‘Fundamental Fairness’ Favors Lender’s Claim to Fire Insurance Funds After Foreclosure

The estate of a Maryland man who, along with one of his children, was killed in a fire in his home is not entitled to all of the proceeds from the fire insurance policy because the homeowner still had a remaining mortgage debt even after the lender received all the money from the foreclosure sale of the property.

The Appellate Court of Maryland said that while it sympathized with the survivors, it concluded that based on “fundamental principles of equity and fairness,” a reverse mortgage servicing firm’s claim to a portion of the insurance proceeds came before the claim of the survivors. The lender’s claim was not extinguished by the foreclosure sale despite language in the deed of trust relied upon by the survivors.

The appeals court reversed a circuit court judgment that was in favor of the survivors and remanded the case for judgment in favor of the loan servicing company.

Under Maryland law, as a general rule, if the proceeds of a foreclosure sale are not adequate to discharge a debt, the lender may attempt to recover the balance due from the borrower. When the foreclosed property is an owner-occupied residential property, the lender’s exclusive remedy is to seek a deficiency judgment within the foreclosure action.

However, in this case, the deed of trust securing the loan explicitly prohibited the loan company from obtaining a deficiency judgment in the event of a foreclosure.

In 2016, a fire destroyed the Elkton, Maryland residence of William R. Pyle, claiming his life, as well as the life of one of his adult children.

In 2013, Pyle had entered into a reverse mortgage loan agreement that was secured by a deed of trust encumbering his residence. The lender retained Celink to act as sub-servicer of the loan. Celink’s responsibilities included foreclosing on the mortgage loan in the event of default.

The loan became due upon Pyle’s death. Celink purchased the property at the foreclosure auction for $175,000, which was $208,108.25 less than the balance due on the loan. Pyle maintained a fire insurance policy on the property. Celink and Pyle’s estate disagreed about how the $287,531.47 proceeds of the insurance policy should be allocated between them.

Celink asserted that it was entitled to the difference between what it paid at auction and the total amount due on the loan. Celink conceded that the estate was entitled to the balance of the policy proceeds. Pyle’s estate contended that it was entitled to all of the proceeds.

The Circuit Court for Cecil County concluded that the proceeds of the policy were the property of the estate and issued a declaratory judgment to that effect. The circuit found that by foreclosing the property, Celink eliminated the indebtedness secured by the deed of trust, “thereby eliminating any right or claim to the insurance proceeds.”

Celink appealed to the intermediate Appellate Court of Maryland, arguing that the circuit court erred in holding that the foreclosure sale extinguished the entire debt, including the deficiency, thereby extinguishing the lender’s right to insurance proceeds up to the amount of the deficiency.

The appellate court weighed two provisions of the deed of trust and their implications for this “loss before foreclosure” case. The first provision required Pyle to maintain fire insurance on the property and also provided that if there was a loss, and restoration or repair of the property was not “economically feasible,” the policy proceeds were to be applied to the balance due on the note, with any excess to be paid “to the entity legally entitled thereto.”

The second provision said that the debt can only be enforced through the sale of the property subject to the deed of trust and explicitly prohibits the secured party from obtaining a deficiency judgment in the event of a foreclosure.

In its brief, the estate acknowledged that the underlying debt was not extinguished by the sale of the property. However, it argued that Celink failed to reserve the right to seek a deficiency judgment in the amount of the balance that was due as the law allows.

However, the appeals court noted in dismissing this argument that Celink did not reserve the right to seek a deficiency judgment because it expressly waived its right to do so in the deed of trust. So, the court determined, this case was not one where the law about seeking a deficiency judgment applies.

Instead, the court focused on the fire insurance requirement. It said the parties were seeking a declaration of their respective rights to the proceeds of the insurance policy. Thus what was needed is the proper interpretation of the provision providing that, if there is an insurable loss and if restoration of the property is not economically feasible, “the insurance proceeds shall be applied . . . to the reduction” of the secured indebtedness.

In reaching its decision, the appeals court reached back to an 1834 ruling (Thomas’ Adm’rs v. Vonkapff’s Ex’rs) in which the literal terms of the mortgage stated that the insurance proceeds were to be used to repair or rebuild the damaged property. But no repairs or rebuilding were possible and, therefore, the lender had no enforceable legal right to the proceeds.

However, the Thomas court concluded — and now today’s court agreed —that a covenant requiring the borrower to provide fire insurance was for the benefit of the lender and its assignees and the lender’s right to enforce its interest stemmed from “fundamental principles of equity and fairness.”

The Supreme Court explained that where a lien cannot in the terms of the contract be specifically enforced, a court of equity is not powerless. “It must administer relief, in the only manner in which it can now be done. As the leading object in effecting the insurance, was exclusively a beneficial one to the [the lender], its great spirit and object will be effectuated by decreeing him the fund. The mode only, of giving relief, will be changed,” the 1834 court concluded.

The current high court noted that there are no appellate decisions applying the loss before foreclosure rule in cases involving reverse mortgages and deeds of trust. Nonetheless, it said, application of the loss before foreclosure rule makes sense in this case.

“Mr. Pyle’s residence, together with the fire insurance policy that he was required to maintain to protect the lender’s interests, was the security for the repayment of the loan. Under the terms of the deed of trust, as well as by Maryland law, Celink was barred from seeking a deficiency judgment. Therefore, we do not agree with the Estate that Celink’s failure to obtain a deficiency judgment somehow precluded its ability to share in the proceeds of the fire insurance policy,” the ruling states.

“In summary, we see no reason why the legal principles that were first articulated by the Supreme Court of Maryland nearly two centuries ago to protect a lender’s interests when the collateral is damaged by fire should not apply in this case.”

Topics Maryland