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Texas Supreme Court Holds Subrogation Available for Mortgagee That Fails to Cure Constitutional Defect

Answering a question certified to it by the U.S. Court of Appeals for the Fifth Circuit, the Supreme Court of Texas recently held that a lender is entitled to equitable subrogation where it failed to correct a curable constitutional defect in the loan documents under Tex. Const. art. XVI, 50.

A copy of the opinion in Federal Home Loan Mortgage Corporation v. Zepeda is available at:  Link to Opinion.

In 2007, the borrower obtained a loan from the original mortgagee to buy a homestead and secured the loan using her homestead as collateral.  In 2011, the borrower refinanced with a home-equity loan from another mortgagee. The borrower used the homestead as collateral, and the subsequent mortgagee paid the balance of the borrower’s original loan to the original mortgagee.

In 2015, the borrower notified the subsequent mortgagee that the loan documents did not comply with Article XVI, § 50 of the Texas Constitution because the subsequent mortgagee had not signed a form acknowledging the homestead’s fair market value. The borrower’s letter requested the subsequent mortgagee to cure the defect within 60 days as required by § 50. The subsequent mortgagee sent the borrower another copy of the fair-market-value acknowledgment but failed to sign it. The subsequent mortgagee later sold and assigned the loan.

The borrower sent the letter to the assignee notifying it of the constitutional defect and offering an opportunity to cure. The assignee did not respond, and the borrower sued to quiet title under the theory that the assignee failed to cure the constitutional defect in the loan documents within 60 days of notification, and therefore the assignee did not possess a valid lien on her property.

The assignee argued that it is subrogated to the original mortgagee’s lien because its assignor paid off the balance of the original mortgagee’s loan to the borrower. Both parties moved for summary judgment.

The federal trial court granted the borrower’s motion and denied the assignee’s motion. The court concluded that the assignee was not entitled to equitable or common law subrogation because it was negligent in failing to cure the constitutional defect in the loan documents.

The assignee appealed. 

On appeal, the U.S. Court of Appeals for the Fifth Circuit observed that it “has applied equitable subrogation in the face of a constitutionally-invalid home-equity loan” “[s]ince at least 1890,” but none of the rulings “involve[d] a constitutional defect that is exclusively the fault of the lender, as is the case here” and interpreted prior rulings as being silent on the question: “If the party seeking equitable subrogation could have satisfied the requirements of § 50(a)(6)(Q)(ix) but failed to do so, does that failure preclude it from invoking equitable subrogation?”

As you may recall, Article XVI, § 50 of the Texas Constitution — specifically, § 50(a)(6)(Q)(ix) — provides that the loan must be “made on the condition that” “the owner of the homestead and the lender sign a written acknowledgment as to the fair market value of the homestead property on the date the extension of credit is made.” The lender has a 60-day window to cure its failure to sign the fair-market-value acknowledgment after being notified of the deficiency by the borrower; if the lender does not cure, it could be required to “forfeit all principal and interest” on the loan in an eventual foreclosure action. 

Having interpreted its prior rulings as being silent, the Fifth Circuit certified the following question to the Texas Supreme Court:

Is a lender entitled to equitable subrogation, where it failed to correct a curable constitutional defect in the loan documents under § 50 of the Texas Constitution?

The Texas Supreme Court noted that “[c]ommon law subrogation has coexisted with this constitutional scheme for more than a century. In the mortgage context, the doctrine allows a lender who discharges a valid lien on the property of another to step into the prior lienholder’s shoes and assume that lienholder’s security interest in the property, even though the lender cannot foreclose on its own lien. This Court has recognized the doctrine in the § 50 context since at least 1890.”

The Court looked to one of its earliest cases, Texas Land & Loan Co. v. Blalock, which also involved a culpable lender but the Court ultimately held “despite the lender’s knowledge that its own lien was unconstitutional, the lender was still entitled to subrogation because it paid off the purchase-money loan encumbered by [borrower’s] property.”  The Court also noted that “[n]one of our subsequent § 50 decisions has considered any factor other than the lender’s discharge of a prior, valid lien. To the contrary, in this context, we have said that a lender’s right to subrogation is “fixed” when the prior, valid lien is discharged.”

The borrower argued that Texas voters eliminated subrogation in the 1990s by adopting specific amendments to § 50 thus eliminating the historical justification for the doctrine.

However, the Texas Supreme Court relied on its ruling in LaSalle Bank National Association v. White, which held Section 50(e) “does not destroy the well-established principle of equitable subrogation.” It “contains no language that would indicate displacement of equitable common law remedies was intended, and we decline[d] to engraft such a prohibition onto the constitutional language.” Adding, the constitutional provisions the borrower relies on were enacted before LaSalle and indicate displacement of equitable common law remedies. Furthermore, since LaSalle was decided, § 50 has been amended twice, but neither set of amendments added language addressing subrogation.

Finally, the borrower argued that “the availability of subrogation as a safety net erodes lenders’ incentives to make loans that comply with all constitutional requirements and to promptly cure any defects.” The assignee countered that “abolishing subrogation would result in a windfall to borrowers, that subrogation does not even make a lender whole because the amount of the subrogated first lien is usually less than the loan on which the borrower defaulted, and that abolishing subrogation would destabilize the Texas real-estate industry and increase the cost of borrowing money.”

The Texas Supreme Court believed revisiting the wisdom of subrogation to be unwarranted given that home-equity loans have been legal in Texas for about 24 years while subrogation has been part of the common law for more than a century.

Accordingly, the Supreme Court of Texas held that under Texas law, a lender who discharges a prior, valid lien on the borrower’s homestead property is entitled to subrogation, even if the lender failed to correct a curable defect in the loan documents under § 50 of the Texas Constitution. Therefore, it answered the certified question “yes”.

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Ryan Grotz practices in Maurice Wutscher's Commercial Litigation, Consumer Credit Litigation, and Appellate groups. He has substantial experience in all phases of commercial litigation, including motion practice, written discovery, depositions, mediations, and bench and jury trials. Ryan received his Juris Doctor from the Chicago-Kent College of Law, where he was an associate editor on the Access to Justice Student Editorial Board. He was awarded his Bachelor of Business Administration degree from the University of Iowa. Ryan is licensed to practice law in Illinois and the U.S. District Court for the Northern District of Illinois. For more information, see https://mauricewutscher.com/attorneys/ryan-grotz/

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