No Equitable Subordination of Liens in Pennsylvania

Posted by NCBRC - March 20, 2020

Neither Pennsylvania nor the Third Circuit apply the doctrine of equitable subordination to reprioritize a junior lien over a modified senior lien. Hamilton v. Pa. Hous. Fin. Agy., No 18-5417 (E.D. Pa. March 5, 2020).

The debtors had a home mortgage for $145,000. They defaulted on their mortgage and applied for Homeowner’s Emergency Mortgage Assistance (HEMAP). Through that program, they entered into an open-ended mortgage with the Pennsylvania Housing Finance Agency (PHFA) which operated as a line of credit with a principal of $51,000. PHFA then satisfied the mortgage arrearage and maintained the mortgage through April, 2013. In May, 2013, the then-current mortgage holder obtained a judgment of foreclosure against the debtors in the amount of $139,447.26. After that, the debtors and the mortgage assignee, entered into a modified agreement which the debtors later defaulted on. When the creditor sought to foreclose, the debtors filed for chapter 13 bankruptcy. PHFA filed a claim for over $18,000 and the mortgage creditor filed a claim for over $189,000. Because the mortgage lien exceeded the value of the property, the debtors moved the bankruptcy court to find the PHFA junior debt wholly unsecured under section 506(a).

PHFA argued that its claim should be prioritized over the mortgage lien because the modification took place after PHFA had recorded its lien and the modification changed significant terms of the senior lien, including maturation date and interest accrual. PHFA maintained that allowing a senior lienholder to increase the debt owed to it prejudices junior lienholders who extended credit in reliance on the earlier recorded lien. PHFA further argued that state recording laws are intended to put subsequent lenders on notice of the existence and extent of prior encumbrances and that allowing the senior lienholder to alter the terms of its loan defeats that purpose.

The bankruptcy court found that no law required a lienholder to notify junior lienholders of a loan modification, and that neither Pennsylvania courts nor the Third Circuit have applied “equitable subordination” of the senior creditor’s lien in circumstances like those before the court. On that basis, the bankruptcy court found PHFA’s lien to be wholly unsecured and valued at zero.

On appeal, the parties agreed that, in Pennsylvania, liens are prioritized in the order in which they are recorded and that recording laws are intended to provide notice of prior encumbrances. The district court, therefore, was asked to determine whether, in light of these precepts, it should apply the equitable subordination doctrine, or section 7.3 of the Restatement (Third) of Property (Mortgages), which provides that “a court may subordinate a senior lien to a junior creditor’s interest when material modifications to the senior lien ‘materially prejudice’ the junior lienholder’s interests.”

It found no decision from the state supreme court that was on point. Turning to lower state courts for guidance, the court considered Newcrete Products v. City of Wilkes-Barre, 37 A.3d 7, 15 (Pa. Commw. Ct. 2012), which flatly stated that Pennsylvania does not apply the equitable subordination rule. That court described only two instances in which a junior lien’s priority may be subject to change: “(1) to reorder creditors’ liens before distribution in federal bankruptcy proceedings to remedy the inequity caused when a company insider obtains a priority position in bankruptcy over outside creditors through inequitable conduct; and (2) when a party has satisfied an encumbrance, to allow it to assume the same priority position as the holder of the prior encumbrance to prevent unjust enrichment.”

Based on this indication that Pennsylvania does not apply the doctrine of equitable subordination or the similar concept expressed in section 7.3 of the Restatement, the district court found that the bankruptcy court did not err in declining to do so in this case. It affirmed.

The Philadelphia Unemployment Project (PUP) filed an amicus brief in support of the debtors.

Hamilton ED Pa March 2020

Tags: ,

Post a Comment

You must be logged in to post a comment.