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 lien holders. 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 lien holder to vary the term or the interest rate of a mortgage are deemed valid and binding upon junior lien holders 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 lien holder. 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 lien holder 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 lien holders 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 lien holder. Typically, even of the mortgagor concurs in alterations to the mortgage instrument, junior lien holders 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 lien holders. The logic, of course, is that the junior lien holders 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 lien holders. 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 result 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 especially 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 lien holder 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 lien holder can “freeze” the borrower’s equity in the property by threatening away junior lien holders while the senior lien holder 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 lien holders. 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 inadvertent 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 lien holder 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 lien holders. Restatement of Mortgages Section 7.3 (a). (Using the term “substantially prejudicial.”)
Where junior lien holders 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 lien holders or to obtain their consent, if the modification is such that it prejudices the rights of the junior lien holders 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 lien holders and the senior lien holder relinquishing to the junior lien holders 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 lien holder’s actions in modifying the note or mortgage have substantially impaired the junior lien holders’ 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 lien holders who take a lien position without actual or record knowledge of prior modifications in the senior lien. One might argue that junior lien holders ought to have a duty of inquiry to determine whether the recorded mortgage reflects the current understandings of their mortgagor and the senior lien holder, 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 lien holders 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 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 interest rate of the mortgage, such modifications normally do not jeopardize 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 lien holders. Restatement 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 lien holder.
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 focusing 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 Gluskinin 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 lien holder] 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 lien holders. 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 lien holder’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 lien holder 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 lien holder 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 lien holders, 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 lien holders. 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 lien holders 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 lien holder 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 lien holders.
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.