REPLACEMENT AND MODIFICATION OF SENIOR MORTGAGES: EFFECT ON PRIORITY

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1 REPLACEMENT AND MODIFICATION OF SENIOR MORTGAGES: EFFECT ON PRIORITY Two relatively recent state court decisions address the effect that the replacement and modification of senior mortgages have on their priority vis a vis the interests of junior lienors. Both of these decisions have been the subject of the Daily Development commentary of Professor Patrick A. Randolph, Jr., on DIRT, an internet discussion group web page which is a service of the American Bar Association Section of Real Property, Probate & Trust Law and the University of Missouri, Kansas City, School of Law. DIRT can be accessed at The first decision, Suntrust Bank v. Riverside National Bank of Florida, 792 So. 2d 1222 (Fla. Dist. App. 2001), was discussed in the Daily Development on DIRT on October 23, 2001, and the second, Burney v. McLaughlin, No , 2001 Mo. App. LEXIS 1714, 2001 WL (Mo. Ct. App. Sept. 28, 2001) was discussed on October 24, Before considering these decisions, a review of the pertinent law is in order. Replacement or Substitution of Mortgages. In general, where the holder of a senior mortgage releases it of record and contemporaneously takes a new mortgage, the new mortgage retains the same priority as its predecessor, except to the extent that (a) the senior mortgagee intends to subordinate its interest to a junior lien interest; (b) paramount equities in favor of a junior lienholder justify subordinating the senior mortgagee s lien; or (c) one who is protected by a recording act acquires an interest in the real estate at a time when the senior mortgage is not of record. 1Grant S. Nelson & Dale A. Whitman, Real Estate Finance Law 9.4, at 888 & n.4 (4 th ed. 2002); Restatement (Third) of Property: Mortgages 7.3(a) and cmt. b (1997); Robert Kratovil & Raymond J. Werner, Mortgage Extensions and Modifications, 8 Creighton L. Rev. 595, 600 & n.31. In considering the rule that a replacement mortgage generally enjoys the priority of its predecessor, reported decisions and commentators have recognized a presumption to the effect that a mortgagee must have intended to keep its mortgage lien alive where essential to preserve it against an intervening interest. 1 Nelson & Whitman, 9.4, at 889 & n.5 ; Kratovil & Werner, at 601 & n.40; Restatement (Third) of Property: Mortgages 7.3(a) & cmt. b, at 476 (1997). Kratovil and Werner have observed that while presumptions are helpful, it is advisable for the senior mortgagee to include in the replacement mortgage a clear statement of the parties intent that replacement of the old mortgage by the new will not disturb the existing priorities and that the new mortgage will have and retain the same priority as the old. Kratovil & Werner, at 602 & n.42. In fact, it is fair to say that, according to Kratovil and Werner, substitutions are illadvised for the reasons that intention is not easily proved and the equities as between a senior mortgagee under a replacement mortgage and a junior mortgagee, to be discussed below, are subject to varying interpretations. Kratovil & Werner, at 602 & n.42, 603 ( [S]ubstitution of mortgages is an imprudent step, ascribable only to ignorance of possible legal consequences. ). As a result, Kratovil and Werner favor the use of a modification or extension agreement where revision of a senior mortgage is desired. The paramount equities exception to the principle that a replacement mortgage generally retains the priority of its predecessor is based on the concept of detrimental reliance, 1 Nelson & Whitman, 9.4

2 at 889 & n.7 (citing Houston Lumber Co. v. Skaggs, 613 P.2d 416 (N.M. 1980)), and is expressed in the Restatement in terms of material prejudice, as follows: 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... Restatement (Third) of Property: Mortgages 7.3(a)(1997). The Houston Lumber Co. decision of the New Mexico Supreme Court, as well as a subsequent decision of the New Mexico Court of Appeals in RTC v. Barnhart, 862 P.2d 1243 (N.M. Ct. App. 1993), illustrate how the concept of detrimental reliance has been applied. In Houston Lumber Co., a senior mortgagee released a construction mortgage, and, at the same time, recorded a permanent mortgage in its place. Mechanics lienholders whose claims had arisen after recordation of the construction mortgage but prior to its replacement with a permanent mortgage, asserted priority over the new mortgage. The supreme court reversed the trial court s decision in favor of the mechanics lienholders, emphasizing that the mechanics lienholders had not detrimentally relied on the release in any way, since the construction mortgage was in place at the time their mechanics lien claims arose. In its 1993 Barnhart decision, the New Mexico Court of Appeals applied and, in some ways, refined the decision of the New Mexico Supreme Court in Houston Lumber Co. In Barnhart, the senior mortgagee released a mortgage securing a $100, loan, as well as a mortgage securing a second $24, loan, and replaced them with a mortgage securing a third loan in the sum of $200,000.00, the proceeds of which paid off the first and second loans secured by the released mortgages. Even though the terms of the replacement mortgage were distinct in a number of particulars from those of the earlier mortgages, the New Mexico Court of Appeals accorded the replacement mortgage the priority of the earlier mortgages, as against the claim of a purchaser of a judgment, a transcript of which had been recorded after recordation of the first two mortgages but before recordation of the replacement mortgage. The court of appeals, however, accorded the replacement mortgage priority only to the extent of the outstanding balances secured under the two released mortgages. The additional amounts loaned and secured by the new mortgage were not accorded priority over the intervening judgment lien. In explaining the rationale for its decision, the Barnhart court unfortunately characterized the principles applied by the Houston Lumber Co. court in terms of the doctrine of reinstatement of liens, losing sight of the Houston Lumber Co. court s approach, which was to analyze whether the senior mortgage had been subordinated, as opposed to whether it had been discharged and should be reinstated. Nevertheless, the Barnhart court did engage in a detrimental reliance analysis, finding no evidence that the purchaser of the intervening 2

3 judgment lien had relied on the release of the prior mortgages when he accepted the assignment of the judgment. 862 P.2d at In discussing application of the paramount equities, or in the language of the Restatement, the material prejudice exception to the rule according a replacement mortgage the priority of its predecessor, the treatise writers have rejected as irrelevant any concern as to whether the mortgagee was or was not aware of intervening liens, upon releasing its mortgage and accepting a substitute or replacement mortgage. Kratovil & Werner, at 602. And they have avoided concepts of restoration or reinstatement of priority in favor of a consideration of whether the new mortgage retains, that is, succeeds to the priority status of the mortgage it replaced. Material prejudice generally does not follow where a new mortgage secures an obligation with a later maturity date or a longer amortization period than the obligation secured by the mortgage it replaces. 1 Nelson & Whitman, 9.4, at 889. But see Kratovil & Werner, at 608. By contrast, a replacement mortgage s increase in the principal amounts secured, including over and above the maximum amount stated to be secured under a future advances provision or otherwise, or an increase in the interest rate over and above a fixed rate specified in the original mortgage generally are deemed materially prejudicial to an intervening lienholder. Restatement (Third) of Property: Mortgages 7.3 (a)(2), cmt. b (1997); 1 Nelson & Whitman, 9.4, at 889. Aside from the case where a senior mortgage is intended to be subordinate or where its changed terms materially prejudice a junior lienholder, there is another case in which a replacement mortgage will lose priority: where an intervening interest holder acquires its interest after release of record of the senior mortgage and prior to the recordation of its replacement. Restatement (Third) of Property: Mortgages 7.3 cmt. b (1997). If the intervening interest holder qualifies as a party protected by an applicable recording act (whether by being a good faith purchaser for value and, in certain jurisdictions, by being first of record, in addition), that act will accord the intervening interest priority as against the replacement mortgage. Id. Extension or Modification of Mortgage A mortgagor and mortgagee may agree to modify rather than replace an existing mortgage or the obligation it secures. As is true in the case of a replacement mortgage, an extension or modification agreement that merely postpones the maturity date of the mortgage and the obligation it secures, or reschedules installment payments, without more, generally is enforceable and does not threaten the mortgagee s priority as against that of intervening lienors. 1 Nelson & Whitman, 9.4, at 890; Kratovil & Werner, at 607. Courts have found that such modifications do not injure the interests of junior lienholders, reasoning that junior lenders are presumed to know that their interests are subject to the rights of senior lienholders, one of which is the ability to delay payment due dates. Kratovil & Werner, at 609 & nn Further, courts generally assume that extension agreements are beneficial to junior lienholders by diminishing the likelihood of foreclosure of a senior mortgage. Kratovil & Werner, at 609; 1 Nelson & Whitman, 9.4, at 890. Of course, it is possible that the granting of an extension to the mortgagor or a rescheduling of payment dates and amounts could materially prejudice the interests of a junior lienholder, so 3

4 that the modification would be ineffective, to the extent of the resulting prejudice to the junior lienholder. Restatement (Third) of Property: Mortgages 7.3 (b) (1997). Where a modification implements what are considered to be material changes in the terms of the underlying obligation or the collateral arrangements therefor, for example by an increase in the interest rate or the amount of the indebtedness secured or by the addition of cross collateral provisions, the senior mortgage will not be accorded priority over a junior obligation, to the extent of the modification, assuming the junior interest holder demonstrates prejudice to its interests as a result of the modification. 1 Nelson & Whitman, 9.4, at 890 & n.18; Kratovil & Werner, at A junior lienholder, in deciding to extend credit to the mortgagor, would normally have consulted the terms of the senior mortgage. Changes in interest rate and in the amount of the indebtedness secured, as well as the addition of cross default or cross collateral provisions would likely be prejudicial to the interest of a junior lienholder, by increasing the debt burden and the possibility of default. Restatement (Third) of Property: Mortgages 7.3, cmt. (c) (1997). Although the sanction normally imposed in the case of such a prejudicial modification is a pro tanto diminution of priority in favor of intervening liens, courts have suggested that a modification can be so prejudicial as to result in a complete loss of priority of the senior mortgage, rather than a pro tanto reduction. 1 Nelson & Whitman, 9.4, at 891 & n.22. The modification of a mortgage can be documented by a single extension or modification agreement, at the same time modifying both the terms of the mortgage and the note evidencing the obligation secured by that mortgage. A modification also can be documented by an amendment to each of the mortgage itself and the promissory note secured by the mortgage. In some instances, the note evidencing the obligation secured by the mortgage is replaced by a new note. Kratovil and Werner urge that, where a replacement note is issued, it should be clear that the debt underlying the mortgage is not being paid, for if the debt is found to have been paid, the lien of the mortgage will be extinguished. Kratovil & Werner, at 604 & n.56. Generally, a modification instrument is preferable to a replacement or renewal note. In fact, there is authority to the effect that the issuance of a renewal note, contemporaneously with the release of the mortgage securing the prior note gives rise to a rebuttable presumption of discharge. Kratovil & Werner, at 605 & nn Drafting Approaches in Modification Instruments Priority problems can be avoided, to some extent, by drafting techniques employed at the time a mortgage is put into place and at the time of modification. Nelson and Whitman raise for consideration a provision to be included in a senior mortgage to the effect that [a]ll those claiming by, through or under the mortgagor consent to any extensions or increases in the interest rate or principal amount of the mortgage indebtedness agreed to by the mortgagee and the mortgagor, their successors and assigns. 1 Nelson & Whitman, 9.4, at 892. Kratovil & Werner question the enforceablity of such a provision, as against an intervening lienholder. They state: The mere fact that this provision [a clause providing the lender may increase the interest rate on the giving of any extension] is included in the original mortgage as recorded will not be sufficient to secure the priority for that increased interest over those who take their interest prior to 4

5 the extension. Kratovil & Werner, at 610. The Restatement states that a reservation in a senior mortgage of a right of modification means that a senior mortgage, as modified, retains the priority of the original mortgage, even if the modification is materially prejudicial to the holders of junior interests in the real estate. Restatement (Third) of Property: Mortgages 7.3 (b), (c) (1997). In fact, Section 7.3(c) recites: If the mortgagor and mortgagee reserve the right in a mortgage to modify the mortgage or the obligation it secures, the mortgage as modified retains priority even if the modification is materially prejudicial to the holders of junior interests in the real estate, except as provided in Subsection (d). The intent behind subsection (c) is to treat a reservation of rights provision in the senior mortgage the same way as a future advances provision in such mortgage, with both protecting the mortgagee against a loss of priority as against subsequent lienors. Subsection (d) sets forth a procedure for a mortgagor to terminate the mortgagee s right reserved in the mortgage to modify the mortgage or the obligation. More specifically, under Subsection (d), where a mortgage contains a reservation of a right on the part of a mortgagee to modify the mortgage or the obligation it secures, the mortgagor is authorized to issue a notice to the mortgagee terminating that right. Upon receipt of such notice by the mortgagee, the right to modify with retention of priority under Subsection (c) of Section 7.3 becomes ineffective against persons taking any subsequent interests in the mortgaged real estate, and subsequent modifications are governed by the paramount equities or material prejudice tests alone. Although the Restatement calls for reservations of modification rights in mortgages to be strictly enforced, even in the face of modifications materially prejudicial to junior lienholders, it is uncertain whether a court would subscribe to the Restatement s position, in the face of a modification shown to be materially prejudicial to the holders of junior interests. Some courts also may be reluctant to defer to reservations of modification rights in mortgages for policy reasons: such provisions can interfere with the alienability of the mortgagor s interests, since third parties may be unwilling to extend a mortgagor credit where the amount of the indebtedness secured by a senior mortgage is uncertain by virtue of its potential for modification. Similarly, courts may be reluctant to subscribe to the Restatement s position on the effect of provisions in mortgages reserving modification rights, where the making of modifications prejudicial to the interests of junior lienors is inconsistent with duties of good faith and fair dealing, which may be recognized in a particular jurisdiction. It is important to recognize that, even if not expressly authorized by a reservation of modification rights, parties can modify mortgages, and the extent to which such modifications are enforeceable without a disturbance in priority, is determinable according to the general rules discussed above, including exceptions for intent to subordinate, material prejudice and the recording act protection where appropriate. Prior to undertaking any modification, whether or not the mortgage includes a reservation of modification rights provision, it is important for a mortgagee to order a title search to determine whether any junior liens relating to the property appear of record. Where a title search reveals the existence of record of junior liens, it is prudent to obtain the consent of each junior interest holder to a modification of the senior 5

6 mortgage and an acknowledgment by such junior interest holder of the continued subordination of its junior lien to the senior mortgage, as modified, either through the junior lienor s signature or a form of acknowledgment and consent affixed to the senior mortgage, acknowledging the continued superiority of the senior mortgage, as amended, or by a separate free-standing subordination instrument. In the event further modifications are contemplated, the subordination agreement of a junior lienholder may include a provision to the effect that the junior lien is, and remains, subordinate to the senior mortgage, as modified by the modification in question, and any further extensions, modifications, or renewals thereof. Kratovil & Werner, at 608 & n.80. Even with such language in a subordination agreement, however, the junior lienor s express consent and acknowledgment of the continued subordination of its lien should be obtained at the time of a future modification. At the time of any modification of a mortgage, the mortgagee should purchase any available title insurance endorsement covering modifications in general, or an additional advanced endorsement, if an additional advance of funds is sought from a lender, within the scope of a future advances clause. As noted above, a modification can be effected through one extension or modification agreement which modifies the appropriate provisions of both the mortgage and the debt obligation at the same time. It is important, in any modification instrument for the borrower and the lender to express their intent to modify the underlying mortgage only, and not to novate the indebtedness secured or discharge it or the mortgage securing it. Kratovil and Werner advise that, where a substitute note, rather than a modification or extension agreement or simple amendment is used, the original note should not be marked paid or paid by renewal or returned to the issuer. Rather, the original note should be retained and marked with a legend reciting that the maturities of amounts due thereunder have been extended pursuant to the terms of an extension agreement and, if there is one, a renewal note. The renewal note, too, should make clear that it does not novate or discharge, but rather continues in effect, the indebtedness evidenced by the original note. As previously mentioned, the use of a modification instrument only, whether (1) one which modifies both the note and mortgage at the same time, or (2) one which modifies the note and another which modifies the mortgage are preferable to the use of a replacement note, in light of the risk that a replacement note will be construed by a finder of fact to discharge, rather than continue in effect, its predecessor. Two Recent Decisions Replacement of Senior Mortgage: Suntrust Bank v. Riverside National Bank of Florida The facts of the case, as recited in the court s opinion and in the October 23, 2001 Daily Development on DIRT, are as follows. In 1993, Suntrust Bank recorded a balloon first mortgage in the amount of $148, In 1995, Riverside National Bank of Florida recorded a $100, second mortgage, notifying Suntrust of the second mortgage, as well as of the borrower s agreement not to seek future advances from Suntrust, and asking that Suntrust refrain from granting more advances without first giving Riverside notice of any increases in loan amount (Professor Randolph s comments published on DIRT in the October 23, 2001 Daily Development mention that a Florida statute permits a junior lienholder to file a notice with a future advance lender). In 1998, Suntrust refinanced the first mortgage, with a loan of 6

7 $136, Suntrust s original mortgage was paid from the proceeds of the refinancing loan and satisfied of record. Suntrust s title search failed to disclose the Riverside mortgage, and Suntrust assumed that, through its new mortgage, it had a first lien position. Later, when the property went into foreclosure, Suntrust discovered Riverside s lien, and asked that its new mortgage, which was in place at the time, be given the priority of its original (and, by then, refinanced and released) mortgage. Suntrust apparently characterized this request as a claim for equitable subrogation to its prior lien. Although the trial court denied equitable subrogation, relying on two Florida appeals denying that relief, the Florida Court of Appeals reversed, en banc, in a split decision, 9-1-2, concluding that equitable subrogation should have been granted. In its opinion, the majority reversed the two prior cases, concluding that the court had not fully analyzed the doctrine of equitable subrogation, and further concluding that, consistent with the position set forth in the Restatement, equitable subrogation will be applied when there is no adverse impact on the expectations of the party being primed. The court found equitable subrogation to be appropriate in the case before it, since Riverside was junior to the original Suntrust mortgage when Riverside made its loan, and Riverside remained junior only to that original mortgage. A concurrence emphasized that the majority opinion should not be construed to provide any benefits other than to accord the new Suntrust mortgage the priority of its released predecessor. At the same time, the concurring opinion appears to suggest that Suntrust, pursuant to its rights under the mortgage loan, could extend the repayment term or, to the extent authorized by law, make future advances. The Suntrust dissent criticized the opinion of the majority on a number of grounds, emphasizing that, under the facts, there was no fraud or even excusable neglect and that, as a result, equitable intervention was not warranted. It noted that subrogation is an equitable remedy which can be withheld, at equity, where not appropriate. The dissent also claimed that the effect of the majority opinion was to extend the term of the original Suntrust loan by more than 20 years, thus prejudicing Riverside s interest. The dissent further noted that because Suntrust had a claim against its negligent title insurer, it had an inadequate equitable position from which to argue for relief. Professor Randolph points out, in his commentary on the case in his October 23, 2001 Daily Development on DIRT, that the most interesting feature of the case is that the analysis employed by the court has almost nothing to do with the legal principles actually at stake. The case involved the law pertinent to the replacement of a senior mortgage, rather than the doctrine of equitable subrogation, which is addressed at Section 7.6 of the Restatement (Third) of Property: Mortgages. According to the Restatement, subrogation is an equitable remedial doctrine under which [o]ne 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. Restatement (Third) of Property: Mortgages 7.6(a) (1997). 7

8 Some, like the dissenting judge in Suntrust and like Professor Randolph, as expressed in his October 23, 2001 discussion, believe that subrogation ought not to be as freely dispensed as the Restatement would allow, but ought to be reserved for cases where, absent application of the subrogation remedy, the performing mortgagee would suffer a loss of priority attributable to fraud or excusable mistake or some similar imposition. The Restatement makes subrogation more readily available, for example, where the party performing the obligation of a senior mortgagee does so to protect his or her interest or upon a request from the obligator, even if that party is aware of an intervening mortgage, provided, however, that the party seeking subrogation can demonstrate that subrogation will not materially prejudice the holders of intervening interests in the real estate. Subrogation, however, is not at issue when, as in the Suntrust case, a lender replaces its own senior mortgage with another from the same mortgagor, in order to secure a refinancing of the very property subject to the senior mortgage. As pointed out by Professor Randolph in his October 23, 2001 discussion, the real question in Suntrust is whether a mortgagor and mortgagee implicitly, independent of any contractual provision, have a right to modify the mortgage in ways that do not injure the interests of third parties. If so, or if the Suntrust mortgage had included an enforceable contractual provision permitting modification, then the new mortgage would simply have been accorded the priority of the mortgage it replaced, automatically, as an implementation of the parties intent. Subrogation, by contrast, involves the intervention of equity in a legal relationship. In the case of replacement or modification of a mortgage, no equitable intervention is required. The only reason not to permit replacement or modification would be if its implementation would be inequitable, for example, where a third party took an interest in reliance upon a record discharge of the prior mortgage, before the replacement or substitute mortgage was recorded. Such an equity was not present in the Suntrust case. Under the Restatement view, modification or replacement of a senior mortgage is available whenever there is no impact on a junior lienholder regardless of whether the senior mortgage permits modification. The Restatement further permits modification or replacement of a senior mortgage even where it is materially prejudicial to the holders of junior interests in the real estate, provided the modification is within the scope of a reservation of right to modify expressed in the mortgage, except where a mortgagor issues a notice to the mortgagee terminating the right of modification reserved in the mortgage. Restatement (Third) of Property: Mortgages 7.3(b), (c), (d) (1997). The traditional majority view is that extension of the time for payment does not work a disadvantage to junior creditors, and, therefore, as Professor Randolph has pointed out in the October 23, 2001 Daily Development, the Suntrust case is much more straightforward than is apparent from the opinion of the court, and the intervention of equity in the case is not necessary. Please note that while the traditional majority view holds that an extension of the maturity date or amortization period of a secured obligation is not deemed prejudicial to the holder of junior interests, 1 Nelson & Whitman, 9.4, at & n.11; Kratovil & Werner, at , if actual prejudice to subsequent lienholders can be shown, an extension agreement may be ineffective as to them, at least in part, Kratovil & Werner, at 608 & n.84. As pointed out in the Suntrust dissent, an extension of the maturity date of an obligation for more than 20 years is significant, and could be found unenforceable by some courts 8

9 against intervening lienors, despite the general rule permitting extension of a mortgage maturity date or a stretching out of installment payments. Finally, it is worth noting that the dissenting opinion in Suntrust raises the notion that equitable relief ought not to be granted where a party has title insurance. Although this idea has been discredited on DIRT, Professor Randolph concedes that a party seeking the intervention of equity perhaps should be required to demonstrate the taking of prudent protective action. He points out that there is no room for such analysis in the Suntrust case, since it is not a case for equitable intervention, but rather a case simply for recognition of the proper priority of a mortgage replacing an existing senior mortgage. Modification of Mortgage: Burney v. McLaughlin At the time the lawsuit was initiated, the Foxborough Inn, consisted of a 178-room hotel in Branson, Missouri, situated on two parcels, a front parcel and a back parcel. In early 1992, the Burneys and the Snadons (collectively, the Burneys) constructed 77 units of the Inn on the front parcel, which they owned. Later in 1992, the Burneys sold the front parcel and the Inn s 77 units to C&J Properties, Inc. (C&J) for a total purchase price of $3.3 million. As part of the sale, C&J paid the Burneys nearly $1,000, in cash at closing, paid off the Burneys $1,000, mortgage loan on the property by borrowing $1.1 million from Ozark Mountain Bank (OMB) and giving OMB a first deed of trust on the front parcel; and gave the Burneys a note for the remaining $1.2 million of the purchase price secured by the lien of a second deed of trust on the front parcel. In 1993, C&J borrowed approximately $3.2 million from the Bank of America (Bank), to refinance the existing OMB debt and to fund C&J s efforts to construct an additional 100 units on the back parcel, which C&J had purchased. This $3.2 million loan transaction was accomplished in three steps. First, on June 23, 1993, C&J borrowed $1.077 million from the Bank of America to pay the balance of the note secured by the first deed of trust held by OMB. This new note (Bank s Note #1) was secured by a deed of trust against the front parcel only (Bank s Deed of Trust #1). Second, also on June 23, 1993, the Burneys executed, in favor of the Bank, a subordination agreement, which provided, in part, that the Burneys subordinated their note and deed of trust on the front parcel to the Bank s Deed of Trust #1. Third, the Bank loaned C&J $2.117 million (Bank s Note #2) to fund the construction of 101 additional units on the back parcel. Bank s Note #2 was secured by a deed of trust placed against the back parcel only (Bank s Deed of Trust #2). On June 2, 1994, C&J granted Bank another deed of trust (Bank s Deed of Trust #3), securing both Bank s Note #1 and Bank s Note #2, with the latter deed of trust encumbering both the front parcel and the back parcel. Soon thereafter, the project became economically troubled, and the Bank and C&J entered into a series of eight separate modification agreements, which extended the maturity date and other terms and conditions of Bank s Note #1 and Bank s Deed of Trust #1, and, in the case of the last three modifications, extended the maturity date and other terms and conditions of Bank s Note #1 and Bank s Note #2. Although each modification was recorded, the Burneys claimed they were never notified of any of the modifications, nor was their consent obtained for any of the modifications. The modifications included 9

10 extensions of the maturity dates of Bank s Note #1, increases in interest rates, the addition of crosscollateralization and cross-default clauses linking the front and back parcel loans, and the addition of closing fees, appraisal fees and certain provisions relating to bankruptcy. Eventually, C&J surrendered, notifying the Bank that it would not reopen the motel following the traditional winter closing. The Bank filed a foreclosure action, intending to sell the front parcel and the back parcel at a foreclosure sale together as a single operation. The Burneys obtained a temporary restraining order enjoining the foreclosure and sought, in addition, a declaration that their deed of trust secured by the front parcel was prior and superior to Bank s Deed of Trust #1, as well as to any other deeds of trust the Bank held against the front parcel, and judicial foreclosure of the Burneys deed of trust. The Burneys argued that their interest in the front parcel should be declared superior to and take[] priority over any interest asserted by Bank because the actions and conduct of Bank... so materially adversely affected and impaired [the Burneys ] collateral and/or destroyed the original economics of the subject property, so as to render [the Burneys ] Subordination Agreement of June 23, 1993[,] null and void Mo. App. LEXIS 1714 at *6-7. The trial court granted the relief sought by the Burneys and found that the Bank s liens were subordinate to the Burneys lien. The court of appeals reversed, in part. In resolving the Burneys claims, the appellate court, quoting from case authority, articulated several determinative principles, as follows: (1) a senior mortgagee can enter into an agreement with the mortgagor [to modify] the terms of the underlying note or mortgage without first having to notify any junior lienholders or to obtain their consent, [but] if the modification... prejudices the rights of junior lienors or impairs [their] security, their consent [including subordination] is required; (2) [f]ailure to obtain [such] consent in these cases results in the modification being ineffective as to junior lienors, [with] the senior lienor relinquishing to the junior lienors its priority with respect to the modified terms; and (3) [w]hile this sanction ordinarily creates only the partial loss of priority noted above, in situations where the senior lienholder s actions in modifying the note or mortgage have substantially impaired the junior lienholders security interests 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 Mo. App. LEXIS 1714, at *12-13 (internal quotation marks and citations omitted). The Missouri Court of Appeals held that the foreclosure could proceed as to the front parcel and that the Bank did not lose its priority merely because it had extended the date of payment under its loan secured by the front parcel. The court held, however, that the modification agreements altering the interest rate and other terms (aside from payment date) would not be effective as against the Burneys. As pointed 10

11 out by Professor Randolph in his October 24, 2001 Daily Development published on DIRT, the court s opinion essentially incorporated the provisions of the Restatement (Third) of Property: Mortgages 7.3(b), establishing that, even absent any reservation of rights language in the loan documents, the parties to a mortgage loan may modify its terms and retain the priority of their original secured positions, provided the modification does not prejudice the interests of junior lienholders. The Restatement, as well as case law and treatises indicate that a simple extension in terms of payment will not normally do injury to the interests of junior lienholders, although they do allow for the possibility that this might not be true in particular cases, as pointed out above. Section 7.3 of the Restatement and the accompanying comments, together with the pertinent case law and treatises, also make it clear that cross-collateralization, increases in the interest rate or increases in the amounts secured are all changes that would generally prejudice the status of junior lienholders, and, thus, generally will not be accorded priority. In commenting on the case in the October 24, 2001 Daily Development featured on DIRT, Professor Randolph concludes that the Burney decision is correct and consistent with prevailing authority, although he notes that there may be a case in which an alteration in payment schedule would work to the disadvantage of a junior interest. Professor Randolph adds, in his comments on the Burney decision, that a junior lender wishing to restrict the mortgagor from making any changes in the terms of the senior lien could do that, as a part of the documentation of the junior loan. Modifications of the senior loan could be made an event of default under the junior loan documents. Professor Randolph points out that the larger issue might be whether an agreement could effectively inhibit the ability of a senior lender to strike an agreement with the mortgagor and retain priority of its lien. He surmises that perhaps a better approach would be for the junior lienholder to notify the senior lienholder of the junior s contractual restrictions on the mortgagor s right to modify the senior mortgage and to be prepared to pursue a potential tort claim for interference with contractual relations if the senior makes any changes. The Daily Discussion of this case on October 24, 2001 on the DIRT website suggests that a senior mortgagee can avoid the problems which arose in the Burney case by including in its mortgage a provision permitting it to modify the senior lien. Restatement, 7.3(c) validates such provisions as preserving priority, but the October 24, 2001 Daily Discussion notes that there may be some policy argument refuting such a position in jurisdictions that attempt to preserve a junior lienor s ability to deal with its equity, including, for example, through a future advances clause. As pointed out by Professor Randolph, a jurisdiction that follows the optional/obligatory test in determining the priority of advances under a future advances clause may have an interest in placing some limitations on the ability of a senior lender to tie up the property by authorizing unlimited modifications. The Burney court declined to address Restatement 7.3(c), given the absence of any contractual provision in the senior bank notes or deeds of trust authorizing the modifications. Professor Randolph has noted that, in some jurisdictions, a junior lienor can complain about a senior mortgagee s prejudicial modifications of its mortgage only when there is an express subordination. Professor Randolph and his colleague, Dale Whitman, disagree with this approach. 11

12 Finally, courts may imply a duty of good faith and fair dealing in a contractual relationship between parties, including, possibly, parties to a subordination agreement containing provisions relating to mortgage modifications. Restatement (Second) of Contracts 205 (1981) ( Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement ); Spencer v. J.P. White Bldg., 585 P.2d 1092, 1095 (N.M. 1978) ( [W]hether expressed or not, every contract includes a covenant of good faith and fair dealing between the parties. ) (internal quotation marks and citation omitted). This duty, as it may be implied from the provisions of the Restatement and from pertinent case law, including the Burney decision, extends through the life of a relationship between junior and senior parties to a subordination agreement. Such a duty of good faith and fair dealing could provide grounds for a junior s objection to the modification of a senior loan, even where language in the senior loan documents authorizes such modifications. Given a duty of good faith and fair dealing on the part of parties to a subordination agreement, language in a senior mortgage permitting unlimited modification might bind the mortgagor, but might not be sufficient to permit a senior mortgagee to make changes in the terms of the senior mortgage that jeopardize the position of the subordinated party, unless the subordination agreement so authorizes. See Cafeteria Operators, L.P. v. Coronado-Santa Fe Assocs., 952 P.2d 435, 440 (N.M. Ct. App. 1997) (an implied covenant of good faith and fair dealing cannot override provisions addressed by express terms of contract); Melnick v. State Farm Mut. Auto. Ins. Co., 749 P.2d 1105, 1110 (N.M. 1988). Conclusion Senior mortgagees should seek to avoid priority problems by utilizing drafting techniques, where possible. The Restatement recommends inclusion in a senior mortgage of a provision authorizing the mortgagor and mortgagee to make future modifications in a mortgage and the obligation it secures. Restatement (Third) of Property: Mortgages 7.3 (c), (d) (1997). According to Section 7.3 (c), [i]f the mortgagor and mortgagee reserve the right in a mortgage to modify the mortgage or the obligation it secures, the mortgage as modified retains priority even if the modification is materially prejudicial to the holders of junior interests. Professors Nelson and Whitman have recommended specific reservation of modification rights language, which is quoted above, for inclusion in a senior mortgage. The purpose of such language is to give notice of the potential for modification, much like a future advances clause does, and therefore to defeat a claim that the priority of a senior mortgage has been lost, in whole or in any part, if a modification occurs. A senior mortgagee may want to consider including a reservation of rights provision at the point of preparation of a mortgage, from a planning vantage, regardless of whether there is precedent for enforcing such a provision in the jurisdiction where the mortgage is recorded. Even in the face of limitations upon the effectiveness of reservation of rights provisions in mortgages, it is fair for the parties to include such provisions in mortgages, nonetheless, to give notice, to the maximum extent possible, of the parties intent to reserve the right to modify the mortgage s terms, without disturbing the instrument s priority. Further, a senior mortgagee may not be in as strong a position to argue in support of the retention of the priority of its mortgage, in the face of a modification, absent inclusion in the senior mortgage of a provision authorizing modification. 12

13 There is authority for the proposition that, even absent any permissive language in the instrument, the parties to a mortgage may replace it with a new mortgage or modify its terms, without first having to notify any junior lienholders or to obtain their consent and subordination, unless the terms in the replacement mortgage or modification agreement prejudice the rights of junior lienholders or impair their security. A senior mortgagee s failure to obtain the consent of junior lienors to a replacement mortgage or modification agreement containing terms that are materially prejudicial to junior interests results in the replacement or modification being ineffective as to junior lienors, with the senior mortgagee relinquishing to junior lienholders its priority with respect to modified terms. While the sanction for such unconsented to prejudicial replacement or modification of terms ordinarily creates only a partial loss of priority, in situations where a senior lienholder s actions in replacing or modifying a mortgage or the obligation it secures have substantially impaired junior lienholders security interests or effectively destroyed their equity, courts may wholly divest the senior lien of its priority and elevate the junior liens to a position of superiority. A modification of the maturity date or the amortization schedule of a loan generally is not deemed to be prejudicial. Increases in the interest rate or the total amount of the obligations secured by a mortgage, and the addition of cross-collateral or other substantive provisions to a mortgage or the obligation it secures, are often found to be prejudicial. In structuring a modification arrangement, use of an agreement which modifies the terms of a mortgage and/or the underlying obligation it secures, is preferable to outright replacement or substitution of such mortgage or a promissory note or other instrument evidencing the obligation secured. The replacement of a secured promissory note or the replacement and release of record of a mortgage raise issues, including issues of discharge and novation, over and above those which otherwise arise in a modification transaction. Any replacement or modification instrument should recite the intent of the parties that the mortgage and the obligation it secures are not being novated, discharged or disturbed, but rather reaffirmed and continued in effect as modified, with the priority of the original mortgage being retained. In negotiating and documenting a mortgage replacement or modification transaction, mortgagee and mortgagor should be cognizant of the duty of good faith and fair dealing and the limitations which such duty presents, particularly with respect to any part of the transaction involving a subordination agreement between a senior mortgage and a junior mortgagee, notwithstanding a reservation in the senior mortgage of rights to modify its provisions without disturbance of the mortgage s priority. Public policies against restricting a mortgagor s ability to alienate or encumber interests in real estate, as well as policies favoring the protection of a junior mortgagee s equity and other interests may similarly limit the effectiveness of reservations of rights provisions in senior mortgages. Before entering into a mortgage modification or replacement transaction, a senior mortgagee should perform a search of the real property records to determine whether junior liens exist. Where there are junior liens, prudence dictates obtaining from junior lienholders and recording a subordination agreement or acknowledgment of continued subordination, prior to entering into the modification agreement or accepting a replacement mortgage. Purchase of title insurance coverage of a mortgage modification agreement, 13

14 whether in the form of a modification endorsement to a mortgagee s policy of title insurance or of a policy insuring the priority of a replacement mortgage, is strongly recommended. 14