Sovereign Bank v. Gillis, A-5132-11T2; Appellate Division; opinion by Sabatino, J.A.D.; decided and approved for publication July 3, 2013. Before Judges Parrillo, Sabatino and Maven. On appeal from the Chancery Division, Somerset County, F-048348-10. DDS No. 15-2-0519 [23 pp.]

This appeal concerns whether a refinancing lender that discharges its own previous mortgage and issues another mortgage loan, and simultaneously pays off the balance owed on a junior lienor's line of credit without having it closed, can rely on equitable principles to maintain its priority over that junior lienor.

In May 1998, defendants Joseph and Eulalia Gillis borrowed $650,000 from Washington Mutual Bank, FA (WaMu) to finance the purchase of a residential property. WaMu secured the loan with a purchase-money mortgage, which was recorded in the first position of priority. In December 1998, the Gillises obtained a home-equity line of credit from Broad National Bank, secured by a mortgage recorded in the second position. In October 2001, the Gillises obtained funding from Crown Bank, NA, secured by a mortgage recorded in the third position.

On March 18, 2003, the Gillises obtained another home-equity line of credit, from Independence Community Bank for the sum of $500,000, also secured by a mortgage. Independence required that the proceeds be used to discharge the two pre-existing debts. Consequently, the March 18, 2003, line of credit with Independence stood in a second lien position behind the May 1998 WaMu purchase-money mortgage.

In January 2005, the Gillises refinanced their mortgage loans, borrowing $1.19 million from WaMu, secured by another mortgage on their property. The principal amount from this refinancing was used to pay off the Gillises' remaining debt secured by the original WaMu purchase-money mortgage and the Independence line-of-credit mortgage. However, WaMu failed to obtain written authorization from the Gillises to close out the Independence line of credit. Consequently, the mortgage on that line of credit was not discharged of record. The WaMu refinanced mortgage was instead recorded behind the Independence line-of-credit mortgage. The Gillises continued to borrow funds under the Independence line of credit. Ultimately, the Gillises defaulted on both the WaMu refinanced mortgage loan and the Independence line of credit.

Pursuant to a January 2010 assignment, appellant Deutsche Bank National Trust Company began holding the WaMu refinanced mortgage. The mortgage on the Independence line of credit was assigned to respondent Sovereign Bank.

Deutsche filed a foreclosure action against the Gillises on the defaulted WaMu refinanced mortgage. Sovereign likewise filed a foreclosure action on the defaulted line of credit.

The trial court granted summary judgment to Sovereign and held that the Independence line of credit has priority over the WaMu refinanced mortgage. Because WaMu had actual knowledge of the Independence line of credit when it paid off the balance on that loan as part of the refinancing, the court concluded that WaMu could not equitably maintain any priority over the Independence loan.

Held: Applying principles of "replacement and modification" and "material prejudice" recognized in the Restatement (Third) of Property — Mortgages (1997), the appellate panel reverses the trial court's decision allowing the junior lienor that had extended the line of credit to vault over the priority of the refinancing mortgage lender.

Deutsche urges reversal of the trial court's decision and application of the equitable remedy of priority, despite WaMu's admitted awareness of the Independence loan at the time of the refinancing. Deutsche contends that the "actual knowledge" exception, at least as applied in these circumstances, unfairly bestows a windfall on the original junior lienor, Independence, and its assignee, Sovereign. Deutsche argues that the actual-knowledge principle wrongfully penalizes a refinancing lender such as WaMu that knowingly pays down a junior debt in full.

Deutsche relies on principles of equity set forth in the Third Restatement, including comment (e) to § 7.6, 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." As the Third Restatement explains, "subrogation cannot be involved unless the second loan is made by a different lender than the holder of the first mortgage; one cannot be subrogated to one's own previous mortgage." The Third Restatement further instructs in comment e to § 7.6 that "[w]here 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 panel finds that because the refinanced mortgage loan in 2005 was provided by the same lender — WaMu — as the original 1998 senior mortgage loan, the priority analysis can be guided by principles of "replacement" and "modification." The lender's actual knowledge of an intervening lien is not a bar to its reliance on equitable principles of priority. Priority for the refinancing lender is appropriate here.

In this context of modification and replacement, the critical question of priority turns on whether the junior lienor, Sovereign, has been materially prejudiced. Actual or constructive knowledge by the refinancing lender, if it is the same original lender or its corporate successor, should be irrelevant. Consequently, summary judgment entered here in favor of Sovereign, which was predicated on a finding of WaMu's actual knowledge, must be reversed. To do otherwise would allow Sovereign to reap an undeserved windfall, particularly since WaMu paid off not only its original mortgage but also paid down in full the balance on the Independence line of credit. On remand, the trial court is directed to determine the proper extent of the refinancing lender's priority, in an amount that avoids material prejudice to the junior lienor.

For appellant — Robert L. Grundlock Jr. (Rubin, Ehrlich & Buckley). For respondent — Vladimir Palma (Phelan Hallinan & Diamond).