Restructuring

Typically, “no signature means no signature.”  That is to say, in the context of a residential mortgage, you can’t be held liable for a mortgage that you did not sign.  “That’s obvious!” you’re probably thinking to yourself.  Not so fast.  The D.C. Circuit recently held in In re Stevenson that, in narrow circumstances, equitable subrogation permits a lender to enforce a mortgage against a property co-owner who refused to sign the mortgage, even where the bank had actual knowledge that the co-owner was refusing to sign. 
Refusing to Sign
The debtor and her son refinanced a jointly owned a house in Washington, D.C with a 2005 loan from Wells Fargo for $135,000 with a 6.5% interest rate.  In exchange for the new mortgage, both the debtor and her son signed a deed of trust giving Wells Fargo certain rights to the house if they failed to repay the mortgage.  Fast-forward a few months, and the debtor, in need of cash, refinanced the home again, this time with Freemont Investment and Loan.  The terms of the second financing provided for a $135,000 mortgage with a 9.65% interest rate and a $6,000 cash payment up front to the debtor.
It is during this second refinancing that our story takes an interesting turn. The debtor’s son refused to sign the paperwork for the Freemont mortgage because he thought that the interest rate was too high.  Despite having actual knowledge that they lacked a signature on the mortgage from one of the co-owners of the property, Freemont went ahead with the loan to the debtor.  In exchange, the debtor alone signed a deed of trust that gave Freemont certain rights to the house if she failed to repay the mortgage.  The debtor’s son did not sign the deed of trust, and Freemont did not obtain any rights to the son’s half-interest in the house.  Freemont subsequently sold the mortgage to HSBC Bank.
This unusual series of events led to an odd result: without paying a cent, the debtor’s son ended up with a half-interest in the home free of both the Wells Fargo mortgage and the Freemont/HSBC mortgage.  Thus, when the debtor stopped making mortgage payments and declared bankruptcy shortly thereafter, HSBC could not foreclose on the home because the son had not signed the Freemont/HSBC deed of trust.  HSBC filed an adversary complaint in the bankruptcy court seeking a determination that it succeeded to the rights of the original mortgagee against the son under the principles of equitable subrogation.  The United States Bankruptcy Court for the District of Columbia agreed with HSBC’s position and the United States District Court for the District of Columbia subsequently affirmed that decision.  The debtor and her son appealed.
Equitable Subrogation Basics
The doctrine of equitable subrogation allows a court to declare that a mortgage holder has the same rights as an earlier-in-time mortgage holder on the same property if certain conditions are met.  As the doctrine’s name suggests, it is an equitable doctrine derived from non-bankruptcy law that is meant to prevent unjust enrichment.  Under D.C. law, equitable subrogation is available where the lender satisfies the following five prong test:

1.    The lender must have paid off the prior mortgage to protect its “own interest”
2.    The lender must not have “acted as a volunteer”
3.    The lender must not have been primarily liable for the prior mortgage
4.    The lender must have paid off the entire prior mortgage
5.    Subrogation would “not work any injustice to the rights of others”

The D.C. Circuit, reviewing the issue de novo, held that the first four prongs were straightforward.  First, Freemont/HSBC paid off the Wells Fargo mortgage to protect its own interest; that is, it paid the mortgage to ensure that it would have priority in any future foreclosure.  Second, Freemont/HSBC did not act as a volunteer because it advanced money intending to get something in return: priority position in a foreclosure.  Third, Freemont/HSBC was not liable for the Wells Fargo mortgage.  Fourth, Freemont/HSBC paid off the entire Wells Fargo mortgage.
The D.C. Circuit found the fifth prong, that subrogation not cause injustice, less straightforward.  Ultimately, the court settled on a compromise.  It held that the debtor’s son was liable on the Freemont/HSBC mortgage, but only for the balance of the prior Wells Fargo mortgage, and only at the lower interest rate of the Wells Fargo mortgage.  Applying equitable principles, the court held that it would be unjust were the debtor’s son to enjoy a windfall at HSBC’s expense.
What About Actual Knowledge?
“That makes no sense!” you might be thinking to yourself.  “Freedom of contract! Freemont had actual knowledge that Smith refused to sign!”  Recognizing that there was no binding D.C. precedent, the court considered this issue in the first instance and relied on two sources of authority to determine whether a plaintiff was entitled to equitable subrogation despite actual knowledge: a 1937 decision called Burgoon v. Lavezzo and the Restatement (Third) of Property.  Although neither Burgoon nor the Restatement addresses whether actual knowledge bars equitable subrogation, both authorities adopt a “liberal” application of the doctrine of equitable subrogation.  Using this liberal approach, the D.C. Circuit held that actual knowledge does not necessarily bar equitable subrogation.  In this particular instance, the court held that its decision was buttressed by the fact that Freemont/HSBC could have achieved the same result by taking an assignment of the original loan instead of paying it off.
The debtor and her son also had raised several defenses under D.C. and federal lending laws to the validity of the Freemont/HSBC mortgage, each of which was dismissed by the court.
So What Does It All Mean?
The D.C. circuit’s decision turned on a unique set of facts, so its precedential value is limited; however, the decision does establish the “liberal” approach to the doctrine of equitable subrogation as the rule in D.C.  Thus, it is likely that we may see courts rely on In re Stevenson to support the application of equitable subrogation to other fact patterns that do not fit squarely in the court’s five prong test but where allowing the plaintiff to step into the shoes of a prior lender is the “fair” thing to do.