and assigned to the insurance company. When Heller Financial discovered the arrangement, it claimed that its mortgage was now in first position because the purchase and assignment of the mortgage to Guaranty Bank and Trust Company extinguished it. Citing Carlton v. Jackson, 121 Mass. 592 (1877), the court in Heller Financial acknowledged that when money is paid for an assignment of a mortgage by one whose duty it is to pay the mortgage in the first place, the assignment acts as a discharge or release of the mortgage. But the court noted that the money, although paid by the developer to acquire the assignment, was Insurance Company of North America’s money, which it had placed in escrow. This relationship prevented the extinguishment of the mortgage, permitting the assignment to vest the mortgage in the assignee, just like in the case of a mortgagee financing a purchase, who is not under an obligation to pay the seller’s mortgage, but who does without knowing of an intervening lien. [Back to Text]