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Awad v. Unity Bank

2009 WL 3489412 (U.S. Dist. Ct. D. N.J. 2009) (Unpublished)

MORTGAGES; EQUITABLE SUBORDINATION — Equitable subordination is an equitable remedy to prevent the unjust enrichment of junior lienors and where a lender relies on the record as to where its mortgage would stand in priority, the doctrine of equitable subordination will not force it to take an inferior position to what it relied upon.

In New Jersey, the priority of competing mortgages is determined by the order in which they were properly recorded, so long as the recording party had no actual knowledge of another party’s prior interest. In 2003, a debtor granted a first mortgage which was recorded. In 2005, it granted a second mortgage which was recorded after the first mortgage. In 2007, the debtors took out a third mortgage on the same property which was recorded after the first two mortgages. Also in 2007, the debtor refinanced the second mortgage by obtaining a new mortgage from the same bank, discharging the second mortgage with the proceeds of the new loan. The second mortgagee did not do a title search when it issued the new mortgage. The refinanced mortgage was then recorded.

The debtor defaulted on the third mortgage. When the bank holding the third mortgage obtained a title report for the property, the report listed three encumbrances with the following priority: (a) the first mortgage; (b) the third mortgage; and (c) the refinanced mortgage held by the original holder of the second mortgage. Relying on its title report, the holder of the third mortgage began a foreclosure action joining the holder of the second mortgage as a subordinate mortgagee. A default judgment was entered against the second mortgagee due to its failure to plead. The debtor then filed a Chapter 13 bankruptcy petition. The Chapter 13 plan classified the third mortgagee’s claim as an unsecured mortgage in the third priority position. The third mortgagee objected to plan confirmation because it contended that its mortgage should be in second priority. The debtor filed an adversary proceeding to determine the two mortgages’ priority.

The Bankruptcy Court held that the third mortgagee had relied to its detriment on the title report, thereafter incurring substantial attorneys’ fees to initiate a foreclosure action and to object to the Chapter 13 plan and in the adversary proceeding. Because of this detrimental reliance, the Bankruptcy Court found that: (a) equitable subordination was not justified; and (b) that the third mortgage had second priority. The holder of the second mortgage appealed.

The District Court affirmed the Bankruptcy Court’s ruling and rejected the second mortgagee’s argument that the Bankruptcy Court had committed reversible error when it found that the attorneys’ fees incurred by the third mortgagee constituted sufficient detrimental reliance to prevent the application of detrimental reliance. It agreed with the lower court that the third mortgagee’s reliance on the title report and the failure of the second mortgagee to raise equitable subordination as a defense during the foreclosure proceeding justified the third mortgagee’s second priority position. The Court noted that the primary purpose of equitable subordination is to prevent the unjust enrichment of junior lienors. It is a discretionary remedy. The Court found that the third mortgagee incurred attorneys’ fees not only in the current priority dispute, but also in its decision to proceed with a foreclosure action and in opposing the debtor’s Chapter 13 plan. It noted that in other cases finding that there was no detrimental reliance, the only attorneys’ fees incurred had been those spent only in the priority dispute. Thus, it held that it was not “clear error” to find that the third mortgagee detrimentally relied on the discharge of the second mortgage when it incurred attorney’s fees related to the foreclosure action and opposing the Chapter 13 plan. Further, the Court stated that lack of knowledge is a prerequisite for equitable subordination. Here, the record showed that the second mortgagee did not run a title search when it agreed to issue a new loan and discharge the old mortgage. The Court believed that the Bankruptcy Court had not find that the second mortgagee lacked actual knowledge of the third mortgage. Rather, it appeared that there was an open issue of material fact. It concluded that, given the Bankruptcy Court’s finding of detrimental reliance on the part of the third mortgagee and the open questions of fact, it was within the Bankruptcy Court’s discretion to deny the request for equitable subordination.

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