February 11, 2009
Ellen Sharp

 

Banks that extend lines of credit or revolving notes secured by mortgages to borrowers who subsequently enter into lending relationships with third party lenders can run into trouble enforcing those mortgages. Recently, a Lexington bank (“First Bank”) that had issued a line of credit to a borrower secured by a mortgage on the borrower’s residence fell victim to an intractable judge while trying to enforce that mortgage. Borrower had subsequently entered a lending relationship with a second bank (“Second Bank”), and indicated to Second Bank that it would pay off the line at First Bank with the proceeds of the Second Bank loan. Second Bank approved the loan and disbursed the funds to the borrower, who did, in fact, pay off the line of credit with First Bank. Borrower never requested that the line be closed, and the terms of the loan documents did not require that First Bank close the line; hence, First Bank left the line open. Upon request of the borrower, First Bank later made further advances on the line, secure in the fact that its mortgage remained valid and enforceable. When the borrower’s financial condition ultimately turned sour, Second Bank foreclosed. First Bank asserted its mortgage as superior based on prior recording, but Second Bank argued that First Bank was required to release its mortgage when Second Bank provided funds to pay off the line of credit.

In 1992, the Kentucky Legislature passed a law intended to protect holders of mortgages securing lines of credit or revolving notes. Although it is in the nature of a revolving note or line of credit to have a fluctuating balance as draws and payments are made, there previously existed some confusion regarding the effect of a zero balance on the continued enforceability of the mortgage, as well as the lender’s obligation to release it. The statute, KRS 382.385, was intended to provide clear direction on the continued enforceability of such a mortgage. Accordingly, KRS 382.385(2)(b) specifically provides that “the mortgage shall remain in full force and effect until released of record as provided in subsection (5) of this section and the validity, continued effectiveness, and priority of the mortgage shall not be affected or impaired by the fact that no loan, advance, or extension of credit is made at the time of the execution or recordation of the mortgage, or that the outstanding balance due under the line of credit or revolving credit plan secured by the mortgage is zero at any time or times.” The statute makes it clear that a mortgage securing a revolving note or line of credit is not rendered invalid or unenforceable if at any time the loan has a zero balance.

Having settled that a zero balance does not affect the enforceability of a mortgage securing a revolving note or line of credit, the statute then goes on to explain under what circumstances a lender is required to release the mortgage. KRS 382.385(5) directs that the mortgage be released under two circumstances:
“(a) if the line of credit or revolving credit plan is closed or terminated in accordance with its terms and all amounts owed by the debtor thereunder are paid in full; or
(b) upon the written request to release the mortgage signed by all debtors or their agents obligated under the line of credit or revolving credit plan, which notice shall be sent by certified mail, return receipt requested, or physically delivered to the lender…”

In the case discussed in the introduction hereto, under KRS 382.385(2)(b), First Bank’s mortgage was not rendered unenforceable due to the fact that a zero balance existed on the line immediately after the borrower used the funds from Second Bank to pay off the line. Similarly, under KRS 382.385(5), First Bank was not required to release the mortgage, as the line of credit was not terminated in accordance with its terms, nor did First Bank receive the notice prescribed by subsection (b). Despite the clear language of the statute, a Kentucky circuit court granted summary judgment to Second Bank, finding First Bank’s mortgage unenforceable, based at least in part on the fact that the payoff estimate provided by First Bank on the line included a $13.00 mortgage release fee. Second Bank claimed that it had relied upon that payoff quote and assumed that First Bank would release its mortgage. Similar cases in Indiana decided under a statute akin to KRS 382.385 found that the second lender who does not ensure that the first lender’s line of credit is closed is “culpably negligent.” See, e.g. Bank of America v. Ping, 879 N.E. 2d 665 (Ind. App. 2008); Dreibelbiss Title Co. v. Fifth Third, 806 N.E. 2d 345 (Ind. App. 2004). The Kentucky circuit court was not persuaded by either the plain language of KRS 382.385 or the Indiana precedent.

The lesson is clear that even an unambiguous statute can fail to protect a lender if a judge thinks the outcome is unfair. A lender contemplating a loan secured by a mortgage that will be used to pay off a previous lender’s line of credit should ensure that its borrower jumps through the appropriate hoops and causes the first lender to close the line. Otherwise, such lender could end up like First Bank in the case above, suddenly finding itself the holder of a very large and very unsecured claim against an insolvent borrower.