Appellate Court Aids Negligent Mortgage Lenders by Rejecting “Gross Negligence” Exception to Equitable Subrogation Rule

Thanks to a recent appellate court decision, refinancing mortgage lenders in New Jersey who seek to subrogate to an original mortgagee’s position, but are negligent in discovering intervening judgment liens, can rest easier and not worry that their liens will be subordinated.

In Investors Savings Bank v. Keybank National Association, 2012 WL 762087 (N.J. Super. App. Div. March 12, 2012), Denis Kelliher (“Kelliher”) sought to refinance the mortgage held by 1st Constitution Bank (“1st Constitution”) on his residential property.  In the summer of 2008, Kelliher submitted a loan application to Investors Mortgage Company (“Investors”), the predecessor-in-interest to the plaintiff, in which he stated that he had not defaulted on any loan and was not a party to any lawsuit.  A title search performed by Investors’ title agent, Quality Closing Services (“Quality”), on August 1, 2008, did not reveal the existence of any judgments against Kelliher.  At the time, however, Kelliher had defaulted on a business loan from and was sued by Keybank National Association (“Keybank”).

Keybank obtained a multimillion dollar judgment against Kelliher and recorded it on September 30, 2008.  Three (3) days later, Quality conducted the closing on Investors’ loan to Kelliher.  At the closing, Kelliher provided an affidavit falsely stating that no judgments had been entered against him.  Quality did not conduct an updated title search, which might have revealed the existence of the Keybank judgment.  Investors eventually recorded its mortgage on October 21, 2008.  Several weeks later, Keybank notified Investors of the existence of its judgment lien and claimed priority over Investors’ mortgage.

Investors filed suit against Keybank in the Superior Court of New Jersey for a declaration that its mortgage had priority over Keybank’s judgment lien, pursuant to the doctrine of equitable subrogation.  The trial court ruled in Investors’ favor, reasoning that Keybank would have been in the same subordinate position if the refinancing had not occurred.  Keybank appealed the trial court’s ruling to the Appellate Division.

The court in Investors Savings Bank began its analysis by stating that pursuant to the doctrine of equitable subrogation, “a mortgagee who negligently accepts a mortgage without knowledge of intervening encumbrances will subrogate to a first mortgage with priority over the intervening encumbrances to the extent that the proceeds of the new mortgage are used to satisfy the old mortgage.”  In that event, the new mortgagee assumes the same priority afforded the old mortgagee.  An exception to this rule exists, however, where the new mortgagee possesses “actual knowledge of the prior encumbrance.”

Keybank failed to uncover any evidence that Investors had actual knowledge of Keybank’s judgment lien.  Thus, the main issue on appeal was whether, as Keybank argued, Investors’ “gross negligence” in failing to discover the existence of Keybank’s judgment lien precluded the application of equitable subrogation.  Although the court in Investors Savings Bank initially questioned whether Quality’s negligence rose to the level of “gross negligence,” it ultimately concluded that the degree of Quality’s negligence was irrelevant.  As long as Investors had no actual knowledge of Keybank’s judgment lien, the court held, it was entitled to subrogate to 1st Constitution’s first lien position.  Accordingly, the court affirmed the trial court’s decision.

Obviously, the court’s decision in Investors Savings Bank is no substitute for the proper exercise of due diligence, and mortgage lenders in New Jersey must continue to take all necessary investigatory measures before closing on a refinancing loan.  Nevertheless, where an intervening judgment lien goes unnoticed at closing, the refinancing lender’s lien priority will likely not be affected.