Mortgage Priority: And What About Equitable Subrogation?

Stambaugh v. PNC Bank, N.A. (In re Stambaugh), 532 B.R. 572 (Bankr. M.D. Pa. 2015)

A chapter 13 debtor sought to establish the priority of certain mortgages, and the bank that held all of the mortgages attempted to reorder the priority based on equitable subrogation and subordination claims.

The debtor owned real property valued at $200,000. A bank held four mortgages on the property securing the following principal amounts: (1) $31,750, (2) $175,000, (3) $225,050 and (4) $63,950. The debtor sought a determination that the $175,000 mortgage was senior (since the $31,750 was junior to it under a subordination agreement), while the bank claimed that the $225,050 mortgage should be senior.

The bank’s equitable subrogation argument was based on its contention that a part of the $225,050 mortgage loan was supposed to pay off the $175,000 mortgage – although that did not in fact happen, apparently due to an error which the bank claims the debtor took advantage of. The court acknowledged that equitable subrogation is a state law remedy that is available in a bankruptcy court.

Although generally priority is determined based on the dates that documents are recorded, equitable subrogation is an exception to the “first in time” rule. Under applicable state law the criteria were as follows:

  • Claimant paid the creditor to protect its own interests;
  • Claimant was not a volunteer;
  • Claimant was not primarily liable for the debt;
  • Subrogation will not “cause injustice to the rights of others.”

The court also noted a rule that “the courts of equity will not relieve a party from the consequences of an error due to his own ignorance or carelessness when there were available means which would have enabled him to avoid the mistake if reasonable care has been exercised.”

In this case the court determined that equitable subrogation was not available to the bank because it had the ability to assure that the $175,000 mortgage was paid off and satisfied of record. The court also noted that the bank was not asserting that it made payments to a different creditor.

The bank next attempted to argue that a subordination agreement gave the $225,050 priority. However, the agreement in question was executed almost six years after the $175,000 mortgage and more than five years after the $225,050 mortgage.

Under Section 510(a) of the Bankruptcy Code subordination agreements are enforceable to the same extent as under non-bankruptcy law. Applying general contract principles, the agreement had to be interpreted to give effect to the intent of the parties, and if a contract is clear and unambiguous, intent should be determined from the express language. Here the court determined that there was no ambiguity: the intent was to subordinate only the $31,750 mortgage to the $225,050 mortgage. The $175,000 mortgage was not even mentioned.

Finally the bank attempted to argue that the debtor was pursuing an equitable action and certain misconduct barred it from maintaining the action. Apparently the debtor was employed by the bank’s predecessor in various capacities, including house closing auditor, loan closer and loan officer. In addition the bank claimed that the debtor misrepresented his income. However, the “unclean hands doctrine” is not applicable unless there is a proceeding in equity.

In this case the debtor was seeking a declaratory action. Although a declaratory judgment seeking specific performance or injunctive relief is equitable, a declaratory judgment seeking damages or other legal remedies is a legal action entitling the plaintiff to a jury trial. The court found that this case was “essentially an inverted lawsuit” (?) as opposed to a traditional equitable claim, so the debtor was asserting a legal claim.

The court noted that it was not condoning the alleged misconduct. The allegations would have been more applicable in an action to seek non-dischargeability of the loan. However, the deadline for filing non-dischargeability complaints had already passed.

Thus, the court determined that the $175,000 mortgage loan held first priority, and the $31,750 loan was subordinate to the $225,050 loan based on the subordination agreement. It expressed no opinion about the relative priority of the fourth loan for $63,950.

One might find it odd that anyone cared about the priority given that all of the mortgages were held by the same mortgagee. The answer appears to lie in the debtor’s strategy for obtaining control of an apparent escrow account surplus of around $33,000 – $35,000. In objecting to the bank’s $275,000 claim, among other things the debtor noted the pending adversary proceeding with the comment that if he was successful the escrow surplus would become associated with the $175,000 loan as the first lien mortgage instead of the $275,000.

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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