In a reported decision issued July 3, 2013, the Appellate Division of the New Jersey Superior Court held that the holder of a first mortgage which refinances its mortgage without obtaining a discharge or subordination from a subordinate mortgagee of which it was aware may still maintain its priority position, at least in part.  In Sovereign Bank v. Gillis, the Appellate Division reversed the trial court which had held that the holder of a mortgage securing a home equity line of credit was in first position following the refinance.

In May 1998, Washington Mutual Bank (“WaMu”) lent Joseph and Eulalia Gillis (the “Gillises”) $650,000.00 to purchase a residential property in Warren Township. The loan was secured by a first mortgage.  In March 2003, the Gillises obtained a home equity line of credit from Independence Community Bank (“Independence”) for $500,000.00 which was secured by a second mortgage.  In January 2005, the Gillises borrowed $1.19 million from WaMu.  The proceeds were used to pay off the existing WaMu loan ($482,023.67) and the Independence Line of Credit ($499,921.93).  The Independence Line of Credit was not closed and the mortgage in favor of Independence was not discharged.  The Gillises continued to borrow funds under the Independence Line of Credit.  Ultimately, the Gillises defaulted on both obligations.  The WaMu Mortgage was assigned to Deutsche Bank National Trust Company (“Deutsche Bank”).  The Independence Mortgage was assigned to Sovereign Bank.

Deutsche Bank and Sovereign Bank both filed foreclosure actions.  The trial court held that the Independence Mortgage was in first position.  The court held that Deutsche Bank was not entitled to invoke the doctrine of equitable subrogation because it was aware of the Independence Mortgage at the time of the refinance.  Under the doctrine of equitable subrogation, a lender providing funds to satisfy a prior obligation may be able to assert the priority position of that obligation.

The Appellate Division reversed, holding that Deutsche Bank was entitled to priority pursuant to the principles of modification and replacement of mortgage.  That doctrine is set forth in the Restatement (Third) of Property – Mortgages, Section 7.6, comment (e) (1997), which states that “where a mortgage loan is refinanced by the same lender, a mortgage securing the new loan may be given the priority of the original mortgage under the principles of replacement and modification of mortgages.”  The Appellate Division discussed the doctrine of equitable subrogation whereby a new lender can assert the priority position of a lender whose obligation was satisfied through the funds it advanced so that the holder of the intervening encumbrance is not unjustly enriched at the expense of the new mortgagee.  The court determined that equitable subrogation did not apply because the same lender was the mortgagee under the original and refinanced loans.

The Appellate Division held that Deutsche Bank was entitled to invoke the principles of modification and replacement of mortgages to maintain its first position.  The court held that to allow Sovereign to assert a first priority position would constitute an undeserved windfall.  The issue left undecided was the extent of priority to be granted to Deutsche Bank.  The court offered three options: (1) $650,000.00, the original amount of the first WaMu loan; (2) $534,000.00, the balance due at the time of the Independence loan in 2003: or (3) $482,000.00, the amount outstanding at the time of the refinance in 2005.  The Appellate Division remanded the matter to the trial court to determine which amount was appropriate.

When refinancing a first mortgage, the lender should make sure that all existing liens are either discharged or subordinated.  While the doctrine of equitable subrogation and the principles of modification and replacement of mortgages may protect the lender if a lien is not discharged, a prudent lender should make sure that if a home equity line of credit is being paid off the line is closed and the mortgage is discharged.  If the line of credit is not being paid off, the lender should obtain and record a subordination agreement.  The same is true for any judgments of record.  If judgments are being satisfied, they should be discharged of record.  If a judgment is not being satisfied, the lender should obtain and record a subordination of the judgment.