A loan modification – while a favored loss mitigation strategy today – can come with certain risks, particularly in the context of subordinate liens. In concert with the elements of a loan modification agreement, subordinate liens may create priority issues that should be examined and resolved prior to entering into any new agreement.
Of course, prior to any modification, one should obtain a title search. If there are any liens on the property, then the law of each applicable state should be thoroughly examined.
Different states have different standards for when a lien may lose its priority. Some states look to whether the agreement results in what could be deemed ‘new money’ – that which would substantially alter the character of the original loan. Some states focus on whether subordinate lien holders are prejudiced and their security interest is negatively affected.
Some changes that benefit the borrower, such as a reduction in interest rate, do not impair the subordinate lien holder and, therefore, would not be an issue. However, some courts have taken a much broader position about what changes, absent the consent of subordinate lien holders, cause priority to be lost.
In 1942, the Arkansas Supreme Court discussed the question of whether a mortgage loses its priority if the mortgagee allows a renewal mortgage. The court in Tell v. Harnden found that priority is not affected when the debt is the same and the collateral is not released from the lien. Tell discussed a theory akin to equitable subrogation, as it relates to the restoration of priority, noting factors such as good faith and the absence of culpable negligence.
In a much more recent Arkansas case, Peoples Bank of Imboden v. Burgess (1997), the Arkansas Court of Appeals held that a bank lost priority, despite its intent not to do so, after it entered into an ‘extension agreement’ that reduced the interest rate and quarterly payments of an original note and mortgage.
In that case, the amount of the loan equaled the unpaid balances of three previous loans, and the bank provided receipts reflecting payment of the indebtedness on two of the loans. In affirming the lower court's decision that the bank had released its first lien, the court emphasized several factors, including the fact that new funds were used to pay off other loans, the interest rate was modified, and there were different parties to the transaction. In its decision, the court pointed out without further explanation that the bank could have taken steps to protect its status.
Cases such as First Fidelity Bank NA, N.J., v. Bock (1994) illustrate the effect of state statutes on these scenarios. In the case, the Superior Court of New Jersey looked to a statute under which a mortgage that has undergone modification relates back to the original mortgage for priority purposes. The court held that the issuance of subsequent promissory notes, coupled with the satisfaction of the original note, constituted loan modification.
The court noted that no new money was advanced, and that while the subsequent notes extended maturity dates and amended loan terms, the mortgagee and mortgagor never intended to release the mortgage, nor was it released on record.
The Restatement Third of the Law of Property, Mortgages, section 7.3(b), provides that if a senior mortgage (or the underlying obligation) is modified, the mortgage as modified retains priority against junior interests in the real estate, except to the extent that the modification is materially prejudicial to the holders of such interests and is not within the scope of a reservation of right to modify.
Looking at this general rule, as well as in the examples cited above, it is clear that if a loan modification is considered by a lender, a careful analysis of the applicable state law should be made. Servicers should explore all available options to avoid unintended consequences associated with the loss mitigation process.
Samuel S. High is an attorney in the litigation department of Wilson & Associates PLLC. He can be contacted at shigh@wilson-assoc.com.
