Refinance Mortgage: “Strong Arm” Powers Meet Equitable Subrogation

Green v. HSBC Mortgage Services, Inc. (In Re Green), 474 B.R. 790 (Bankr. D. Md. 2012)

In Green, a lender refinanced a first priority deed of trust loan that had been made by IndyMac Bank, F.S.B.  For some unknown reason the new deed of trust of the refinancing lender was not recorded.  IndyMac Bank also had made a second priority deed of trust loan that was transferred to a third lender, HSBC Mortgage Services, Inc.

Chase Home Finance LLC, as servicer for the refinance loan, filed a complaint in state court seeking declaratory relief that it had a valid first priority lien based on an equitable mortgage or equitable subrogation.  According to the court, equitable subrogation allows a lender that pays a debt to an existing lien holder and takes a new lien to step into the shoes of the original lien holder against intervening liens (including pre-existing subordinate liens).

The court noted that equitable subrogation cases often come up between two lienholders where the value of the property is not sufficient to satisfy both liens so that relative priority is critical. In this case, the difference for HSBC (as holder of the second priority deed of trust) was between (i) receiving payment in full of its claim based on its secured position and (ii) being treated as an unsecured creditor.

When the debtor subsequently filed bankruptcy, she eventually sought to have Chase’s lien avoided on the basis that it was not perfected.  As discussed in prior blog posts (for example, Bye Bye Mortgage), the “strong arm” powers of a trustee or debtor include the ability to assert the rights of a hypothetical bona fide purchaser of real estate as of the commencement of the bankruptcy case.  In most states a bona fide purchaser generally takes free of unrecorded interests, which means that an unrecorded deed of trust can usually be avoided.

In evaluating whether or not a purchaser would be able to take free of Chase’s lien it was necessary to consider whether the purchaser would have had constructive notice of the lien.  Although normally constructive notice is provided through a recorded document, the refinance deed of trust was not recorded in this case.  However, under Maryland rules, the filing of a complaint is constructive notice of lis pendens for real property in the county where the complaint is filed.  (For any other county a copy of the complaint or a notice of lis pendens would have to be filed to provide constructive notice of the action.)  Since the Chase litigation was filed in the county where the property was located, the court found that under Maryland law constructive notice would prevent a purchaser from being a bona fide purchaser so that the Chase lien was not avoidable by the purchaser.

The plaintiff also contended that the lis pendens arose during the preference period and therefore itself was avoidable, with the result that it could not provide constructive notice.  However, the court disagreed because the issue was the standing of a bona fide purchaser at the beginning of the bankruptcy case.  As of that time, all parties had constructive notice of Chase’s claim as a result of the court filing.  A potential avoidance of the lis pendens “could not have the effect of retroactively erasing that notice – the proverbial bell cannot be unrung.”

Here the effect of the notice was to allow Chase’s rights to relate back to the date it refinanced the first lien deed of trust, which was outside of the preference period.  Thus the court found that Chase was entitled to be equitably subrogated to the position of the first deed of trust with rights senior to those of the second deed of trust held by HSBC.

Application of equitable subrogation can be very difficult to predict, and oftentimes a mortgagee seeking equitable subrogation does not prevail.  Certainly a lender would be better served if the issue did not come up in the first place.  Assuring that a mortgage or deed of trust is timely recorded is critical.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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