Purchase Money Priority Hypo. Purchase Money Mortgage Defined

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1 Q&A: Thursday evening, Dec. 3, at 7:00 pm in Room 5 Q&A: Monday, Dec. 14, at 7:00 pm in Room 5 Exam: Wednesday, Dec. 16, at 1:30pm (1:30 to 5:00) Exam consists of MC, short answer, and essay Exam will be in open laptop mode (no network access) You may bring an outline that you prepared or contributed to in a study group (no other materials) I will post sample essay questions from prior exams on class website Purchase Money Priority Hypo 2007: X gets judgment vs. Davis for $75,000 (judgment is still unsatisfied in 2015) 2015: Davis buys Blackacre for $250,000, using the proceeds of a $200,000 loan from Bank Bank takes/records mortgage on Blackacre Whose lien attached first: X s judgment lien, or Bank s mortgage? Which lien has first priority if Davis defaults? Purchase Money Mortgage Defined A mortgage is a purchase money mortgage if it: Is retained by a seller of land as security for the buyer s subsequent payment of part/all of the purchase price of the land, or Is taken by a lender that provides a loan that enables the mortgagor to acquire the land and that is actually used to acquire the land Analogous to Article 9 PMSI definition X s judgment lien attaches at the exact moment that Davis acquires Blackacre (in most states) Bank s mortgage attaches to Blackacre at the moment that Davis executes a mortgage to the Bank Typically, Davis wouldn t execute a mortgage to the Bank until AFTER Davis received title to the land by deed Thus, based on timing (prior-in-time), it would seem that X s judgment lien would have arisen before Bank s mortgage

2 Restatement 7.2(b): A purchase money mortgage... has priority over any mortgage, lien or other claim that attaches to the real estate but is created by or arises against the purchaser-mortgagor prior to the purchaser-mortgagor s acquisition of title... Bank thus has priority over X Does this result make sense? Rationale for purchase money priority: giving priority to PM mortgage lender (Bank) does not harm Davis s prior creditors (such as X) In accounting terms, extension of PM credit had no negative impact on Davis s balance sheet (Davis did incur a new liability to Bank, but it enabled Davis to acquire a new asset, Blackacre) Giving Bank PM priority makes X no worse off than X was before Davis acquired the land (and makes X better off, to the extent Davis has equity in Blackacre)! Now suppose that Bank failed to record its mortgage Page 973: Bank s unrecorded mortgage would still have purchase money priority over X s judgment lien (despite Bank s failure to record the mortgage) Can you explain why? Is this a sensible result? Rationale: X (judgment lienholder) is not a reliance creditor (e.g., like a buyer or mortgagee) who would have relied on a record search; thus, recording act doesn t protect X Recording is necessary to protect Bank against subsequent purchasers from Davis But note: if court orders a sheriff s sale of land to satisfy X s lien, buyer at that sale without knowledge of Bank s unrecorded mortgage would be a protected BFP!

3 Restatement 7.2(b): PM mortgage has priority over any other mortgage or lien that attaches to the land that is created by or arises against the purchaser-mortgagor by virtue of acts that occurred before purchaser-mortgagor acquired title to the land Construction Loan Scenario 2012: X has $70,000 unpaid judgment vs. Davis 2014: Davis borrows $200,000 from Bank, and uses $40,000 of it to buy Blueacre (raw land), and grants Bank a mortgage on Blueacre (which the Bank records) Davis then uses the other $160K to build a home on Blueacre 2015: Davis defaults to Bank, which forecloses If sale price is $240,000, how should proceeds be distributed between Bank and X? Majority/Restatement rule: Bank has a PM mortgage (and PM priority) for the full loan amount ($200K) Bank gets first $200K of sale proceeds, X gets next $40K Minority/MO rule: PM priority extends only to price of land, not improvements [note 2, p. 972] First $40K to Bank; next $70K to X; remaining $130K to Bank (leaving Bank with an unsatisfied deficiency of $30K) Which rule makes better sense? In MO, how would Bank need to structure the transaction to account for the minority rule? Restatement rule is economically sensible Bank s loan enabled Davis to acquire Blueacre and increase its value by improvement, so giving Bank PM priority doesn t harm a judgment lien creditor like X How can Bank avoid Missouri rule? 1) It can refuse to make the loan to Davis unless X will agree to subordinate its judgment lien to Bank s mortgage (priority between creditors is always subject to modification by agreement), or 2) Bank can have the builder buy the land and build the home; then, have the builder sell the completed home to Davis (then, Bank s loan to Davis to finance that purchase would be a PM mortgage to the full extent of $200K loan amount)

4 PM Seller v. PM Lender: Problem Seller sells land to Buyer for $800K Buyer pays $600K in cash, signs $200K PM note and mortgage to Seller But, Buyer got the $600K cash from a mortgage loan from Bank When mortgages were recorded, Bank s mortgage was recorded first, then Seller s mortgage was recorded second Both Seller and Bank have PM mortgages; which gets first priority if Buyer defaults? Possible Rules (1) Common law first in time, first in right (i.e., whichever lien arose first gets priority, subject to the application of the recording statute) (2) Shared priority (pro rata) (3) PM Seller gets priority over PM Lender [Restatement of Mortgages 7.2(c)], unless PM Seller expressly agrees to subordinate its lien Note 1, page 981: PM Seller has priority over PM Lender [Restatement 7.2(c)], unless PM Lender obtains a subordination agreement from PM Seller Rationale: The equities favor the vendor. Not only does the vendor part with specific real estate rather than money, but the vendor would never relinquish it at all except on the understanding that the vendor will be able to use it to satisfy the obligation to pay the price. [Restatement 7.2 cmt. d] Insight LLC v. Gunter (page 974): Idaho Supreme Court rejected Restatement 7.2(c), and ruled that Bank (PM Lender) had priority over PM Seller Reasoning: Bank s mortgage was the first one executed (and thus the first to attach); thus, Bank prevails under first-in-time, unless state s recording act says otherwise To prevail under Idaho race-notice statute, Seller would ve had to be the first to record, but Bank s mortgage was recorded first, so Bank still prevails as first-in-time Is this a sensible result?

5 In this context, it is inappropriate to think of the mortgages as arising at different times (even if they didn t arise simultaneously) Order of execution is subject to manipulation by lenders, who are likely more sophisticated than sellers (and more likely to be handling the closing) Seller and Lender PM mortgages in same transaction should be deemed to have arisen simultaneously Also, closing/recording was handled by title company (escrow), which recorded Lender s mortgage first as per Lender s instructions Modification of Mortgage The mortgagor and the mortgagee are free to modify mortgage loan terms, such as by: A change in principal amount, which could include: The extension of additional credit by mortgagee Capitalizing unpaid interest (adding it to principal balance) Write-down or reduction of principal Change in interest rate (either an increase or a decrease) Extension of mortgage term (e.g., going from 15-year term to 30- year term) Suppose that Smith is in default on a 15-year mortgage held by Bank1 Principal balance = $1MM Accrued but unpaid interest = $100K Bank2 has a second mortgage (unpaid balance = $500K) Bank1, Smith agree to modify the loan to capitalize unpaid interest (increasing the principal balance to $1.1MM) and increase interest rate to 12% Modification Modification of mortgage loan is effective between mortgagor (Smith) and mortgagee (Bank1) But the full effectiveness of the modification may be limited as against the junior lienholder (Bank2) Modification of mortgage loan is effective vs. junior lienholder, but not to the extent that the modification is materially prejudicial to the junior lienholder [Restatement 7.3(a)] Is this modification materially prejudicial to Bank2?

6 At the time Bank2 made its loan, it knew (or should ve known) it was behind Bank1 to the extent of the original loan terms As of date of modification, then, Bank2 was behind Bank1 to the extent of the then-unpaid balance of the debt ($1.1MM) But, capitalization of unpaid interest (which increases the principal balance) and increase in interest rate means loan will now accrue more interest (and, on an amortizing loan, the principal balance would amortize more slowly) Modification materially prejudices Bank2 to that extent Modification: Before and After Before: each month, the loan would accrue additional interest = ($1MM x 10%)/12 = $8, After: each month the loan will accrue additional interest = ($1.1MM x 12%)/12 = $11,000 The difference between these amounts = material prejudice to Bank2 Bank2 reasonably expected that it would have priority after Bank1 s original mortgage loan was repaid, based on the loan s original terms and amortization schedule Bank1 s lien priority remains subject to original terms of Bank1 loan, but not to the modified terms, unless Bank1 obtains Bank2 s effective consent to the modification Obviously, Bank1 can obtain Bank2 s consent at the time of the modification; can this consent actually come before the modification, by drafting in Bank1 s mortgage? Reservation of Rights: Consent? Restatement 7.3(c): if the senior mortgage provides that a modification of the senior mortgage is enforceable against third parties claiming through the mortgagor (e.g., junior lienholders), that provision is enforceable against junior lienholders [Note 3, p. 1007] Rationale: if Bank2 makes loan after having constructive notice of Bank1 s mortgage, which has such a reservation of rights clause, Bank2 has consented to future modifications Should this be enforceable?

7 Refinancing and Intervening Liens Uphoff owns land, subject to 2 mortgages First priority: Bank1 (debt = 7%) Second priority: Bank2 (debt = $50K) 2015: Uphoff goes to Bank1 to refinance Bank1 takes a new mortgage to secure repayment of a new $100K promissory note (at 4% interest rate) Bank1 records the new mortgage and releases the old one Bank2 argues: our mortgage was recorded before Bank1 s new mortgage, so we now have first priority Is Bank2 correct? No, Bank 2 s argument is not correct Replacement mortgage gets the same priority of the original mortgage, except to the extent of material prejudice to the junior lienholder [Restatement of Mortgages 7.3(a); Sovereign Bank v. Gillis, p. 998] In this Problem, there s no material prejudice to Bank2 the interest rate was lowered, not raised, and the principal balance did not increase (no new money was loaned to Uphoff) Rationale: this equates treatment of (1) a replacement mortgage and (2) modification of original mortgage Third-Party Refinancing Hypo Uphoff owns land, subject to 2 mortgages First priority: Bank1 (debt = $100K, 7% interest rate) Second priority: Bank2 (debt = $50K) 2015: Uphoff goes to Bank3 to refinance at 4%, but borrows $120K $100K is paid to Bank1 to pay off Bank1 $20K paid to Uphoff (which he uses to buy wine/cigars) Bank3 records a new mortgage; Bank1 releases the old one Does Bank2 now have priority over Bank3? Subrogation: Restatement 7.6 (a) 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. (b) By way of illustration, subrogation is appropriate to prevent unjust enrichment if the person seeking subrogation performs the obligation... upon a request from the obligor... to do so, if the person performing was promised repayment and reasonably expected to receive a security interest in the real estate with the priority of the mortgage being discharged, and if subrogation will not materially prejudice the holders of intervening interests in the real estate.

8 Under Restatement 7.6, Bank3 would get priority (it would be subrogated to the priority of the paid-off Bank1 loan) to the extent of the $100K balance being refinanced Bank3 would not have priority to the extent of the additional $20K loaned to Uphoff (increase in the loan amount would materially prejudice Bank2 as intervening lienholder) Thus, if Bank3 foreclosed, and sale brought price of $150K, Bank3 would get the first $100K plus any accrued but unpaid interest; Bank2 would get the rest of the proceeds Houston v. BOA Federal (p. 1009) reflects this view Some courts reject the Restatement s subrogation rule (e.g., Countrywide, p. 1013) In these states, Bank3 would not be subrogated to the priority of Bank1 s mortgage, because Bank3 had constructive notice of Bank2 s mortgage Under that view, Bank2 s mortgage would then have priority over Bank3 s mortgage Countrywide: the need for clarity and certainty in matters of land title justifies rejecting equitable subrogation [p. 1017] Is this argument persuasive? Argument for Bank3? Bank1 could ve assigned its mortgage to Bank3 so that Bank3 would ve taken the priority of that mortgage, at least to the extent of then-existing balance ($100K) Bank3 s loan was refinancing Bank1 mortgage, and Bank2 knew or should ve known it was subordinate to Bank1 s lien position Giving Bank2 priority over Bank3 would give Bank2 an unbargained-for windfall In equity, Bank3 should be subrogated to the priority of original Bank1 mortgage (even though it is released of record) Arguments for Bank2? Priority is usually governed by the recording act; Bank2 s mortgage was recorded prior to Bank3 s; Bank3 thus had constructive notice of Bank2 s prior mortgage Bank3 could ve (1) taken an assignment of Bank1 s mortgage (and thus gotten its priority by assignment), or (2) could have required subordination by Bank2 as a condition of its willingness to make the refinancing loan If Bank3 didn t bother to do either (if it was sloppy ), the court shouldn t step in and use its equitable power to protect a lazy creditor like Bank3

9 Countrywide and its integrity of the recording act argument misunderstands the purpose of the recording act and who it is meant to protect As between Countrywide (which refinanced the AWL first mortgage) and FNB (the junior), FNB isn t a reliance creditor; it knew it was behind the AWL first mortgage (and thus behind anyone who acquired the ability to enforce the AWL mortgage debt) If a BFP had come along and purchased FNB s loan, believing (based on the land records) that it was first in priority, the BFP would be protected (equitable subrogation would result in material prejudice to the BFP based on its reliance) Future Advances In some situations, mortgage explicitly contemplates that it will secure not only the original loan amount, but future advances as well Common scenarios include: E.g., construction loans (typically funded in periodic draws, as construction proceeds) E.g., home equity lines of credit, or business lines of credit secured by real estate This Deed of Trust shall secure repayment of the sum of all (1) principal, interest and other amounts due under or secured by the Loan Documents, (2) principal, interest, and other amounts which may hereafter be loaned by Beneficiary, its successors or assigns, to or for the benefit of the owner of the Mortgaged Property, when evidenced by a promissory note or other instrument which, by its terms, is secured hereby, and (3) all other indebtedness, obligations and liabilities now or hereafter existing of any kind of Grantor to Beneficiary under documents which recite that they are intended to be secured by this Deed of Trust. THIS DEED OF TRUST SECURES FUTURE ADVANCES UNDER R.S.Mo UP TO THE MAXIMUM AGGREGATE AMOUNT OF $. Objective of a future advances clause is to enable lender to claim the same lien priority for future advances as for the original loan E.g., Bank records its mortgage on Jan. 1, 2015 Bank then advances $12MM construction loan over next 12 months in $1MM monthly draws Intent: Once loan is fully funded, Bank s lien priority for the entire balance should relate back to 1/1/2015

10 Future Advances and Priority What if another creditor gets a lien AFTER the original loan, but BEFORE the later advance? 1/1: X gets $50K business loan from Bank; Bank records future advance mortgage 3/1: Plaintiff gets $25K judgment vs. X 4/1: X borrows an additional $25K from Bank 6/1: Bank forecloses; sale price = $75K. How to distribute sale proceeds? Traditional rule: Bank gets first priority for both $50K original loan and $25K future advance only if the future advance was obligatory [p. 1192] If advance was optional, Bank s priority for the future advance would date from time of advance Priority would look like an Oreo [p. 1192]: 1st priority to Bank (original $50K loan); 2nd priority to Plaintiff ($25K judgment); 3d priority to Bank ($25K optional advance) Future Advance Priority Rules Rationale for optional/obligatory distinction: blanket future advance priority could prevent landowner from obtaining credit based on its equity in land Bank should get relation-back priority only if it was obligated to make the advance (thus assuring mortgagor of access to credit) Restatement 2.3(a): rejects optional vs. obligatory advance distinction; mortgagee has same priority for all advances Restatement 2.3(b): mortgagor can give cutoff notice to mortgagee, cutting off effectiveness of a future advance clause going forward E.g., X owes Bank1 $200K, Bank1 holds mortgage on X s home (securing future advances) X gives Bank1 cutoff notice Bank2 then loans X $200K, takes 2d mortgage Later, Bank1 loans X $100K; then X defaults, Bank1 forecloses, sells home for $400K Distribution: $200K to Bank1, $200K to Bank2

11 Missouri Future Advance Statute (2): Security instruments may secure future advances... whether the advances... are optional or obligatory (5): [T]he priority of the lien of a security instrument securing future advances shall date from the time the security instrument is recorded... whether or not such advances... are optional or obligatory... Missouri Future Advance Statute (6): Mortgagor may issue a stop notice cutting off effectiveness of future advance clause (2): Fact that lien secures future advances must be clearly stated; deed of trust must recite it is governed by RSMo ; and deed of trust must recite maximum amount to be secured