The foreclosure purchase by the equity of redemption holder or other junior interests: when should principles of fairness and morality trump normal priority rules?

• Author: Nelson, Grant S.
• Position: Symposium: A Festschrift in Honor of Dale A. Whitman

1. INTRODUCTION

   I am both delighted and honored to be able to participate in this celebration of Dale Whitman's forty years as an outstanding teacher, dean and scholar. Our relationship goes back to 1973, when Roger Noreen, a vice president at West Publishing Co (now West Group) asked the two of us to consider doing a real estate finance casebook together. Dale and I had never met, but within a few days we had a long telephone conversation during which we agreed to collaborate on the casebook project. As they say, "the rest is history." The Nelsons have enjoyed an almost thirty-five year close friendship with Dale and his family. I have been equally blessed by a long and fruitful professional partnership during which Dale and I have worked together on numerous books and articles and as co-reporters on the Restatement (Third) of Property: Mortgages. Needless to say, Roger Noreen had a major impact on our lives.

   Real estate finance law is a natural fit for Dale. Teaching mortgage law is in many respects like teaching math or algebra. Like algebra, mortgage law is both logical and analytically demanding. Both subjects employ certain basic rules. Moreover, to understand and apply mortgage law, one must have skills that are similar to those required in mastering algebraic formulae and solving algebraic word problems. As teachers we spend countless hours pressing students on the law of mortgage priorities and the maximum amount that a rational person should bid at a foreclosure sale. On this subject we emphasize two rules. First, we stress that a validly conducted foreclosure of a senior mortgage wipes out all junior interests in the foreclosed real estate. (1) Consequently, the purchaser may rationally bid up to the fair market value of the property because she will purchase a title free and clear of liens. Second, we emphasize that a valid foreclosure of a junior mortgage is subject to all senior interests in the real estate. In other words, senior liens and other senior interests will continue to encumber the title in the hands of the foreclosure purchaser. (2) Consequently, in calculating the maximum foreclosure bid, a rational purchaser should subtract the amount of any senior liens and other interests from the fair market value of the land.

   Dale is superbly qualified for the foregoing task because in an earlier life he was a practicing electrical engineer. Thus, the analytical and logical side of Dale's brain is a perfect match for much of what we do as teachers and scholars of mortgage law.

   There is another important reason why mortgage law and Dale are uniquely suited to each other. Mortgage law, after all, is more than the sum of logic and analytical rigor--its origins are significantly rooted in fifteenth century English chancery (Equity). (3) Moreover, "the chancellor was usually a great ecclesiastic, learned in the canon and moral law." (4) Consequently, mortgage law has always been deeply rooted in and tempered by concepts of justice and fairness. For example, Equity recognized early that a mortgagor in default has an "equity of redemption" which may only be cut off by a valid foreclosure. (5) Moreover, mortgage law will not enforce an ex ante agreement of the parties to dispense with foreclosure in the event of mortgagor default. (6) This prohibition against "clogging the mortgagor's equity of redemption" has been a fixture of mortgage law for several centuries.

   Here is where another side of Dale's persona is compellingly important. He is a deeply moral and principled person. Part of this surely stems from his Mormon religion and the fact that he has served it virtually all of his adult life both as a pastor and an administrator. But Dale is more than the product of his religion. Everyone who comes into contact with him quickly senses that he is a genuinely caring and compassionate person who exudes integrity. Moreover, as one who has been Dale's friend for over three decades, I can attest that not only does Dale's character survive first impression, the more one deals with him, the more one senses that he is an exceptionally moral man.

   In sum, while Dale, as an engineer, brings to mortgage law a highly analytical and logical approach, it is always tempered, like mortgage law's equitable underpinnings, by an overriding and deep concern for normative fairness and morality. For me, it is a bit disappointing that this bimodal approach to mortgage law at least initially eludes students. One example from the classroom stands out in this regard. Each year when I teach foreclosure and mortgage priority, I start with the rule explained earlier that a valid foreclosure of a senior mortgage destroys junior liens and other junior interests in the real estate. After substantial class discussion, a student will ask the inevitable question: "Why shouldn't a mortgagor in default simply wait to act until the foreclosure sale and then attempt to be the successful foreclosure purchaser? At that point, after all, he will own the real estate free and clear of preexisting junior liens." Of course, if mortgage law were purely logical, the student's intuition would be correct. But, as we see later in this paper, this is a situation where logic is often tempered by fairness concerns. My initial response is to request that the student hold this question until the issue is confronted specifically later in the course. Nevertheless, I do raise some preliminary questions. I ask whether such an approach seems too good to be true. I also ask whether a mortgagor should be rewarded for breaching his promise to pay promptly. Usually I also interject the law professor's favorite maxim that "perhaps one should not be able to accomplish in two steps what cannot be accomplished in one."

   The foregoing leads to the major question posed by this paper--when should the logic of mortgage foreclosure law and its priority rules be trumped by an overriding concern for fairness and morality? This question is uniquely suited to a symposium dedicated to Dale Whitman's career as a teacher and scholar. This paper examines this question in two distinct contexts. In Part II of this paper, the focus is on whether the mortgagor or other holder of the equity of redemption (7) who purchases the property at the foreclosure sale of a senior lien acquires a title free and clear of junior interests. Part III examines whether the holder of a junior interest who purchases at a foreclosure sale of a senior lien acquires a title free and clear of the mortgagor's equity of redemption and other interests that were junior to the foreclosed lien. Part IV offers a brief conclusion.

2. FORECLOSURE PURCHASE BY THE HOLDER OF THE EQUITY OF REDEMPTION

   This Part focuses on a variety of fact situations where the original mortgagor or the holder of the equity of redemption purchases at the foreclosure of a senior mortgage or other lien. In each case, the purchaser claims that she owns the land free and clear of any liens that were junior to the foreclosed lien. In response, we assess whether normal foreclosure rules should apply or whether fairness or moral considerations dictate a contrary result.

   1. Mortgagor Purchase at a Foreclosure Sale of a Senior Lien

      The textbook or paradigm case is the purchasing mortgagor who asserts the destruction of a junior mortgage where the mortgagor is personally liable on its underlying obligation. Consider the following illustration from section 4.9 of the Restatement (Third) of Property: Mortgages:

      Mortgagor borrows money from Mortgagee-1 and gives Mortgagee-1 a promissory note secured by a Mortgage on Blackacre. The mortgage is immediately recorded. Mortgagor then borrows money from Mortgagee-2 and gives Mortgagee-2 a promissory note secured by a mortgage on Blackacre. The latter mortgage is immediately recorded. Mortgagor later goes into default on the obligation secured by the mortgage to Mortgagee-1 and Mortgagee-1 validly accelerates that obligation and forecloses its mortgage. Mortgagor purchases Blackacre at the foreclosure sale. Mortgagee-2 still has a valid lien on Blackacre. (8) Indeed, some courts go so far as to characterize a mortgagor's purchase at a senior foreclosure sale as constructively fraudulent vis-a-vis the junior lienor. (9) A focus on terminology is important in this connection. Under the foregoing illustration, the junior lien survives rather than revives because it was not destroyed by the senior foreclosure in the first place.

      What is the justification for a departure from the normal rule that a foreclosure purchaser acquires a title free and clear of all interests that were junior to the lien that was foreclosed? First, courts frequently employ the payment theory. Under this reasoning,

      the mortgagor is in effect paying the first mortgage and the second mortgage moves into first position. This is what would have occurred if the mortgagor had paid the first mortgage when it became due. If payment after foreclosure were to alter this result, the mortgagor would be profiting by his own wrong in failing to pay when due. (10) Second, some courts emphasize the "warranties of title" concept. Under this approach,

      the [junior] mortgage ... usually contains a warranty that the mortgagor agrees that he will defend the title against all lawful claims. Permitting the foreclosure of the first mortgage is a breach of warranty to defend the title. Even if the [junior mortgagee] takes subject to the first mortgage, it has been held that the warranty to defend title is not affected by the reference to the first mortgage. (11) The Restatement endorses both of the foregoing rationales in taking a "pro-survival" approach: "Where a mortgagor is personally obligated on a junior lien, or where the mortgage simply contains the usual warranties of title, it would be undesirable and inequitable to allow the mortgagor to profit by violating those obligations." (12)

      Finally, survival is justified where there is a provision in a...