Foreclosing Lender's Failure To Serve Junior Lienholder Leaves Latter With Major Windfall

A recent ruling by the Indiana Supreme Court may be of some interest to title agents and examiners (who are already in the unenviable position of being expected to insure title to homes that have a foreclosure judgment and foreclosure deed in its chain of title), and to some real estate operators (those who profitably dabble in the "trafficking" of seemingly worthless junior liens on properties in foreclosure).

In a nutshell:

• A mortgage holder foreclosed its mortgage, took title to the subject property at a sheriff's sale, and then sold the property to a third party;



• The foreclosing mortgagee subsequently discovered it had inadvertently failed to name a junior lienholder in the foreclosure action.



• The foreclosing mortgagee then went back into court and got the judge to order the junior lienholder to either redeem its interest by paying off the foreclosing mortgagee or lose its lien foreever.



• The junior lienholder appealed, and the Indiana Court of Appeals reversed.(1)



• On review, the Indiana Supreme Court, while disagreeing with the legal reasoning employed by the Court of Appeals, reached the same end result.



• It essentially said that the foreclosing lender's failure to name the junior lienholder in the foreclosure action without a good reason to explain the omission allows the latter's lien on the property both to:
  
  a) survive, and
  b) move up in priority with respect to its claim on the foreclosed property.
  


• The state high court stated that, given the facts of the case, the equitable remedy of strict foreclosure / reforeclosure was unavailable to the foreclosing mortgagee, and the doctrine of merger was applicable.(2)
(which operated to obliterate any claim of priority that the senior (foreclosing) mortgagee may have had over the junior lienholder).


• Consequently, the foreclosing mortgagee was stuck with a property encumbered by the debt secured by the junior lien.(3)

For the ruling, see Citizens State Bank of New Castle v. Countrywide Home Loans, Inc., No. 76S03-1009-CV-515 (Ind. June 29, 2011).

(1) Citizens State Bank of New Castle v. Countrywide Home Loans, Inc., 922 N.E.2d 655 (Ind. Ct. App. 2010).

See also, Sloppy Service, Subsequent Title Transfer In Foreclosure Process Leaves Lender Holding The Bag On $111K+ Error.

(2) However, in the following excerpt from the ruling, the state high court added that had there been no screw-up on the part of the foreclosing mortgagee in naming the junior lienholder in the foreclosure action, the result in this case may have been different (bold text is my emphasis, not in the original text):

• We hasten to add that although the mortgagee's intent is the primary consideration in determining whether a merger has occurred, there may be circumstances under which the equitable remedy of strict foreclosure may nonetheless be appropriate.
  
  For example, this is not a case in which a junior lienholder was not joined in the foreclosure action because of an indexing error resulting in the lien not appearing in the court records. See U.S. Bank of Wash. v. Hursey, 806 P.2d 245, 247 (Wash. 1991) (declaring that a "reforeclosure" was appropriate where a junior lienholder was omitted from a foreclosure action because of indexing error by the court clerk's office).
  
  Were such facts before us, then the outcome of this case very well may have been different.
  
  Instead, the record is clear that Citizen Bank's lien on the property was properly recorded and indexed. Other than essentially declaring mistake or inadvertence Countrywide does not explain why the lien was overlooked. In sum, Countrywide has failed to demonstrate that it is entitled to the remedy of strict foreclosure.

(3) It is undeniable that there are plenty of junior lienholders that have ostensibly been foreclosed by the owner/holder of a superior 1st mortgage. If the junior lienholder was not served in the foreclosure action, this case appears to state that the junior lienholder will score a windfall.

Further, if there was "sloppy" service attempted on the junior lienholder that was so ineffectual so as to render it void (or at least voidable), this ruling may support the same proposition, although the court did not specifically address the issue of defective service of process.

One thing is clear, however:

• title examiners, agents, insurers (at least in Indiana, and possibly elsewhere) have one more issue to sweat about when underwriting a title insurance policy on a foreclosed property,


• buyers of homes that have a foreclosure sale in their chains of title have one more source of possible surprise and chagrin, and


• clever real estate operators who seek out and buy junior liens (usually at a steep discount) may have found one more potentially profit-pocketing opportunity available to them.