Lender Beware: (June Litigation Quarterly 2009)

A primer on priority of interest in the face of commercial mortgage modifications and future advances in the State of Florida

Lenders, in today’s economic climate, are faced with more loans in default than any time since the Great Depression. The aptly dubbed “mortgage crisis” is riddled with obstacles harmful to both borrowers and lenders. In an effort to avoid default, a lender may feel forced to modify or restructure a loan. But lender, beware! Modification can lead to loss of priority, and the consequences can be staggering.

This advisory article will begin with a general discussion on priority. It will then discuss problems modifications give rise to that can lead to a loss of priority. This article will also address future advances. Finally, it will present practical approaches to those problems and safeguards lenders should implement in this marketplace, on the advice of counsel.

I. Priority Generally

Florida is a notice jurisdiction, such that its pure notice recording act protects subsequent grantees who are bona fide purchasers, i.e., a purchaser for value who takes without notice of any earlier transactions.[i] The Florida statute has been construed to protect lien and judgment creditors who take without notice as well.[ii] “Without notice” means the purchaser or lender had no actual inquiry or constructive notice at the time the transaction took place. Actual notice may be expressed or implied. A lender is put on constructive notice when the lien is recorded. A lender is put on inquiry notice where other lenders would have inquired as to certain events from the facts available at the time of the transaction. Even though Florida has a pure notice recording statute, there is a presumption of lack of notice of an unrecorded instrument by a person subsequently acquiring an interest in the property. The burden is on the claimant with the unrecorded instrument to show the subsequent lender had actual knowledge.[iii] It is therefore critical for a lender to record its mortgage because an unrecorded mortgage may allow a subsequent lender to argue its lien has superior priority.[iv]

Although lenders may take proper steps in recording a mortgage, priority can still be affected by way of a modification of that mortgage. A lender, for instance, may unintentionally waive priority if its mortgage is modified in such a way that the new obligation is characterized as a new mortgage that discharges the original mortgage and its priority. Many lenders and borrowers foresee that the borrower will eventually need additional funds. They, thus, carve a future advance clause into the mortgage agreement. While advances made under these clauses normally retain the priority of the mortgage, certain actions taken by the lender can cause intervening encumbrances to become superior.

II. Modification

While there are many issues of which to be cognizant in order to maintain priority over junior liens, modification documents, at the very least, should refer to the original mortgage. Here, the lender must beware, as there are various modifications that may create a loss of priority. These include: (1) a change in parties; (2) a change in security, new consideration or a different debt; (3) mistake in fact or fraud; (4) failure to execute or record a new mortgage at the same time as the discharge of the original; and (5) new obligations that adversely affect the rights of an intervening lender. When these situations arise, it is up to the court to determine whether a new agreement is a renewal or an extinguishment of the original.[v] In so doing, courts will normally examine the intent of the parties to determine which lien has priority.

A. Renewal and the Importance of the Parties’ Intent

During the Great Depression, the Florida Supreme Court established a clear rule on renewal (the “Godwin rule”). The Godwin rule states that a new mortgage deemed a renewal of an old debt can keep its priority over an intervening lien and/or judgment.[vi]

In Federal Land Bank of Columbia v. Godwin[vii] (“Godwin”), Mr. Godwin had four mortgages with three different lenders. After he executed mortgage 1 and mortgage 2, he renewed mortgage 1 (renewed mortgage 1 will be referred to as mortgage 3). As to the priority between mortgage 2 and mortgage 3, the court looked to the intention of the parties to determine whether mortgage 3 was a renewal or an extinguishment of mortgage 1. It was clear to the Court that the intention of the parties was to “simply . . . make a renewal and extension of the old debt.”[viii] The mortgage was between the same parties, for the same real property, made in good faith, and the satisfaction of mortgage 1 was practically simultaneous to the taking of mortgage 3. Mortgage 3, thus, retained priority over mortgage 2.[ix] Although the parties’ intentions are not always as clear, where the trier of fact finds a good faith intention that a new mortgage is substituted for the old to affect a renewal of the loan, most Florida appellate courts agree that the original debt is not discharged. See diagram 1.

B. Right of Subrogation

The right of subrogation in this context is the right to assume the legal rights of an entity for which a debt has been paid.[x] For purposes of this article, this includes the right to retain priority. To be entitled to the right of subrogation and the retention of priority, a subsequent loan must pay off the original, and the lender should not be on notice of any intervening mortgages or judgments.[xi] In Godwin, along with determining the priority between mortgage 2 and mortgage 3, the Court also had to determine the priority between mortgage 2 and a fourth mortgage Mr. Godwin executed and delivered, mortgage 4.[xii]

In his loan application to mortgage 4’s lender,[xiii] Mr. Godwin represented that there were no other mortgages or liens on the property, such that the mortgage was given for the purpose of securing mortgage 4’s lenders with all the rights Mr. Godwin had in the property, and that mortgage 4, when recorded, would be a first lien. [xiv] In addition, mortgage 2 was not recorded, thus mortgage 4’s lender had no constructive notice of mortgage 2.[xv] There was also evidence to show that mortgage 4’s lender paid mortgage 3’s lender directly. The court found it was the parties’ intent to subrogate mortgage 4’s lender to the rights of mortgage 3’s lender.[xvi] Mortgage 4 was executed to pay off mortgage 3, and mortgage 4’s lender was not aware there were any other liens on the property. Thus, mortgage 4 had priority over mortgage 2.

It should be noted, and will be discussed more extensively below, that had mortgage 2 been placed in a worse position by the subrogation, it is likely the court would not have allowed mortgage 4 to retain priority.[xvii]

C. Change in Parties

The Godwin rule is not always applicable where there is a change in parties. [xviii] A court will take into account the fact that a mortgage executed to pay off an original debt was given to a different lender.[xix] For example, borrower has three mortgages, mortgage 1 executed to lender 1, mortgage 2 executed to lender 2, and mortgage 3 executed to lender 3. As mentioned above, if mortgage 3 is executed to pay off mortgage 1, it may retain priority over mortgage 2 under the right of subrogation. However, if lender 3 assigns mortgage 3 to a new lender, lender 4, this may cause mortgage 3 to lose priority over mortgage 2. This occurred in Resolution Trust Corp. v. Niagra Asset Corp.[xx] In Resolution Trust, the court had to determine whether mortgage 2 had priority over mortgage 3. Mortgage 3, originally executed to lender 3, was assigned to lender 4. The court found that, among other things, because there was a change in parties, it could not presume that mortgage 3 was a renewal of mortgage 1. [xxi] It follows that mortgage 3 did not retain priority over mortgage 2.

D. Change in Securities: New Consideration / Different Debt

Ordinarily, the mere substitution of one form of security for another can be part of a mortgage renewal, which does not result in a loss of priority. Sometimes, however, a change in a security indicates to the court that the parties intended to extinguish the original lien, which can cause a mortgage to lose its priority. For instance, in Travers v. Stevens,[xxii] the new mortgage was not secured by the identical property securing the original. Thus, the court determined this was a factor indicating that the new mortgage was not a renewal.[xxiii]

Similarly, where a new mortgage is for a different debt than an earlier mortgage, it fails to operate as a renewal of the original mortgage.[xxiv] In Smith v. Metzler, the court dealt with the issue of renewal versus extinguishment in the face of new consideration and a change in parties. In Smith, the borrower bought real property. He assumed the payment of a mortgage, mortgage 1, held by lender 1. The borrower then executed a second mortgage, mortgage 2, to the seller, to secure the rest of the purchase price.[xxv] Mortgage 1 clearly had priority over mortgage 2, as it was properly recorded before mortgage 2. However, when mortgage 1 had $2,000 left to be paid, the borrower executed and delivered a new mortgage, mortgage 3, to lender 1 for $12,000, which was assigned to a different lender, lender 2. This amount was then delivered to the borrower in the form of cash and securities. [xxvi] See diagram 3.

The Court had to determine whether mortgage 3 was a renewal of mortgage 1, and whether it had priority over mortgage 2. Although the borrower used part of the cash and securities from mortgage 3 to pay off mortgage 1, mortgage 3 was not considered a renewal of mortgage 1 because it secured an additional principal amount that was entirely different, and much larger, than the debt that had to be satisfied.[xxvii] Accordingly, mortgage 3 was considered an entirely different obligation, and it did not retain mortgage 1’s priority over mortgage 2.[xxviii] It bears mentioning that mortgage 3 could have established a right of subrogation to mortgage 1 to the extent the money was used to satisfy mortgage 1 ($2,000). [xxix] In other words, $2,000 of the $12,000 debt secured by mortgage 3 could have had priority over mortgage 2.

E. Mistake in Fact / Fraud

A mistake in fact is defined as, “a mistake about a fact that is material to a transaction.”[xxx] During the process of a mortgage transaction, a party may make a mistake that affects a lender’s knowledge of other encumbrances on the property. A lender, for example, may perform a negligent title search, or a prior lender may record improperly. In addition, a borrower may make fraudulent representations that induce a lender to complete the transaction. If a lender does not know about an intervening lien, it may argue that he was not put on notice of that lien, which, as mentioned earlier, may aid a lender in claiming superior priority. Depending on the mistake, or the reasons that the lender was not on notice, a mistake in fact and/or fraud may affect a court’s decision in determining priority.

In Florida, the lender has an affirmative duty to search for other encumbrances on a property prior to executing a mortgage.[xxxi] This is largely because of Florida’s Notice Statute. No mortgage of real property is effective in law against subsequent lenders unless and until it is recorded, and the act of recording that mortgage puts all subsequent lenders on notice[xxxii] that there is an encumbrance on that property.[xxxiii] Therefore, if an intervening lien, mortgage 2, is recorded according to the law in Florida, and a Florida court must determine whether mortgage 3, a refinancing of mortgage 1, has priority over mortgage 2, mortgage 3’s lender’s argument that he did not know about mortgage 2 will be unsuccessful.[xxxiv]

It is well established that constructive notice can prove outcome determinative in the aforementioned context. But if the lender is claiming a right of subrogation, whether it had notice may prove to be irrelevant in determining its priority. In other words, even if a lender does not know about another lien because he performed a negligent title search, a court may find that this fact has no bearing on priority. In Suntrust Bank v. Riverside Nat’l Bank of Fla.,[xxxv] the court had to determine the priority between mortgage 2 and mortgage 3, where mortgage 3 refinanced and satisfied mortgage 1. In that case, mortgage 3’s lender assumed its mortgage was the first mortgage because its title search failed to reveal mortgage 2. The court held that a refinancing lender is subrogated to the priority of mortgage 1, even where it had actual knowledge of the intervening lien.[xxxvi] However, Florida courts disagree on this issue. Some courts honor the more traditional law that when a lender is on notice of a second lien, subrogation is not available to give that lender the first lien’s priority.[xxxvii] As the law in Florida is unclear, it is best for lenders to retain real estate counsel to perform a diligent title search when modifying a mortgage or lien.

In some cases, a lender may not be on notice of an intervening lien due to fraud committed by the borrower. If, for example, mortgage 3’s lender is induced into renewing a mortgage by a borrower who falsely represents that mortgage 2 had been paid and discharged, mortgage 3 will normally retain priority over mortgage 2. Fraud was crucial to the court’s decision in Godwin, which gave mortgage 4 priority over mortgage 2. As previously mentioned, Mr. Godwin misrepresented to mortgage 4’s lender that there were no other encumbrances on his property.[xxxviii] As a result of this fraud, and a failure to locate any other liens or mortgages on the property, mortgage 4’s lender advanced Mr. Godwin money to pay off mortgage 3. The Court decided that due to Mr. Godwin’s false representations, among other things, mortgage 4 had priority over mortgage 2.[xxxix]

F. Equities in Favor of Subsequent Lenders

Regardless of whether a court is deciding priority based on mistake in fact, fraud, a change in security, or a change in party, the final and most important determinant in a court’s decision of priority is whether an intervening lender would be adversely affected by a modified lien.[xl] That is, if a modification puts an innocent intervening lender in a worse position, a court will likely find that the innocent intervening lien has priority over the modified one. A lender must be careful in a situation where an intervening lender claims its rights were prejudiced by a mortgage modification made without his consent. The best approach for a lender to take when it wants to modify the loan, and there is an intervening lender, is to obtain the consent of that lender and a confirmation that the intervening lien remains subordinate prior to execution of any modification. This agreement should be unambiguous and appropriately filed with the mortgage.[xli]

III. Future Advances

A future advance mortgage is defined as “[a] mortgage in which part of the loan proceeds will not be paid until a future date.” Under Florida Statute § 697.04, future advances do not, in theory, affect the priority of a mortgage, provided they meet statutory requirements. However, when a future advance clause does not meet statutory requirements, any future advance made in the course of the lender/borrower relationship may be subordinated to junior liens.

Florida law on future advances appears to have become a bit more flexible than the law on modification as described above. One example is, prior to the enactment of Florida Statute § 697.04, there was a distinction between obligatory and optional future advances such that those made at the option of the lender did not have priority over intervening encumbrances. Today, however, future advances are protected regardless of whether they are obligatory or optional, so even future advances made at the option of the lender maintain priority over junior liens.[xlii]

Similarly, older Florida cases have found that the maximum amount of the loan must be specified in the mortgage.[xliii] Thus, if the future advances exceeded the maximum amount of the mortgage, any amount in excess would be subordinated to junior encumbrances. Today this is expressly set forth in § 697.04. However, in 1967, Florida adopted the Uniform Commercial Code, and the UCC provision on the same issue does not require a stated maximum of future advances in the mortgage on personal property.[xliv] This concept is applicable to construction loans as well. Florida Statute § 697.04 makes it clear that advances made under a construction loan to enable completion of a project are secured by the original mortgage.[xlv]

Another area that has evolved is the expression of the future advances. Although § 697.04 provides that in order to secure a future advance the mortgage must expressly say so on its face,[xlvi] Florida courts have found that if an advance and a mortgage are similar types of obligations, or relate to the same transaction, it is sufficient to show that the parties intended to secure the advance by the prior mortgage.[xlvii] Similar to modification law, the parties’ intent will be a pivotal factor in a court’s decision as to whether a future advance retains the mortgage’s priority.[xlviii] Even though courts may find that the parties intended to secure a future advance without expressly stating it, it is best for lenders to clearly indicate a future advance clause in the mortgage.[xlix]

A court may still find that the advances made do not have priority over junior liens even where there is a clear future advance clause set forth in the mortgage. For instance, in United States v. Crestview,[l] the future advance clause found in the mortgage gave the lender the option of making advances “necessary for the security or title”[li]of the mortgage property. The lender then advanced the borrower funds to settle an unrelated civil suit. The court found that this advance was not within the purview of the agreement, and thus, any intervening encumbrances had priority over that advance.[lii] Another situation where a lender might find his future advance becomes junior to an intervening encumbrance is where lender 1 agrees with lender 2 that he will not make any advances to the borrower under the mortgage. If lender 1 then breaks that promise, a court may find that the funds advanced do not retain the priority of the original mortgage.[liii]

IV. Recommendations

It is critical for lenders to learn from mistakes of the past. Be cautious and prudent when conducting a loan modification. A lender has to be aware of any rights a junior lender may have, and it has to know what steps need to be taken to ensure its lien retains priority. Without exception, a lender must conduct a title search and advise the client about the priority implications, in writing, before any modification of a mortgage. The writing should underscore that the there is no bright-line rule in this area of law and a court’s potential ruling on the issue is decidedly uncertain.

The title search may require reviewing the mortgage, deeds of trust, notes, security agreements, UCC financing statements, personal and corporate guarantees, assignments of rents and title policies, and other relevant documents. Any modification should also reference the original mortgage. That way there is no question as to the relation between the two. It is also crucial, with regard to both modification and future advances, for the parties’ intent to be made exceedingly clear in the mortgage. This can be one of the most essential parts of a modification, as a court should look to the intent of the parties. Thus, if a lender and borrower agree that a modification will retain the first lien, this should be clearly stated in the mortgage. A “whereas clause” is probably the best vehicle in that regard.

If a lender wants to be subrogated to the rights of the original mortgage, the new mortgage should be executed or recorded simultaneously with the discharge of the original. Moreover, a lender should be wary of a change in parties. While not always leading to the loss of priority, a change in parties may influence a court’s decision.

There should never be a drastic change in securities. If a new loan is secured to pay off an original mortgage, and the new lender wants to step into the shoes of the original lender, he should not lend the borrower money in excess of what is needed to pay off the original mortgage. In addition, the lender must examine the extent of the property that secures the mortgage. If the property is not identical to that which secured the original mortgage, a court may find that the new mortgage is not a renewal.

Finally, the most important and oftentimes overlooked principle learned from the Great Depression, is that courts will always consider whether a loan modification prejudices the rights of an intervening lender. If a junior lender is worse off because of the modification, and he did not agree to the modification, it is most unlikely that a court will allow a loan modification to retain the priority of the original mortgage. A prudent lender, therefore, will obtain the consent of the intervening lender as well as a confirmation that the intervening lien remains subordinate prior to execution of any modification and record it in the public records.

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[i] This is distinct from other jurisdictions that have “Race” or “Race-Notice” Statutes. Florida statutes provide the specific guidelines for the recording of the mortgage and its assignments. It is critical for a lender to comply with the Florida statutes if she wants to maintain the priority of her lien. See Fla. Stat. §§ 695.01, 695.25, 695.26, 701.02 (2008). The fundamental inquiry is notice. As such, recording is important to the extent it imparts constructive notice.

[ii] Sapp v. Warner, 141 So. 124 (Fla. 1932); Mortgage Investors of Washington v. Moore, 493 So. 2d 6 (Fla. 2d DCA 1986); Sheres v. Genender, 965 So. 2d 1268 (Fla. 4th DCA 2007).

[iii] In other Notice jurisdictions, the burden is on the subsequent purchaser, not the holder of the unrecorded instrument as it is in Florida.

[iv] Gabel v. Drewrys, Ltd. 68 So. 2d 372 (Fla. 1953).

[v] Where a court finds that there is a renewal, or the extension of the maturity of a loan, the transaction will not affect the priority. Where a court finds that an original mortgage was extinguished, the modified mortgage could lose priority to junior liens.

[vi] Id.

[vii] 145 So. 883 (Fla. 1933).

[viii] Id. at 884 (emphasis added).

[ix] Id.

[x] The doctrine of equitable subrogation “provides that when loan proceeds are used to satisfy a prior lien, the lender stands in the shoes of the prior lienor, if there is no prejudice to other lienors.” Suntrust Bank v. Riverside National Bank of Florida, 792 So. 2d 1222, 1223 (Fla. 4th DCA 2001).

[xi] In re Gordon, 164 B.R. 706, 708 (S.D. Fla. 1994). As will be discussed below, Florida courts differ on whether a lender who knew about an intervening encumbrance is entitled to equitable subrogation.

[xii] Remember, mortgage 3 was a renewal of mortgage 1 and has priority over mortgage 2. Godwin, 145 So. 883.

[xiii] Mortgage 4’s lender was the Federal Loan Bank of Columbia, the bank that initially filed the complaint. Id.

[xiv] The Court considered this to be fraud perpetrated on the lender by Mr. Godwin. Id. at 885.

[xv] As mentioned above, if mortgage 2 had been recorded, mortgage 4 would have had notice of the prior encumbrance, and thus, would not have been able to claim he did not have knowledge of mortgage 2.

[xvi] Id. at 886.

[xvii] As discussed infra, prejudicing the rights of a third party tends to create a novation, i.e., a new mortgage.

[xviii] Priority is not given to intervening judgments and/or liens where the parties intend to renew an old debt.

[xix] Resolution Trust Corp. v. Niagra Asset Corp., 598 So. 2d 1074 (Fla. 2d DCA 1992).

[xx] Id.

[xxi] The court also took into account that mortgage 3 exceeded the amount of mortgage 1, and the intent of the parties was not expressed in the new mortgage. Id. at 1077.

[xxii] 145 So. 851 (Fla. 1933).

[xxiii] Id.

[xxiv] Smith v. Metzler, 139 So. 823 (Fla. 1932)

[xxv] Id.

[xxvi] Id. at 823.

[xxvii] The borrower only had $2,000 left to pay off on mortgage 1, and he used mortgage 3 to secure a debt of $12,000 in cash and securities. Id.

[xxviii] The fact that there was a change in parties (lender 1 assigned mortgage 3 to lender 2) was also important to the court’s decision that mortgage 3 was not a renewal of mortgage 1. Id.

[xxix] Id. Similarly, the Alabama Supreme Court held where the renewal mortgage is for a larger amount than the original mortgage, the lien of the new mortgage, in the amount by which it exceeded the original mortgage and thus secured a new debt that was not provided for in the first mortgage, was subordinate to the intervening lien. Berry v. Bankers Mortgage Building & Loan, 168 So. 427 (Ala. 1936).

[xxx] Blacks law Dictionary.

[xxxi] See First Federal Savings Loan Ass’n of Miami v. Fisher, 60 So. 2d 496 (Fla. 1952).

[xxxii] A lender does not have to have “actual” notice that an encumbrance exists, if it is his duty to know, and he did not use the means available to acquire the knowledge (such as searching the records in the County Recorder’s office), he is under constructive notice, and thereby a junior lienor under Florida law. Id. at 499 (citing Sapp v. Warner, 141 So. 124 (Fla. 1932)).

[xxxiii] Fla. Stat. § 695.01(1) (2008).

[xxxiv] Florida courts do not require lenders to search beyond the records in the Clerk’s office to find whether there are encumbrances on the property. Pierson v. Bill, 189 So. 679, 682-83 (Fla. 1939). If, however, the record of a mortgage containing a description of the property covered is so defective that the court is required to reform it, the record is not considered sufficient notice to subsequent lenders. Air Flow Heating & Air Conditioning, Inc. v. Baker, 326 So. 2d 449 (Fla. 4th DCA 1976). Lender, beware! Even if mortgage 2’s lender did not record its mortgage, or did so improperly, a lack of knowledge argument may still be unsuccessful if mortgage 2’s lender can prove that you knew about mortgage 2 through some other means.

[xxxv] Suntrust Bank v. Riverside Nat. Bank of Florida, 792 So. 2d 1222 (Fla. 4th DCA 2001).

[xxxvi] Please note that mortgage 3 satisfied the requirements for subrogation – it was used to pay off mortgage, it was the parties’ intent to subrogate mortgage 3 to the rights of mortgage 1, there was no change in parties, and no change in security. Id. at 1225. The dissenting opinion of this case stated that this decision would allow a windfall to negligent lenders. Id. at 1227 (Farmer, J., dissenting).

[xxxvii] Picker Financial Group v. Horizon Bank, 293 B.R. 253, 256 (M.D. Fla. 2003).

[xxxviii] See supra note 14.

[xxxix] Godwin, 145 So. at 883.

[xl] See e.g. Id. at 885 (stating that the doctrine of equitable subrogation is used to relieve from fraud or mistake, but is not allowed if it works any injustice to the rights of others); See also Suntrust, 792 So. 2d at 1222; McAdow v. Smith, 172 So. 448 (Fla. 1937).

[xli] See Southern Floridabanc Federal Sav. and Loan Ass’n v. Buscemi, 529 So. 2d 303 (Fla. 4th Dist. 1988); Marion Mortg. Co. v. Howard, 131 So. 2d 529 (Fla. 1930).

[xlii] Silver Waters Corp v. Murphy, 177 So. 2d 897 (Fla. 2d DCA 1965); Simpson v. Simpson, 123 So. 2d 289 (Fla. 2d DCA. 1960).

[xliii] Fla. Stat. § 697.04(1)(b)(2008); See e.g. Guaranty Title & Trust Co. v. Thompson, 93 Fla. 983, 113 So. 117 (Fla. 1927).

[xliv] Fla. Stat. § 671 (2008); Mason v. Avdoyan, 299 So. 2d 603 (Fla. 4th DCA 1974).

[xlv] § 697.04.

[xlvi] Id.

[xlvii] Garnder v. Guldi, 724 So. 2d 186 (Fla. 5th DCA 1999).

[xlviii] Uransky v. First Federal Savings & Loan Ass’n of Ft. Myers, 342 So. 2d 517 (11th Cir. 1976). Florida courts have held, since the 1930s, that a mortgage cannot secure future advances unless the parties intended to do so. Bullard v. Fender, 192 So. 167 (Fla. 1939).

[xlix] Please note that a mortgage to secure future advances, at any particular time, is a lien only for the amount for which the borrower actually owes the lender at that time and not for the principal amount stated in a mortgage. Johnson v. Fl. Bank at Orlando, 13 So. 799 (Fla. 1943).

[l] U.S. v. First National Bank of Crestview, 513 So. 2d 179 (Fla. 1st DCA 1987).

[li] Id. at 180.

[lii] Id.

[liii] See NCNB Nat’l. Bank of Fla. v. Barnett Bank of Tampa, N.A., 560 So. 2d 360 (Fla. 2d DCA 1990).