Disbursement of surplus proceeds from a foreclosure sale - the urban myth of the race to the courthouse.

• Author: Perlin, Asher

Financial industries have a way of generating urban myths that lead people to believe that they can manipulate the system to obtain wholly unjustified windfalls.

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An urban legend is usually a (good/captivating/titillating/engrossing/incredible/worrying) story that has had a wide audience, is circulated spontaneously, has been told in several forms, and which many have chosen to believe (whether actively or passively) despite the lack of actual evidence to substantiate the story. (1)

They're unlikely, bizarre, creepy, or funny stories, often involving some kind of corporate ... or personal ... conspiracy, payback, hoax, or intrigue. (2)

Examples of urban legends include:

* A borrower wipes out her debt by mailing in the last coupon in the payment book with her first payment. (3)

* "Enterprising crook scams money by leaving blank deposit slips imprinted with his account number in the bank." (4)

* A debtor discharges his debt by sending the creditor a check for a fraction of the debt with the words "paid in full" written on the face of the check. (5)

These urban legends, also known as urban myths, are amusing because, despite being unlikely or bizarre, they are almost believable; and we can all imagine someone having the audacity to try to pull off one of these swindles. Also, in the particular examples cited above, it is not only conceivable that they would work, but the underlying "theory" of each scam seems viable. For example, by depositing the check for a fraction of the debt, isn't the creditor accepting the partial payment as a full satisfaction?

Unfortunately, in our practice, we have repeatedly encountered another myth that has in fact "worked"--not only at first blush, but even through to final judgment--until reversed on appeal. As explained below, the result is bizarre; still, many have had the audacity to pull it off."

A debtor's lawyer convinces the trial judge to disburse the surplus from a foreclosure sale to the debtor or the lawyer, despite the fact that outstanding claims of superior creditors remain unsatisfied.

The scenario works like this: A borrower defaults on a mortgage loan. The mortgagee files a foreclosure against the real property securing the loan and names inferior lienholders as defendants. Upon the completion of the foreclosure, the clerk of the court sells the property to satisfy the mortgagee's judgment. The sale nets more money than the amount owed to the first mortgagee. This excess is called a "surplus."

It has long been the law in Florida that any surplus remaining after a foreclosure sale should be paid to the junior lienholders in accordance with the priority of their liens on the property and that only after the liens have been satisfied may any surplus be disbursed to the owner of the equity of redemption. (6)

This rule seems elementary. Any surplus generated by the sale should be used to satisfy the debts owed to the junior secured creditors; and only if additional proceeds remain after these distributions should the borrower receive any share in the sale proceeds. However, mistaken, overzealous, and sometimes dishonest debtors' lawyers frequently convince courts to distribute surplus proceeds to the mortgagors, leaving the junior secured creditors with no security and no means of enforcing their claims. Likewise, lawyers representing junior creditors will often improperly seek disbursement to their clients regardless of their lack of priority.

Like the myths mentioned above, the mistake is obvious, but only after some thought. Nonetheless, trial judges are frequently misled into ordering disbursement to junior interest holders, including junior creditors, debtors, or lawyers. This error would clearly be (and has consistently been) reversed upon appeal. However the reversals come at great expense to the parties and to the judicial system. More significantly, these wrongful distributions often go unchallenged because creditors know that any appellate victory will be pyrrhic. By the time the order is reversed, the proceeds (and the security) are usually long-gone. This article aims to educate lawyers and judges alike regarding the correct priorities, rules, and procedures for distribution of foreclosure sale surplus when junior secured creditors and mortgagors compete for the funds.

Urban Myths That Lead to Wrongful Distributions

To understand how to avoid these wrongful distributions, we should explain how they occur in the first place.

1. The default myth and its variations.

   When a borrower goes into default, the first mortgagee will often file a foreclosure complaint naming the mortgagor and all junior lienholders as defendants. Knowing that they have no defense against the senior lienholder's claim to priority, junior lienholders sometimes ignore the complaint or fail to respond to subsequent pleadings. Lawyers and judges mistakenly view this failure to respond not only as implicitly conceding to the first mortgagor's seniority but also as a default respect to the junior creditor's own claim to the security and any surplus. This misunderstanding is neither consistent with the rules of civil procedure nor with substantive foreclosure law.

   If a party defaults in an ordinary civil case, the failure to respond is deemed an admission of the allegations of the complaint. Fla. R. Civ. P. 1.500; Wiseman v. Stocks, 527 So. 2d 904 (Fla. 1st DCA 1988). In the foreclosure context, when a junior creditor fails to respond to a senior creditor's complaint, all this means is that the junior creditor is admitting that the senior creditor's claim is, in fact, senior to its own. It does not constitute an admission that the junior creditor has no claim to the property because the senior creditor would have no need to make such an allegation. In fact, the reason the junior creditor was named was because it does have a claim to the property, albeit inferior to that of the foreclosing party.

   In Schroth v. The Cape Coral Bank, 377 So. 2d 50 (Fla. 2d DCA 1979), the property owners failed...