New Jersey Lenders Beware: Mortgages Securing Future Advances May Lose Priority

A recent opinion by the New Jersey Supreme Court presents a cautionary tale for New Jersey lenders. Most lenders typically rely on the general rule of mortgage priority: “first in time, first in right.”i However, in Rosenthal & Rosenthal v. Vanessa Benun, et al.,1 the Court enforced an exception to that rule holding that a lender with a first priority mortgage lien securing future advances may lose priority for any optional future advances made after the lender receives actual2 notice of a subsequent mortgage. Further, the Court reiterated a special rule for construction loans noting that construction lenders may lose priority for construction advances made after a subsequent mortgage is recorded, regardless of whether the construction lender had actual notice of that mortgage. The Rosenthal opinion serves as a stark and potentially costly reminder for those lenders who fail to take heed of these exceptions.

Facts of Rosenthal

In Rosenthal, a commercial factor entered into factoring agreements to finance accounts receivable of several related companies. The factoring agreements provided the factor with the option to make future advances. The agreements were secured by a mortgage on real property owned by a guarantor.

Several years later, a New Jersey law firm was granted a subsequent mortgage on the property to secure unpaid legal bills. Significantly, the factor received actual notice of the law firm’s mortgage and the factor’s counsel acknowledged that mortgage in an email to the law firm. Despite having notice of the subsequent mortgage, the factor continued to make advances totaling millions of dollars under the factoring agreement on the mistaken belief that those advances were secured by its mortgage.

After the companies filed for bankruptcy protection, the factor and law firm litigated the priority of their respective mortgages which collectively exceeded the value of the mortgaged property. The priority dispute wound its way through the courts up to the New Jersey Supreme Court.

Rosenthal’s Holding and Rationale

Significantly, the Rosenthal Court held that the law firm’s subsequent mortgage held priority over the factor’s first mortgage with respect to the advances made by the factor after the law firm’s mortgage was recorded. The Court commenced its analysis with a thorough review of the common law rule in New Jersey that a mortgage given to secure future advances retains its priority over a subsequent encumbrance if the future advance is mandatory or if the prior mortgagee did not have actual notice of the intervening lien. Stated another way, a prior mortgage loses priority if a future advance is optional and made with actual notice of the intervening mortgage. New Jersey’s mortgage priority statute, N.J.S.A. 46:9-8.2, which preserves mortgage priority for obligatory advances, also provided a legal foundation for the ruling. The Court recognized that the exception to general rule has been the subject of criticism by commentators and was inconsistent with priority laws in other states. However, because the priority scheme was codified by statute, the Court cautioned that it was the New Jersey legislature’s province to alter the priority scheme.

Special Rule for Construction Financing

The Rosenthal opinion also noted that New Jersey courts recognize a more restrictive rule for construction loans. The Court highlighted its prior approval of lower court precedent3 authorizing the subordination of optional future advances by a construction lender who had constructive notice of an intervening lien. In other words, even if construction lenders lack actual notice of a subsequent mortgage, they lose priority for future advances if the subsequent mortgage was recorded before the advance is made. The underlying rationale for this policy is that construction lenders can protect themselves by conducting a title search before each advance to ensure that no subsequent lien was recorded.

Navigating Future Advances

The continuation of the exception to the first in time rule for future advances puts lenders in a difficult position. Before making an advance under lending facilities (other than construction loans) that are secured by mortgages, lenders would be well advised to make two critical inquiries. First, is the advance optional or mandatory? The resolution of that inquiry is likely resolved through legal analysis of the underlying loan documents. If the lender has confirmed that the advance is mandatory, Rosenthal instructs that the advance will be secured by the prior mortgage lien. However, if the advance is optional, lenders, particularly larger institutions, are faced with something of a dilemma. With each advance, the lender must inquire as to whether it has actual notice of a subsequent encumbrance. This put lenders in the tenuous position of confirming that none of their employees or agents received any communications that provided the lender with notice of the lien. This is obviously a much greater task with larger institutions. While it may be highly impractical, the harsh consequences of Rosenthal’s holding may compel lenders to conduct a title search prior to each optional advance.

For More Information

If you have any questions regarding this News Alert, please contact John C. Kilgannon at 215.751.1943 or the Stevens & Lee attorney with whom you normally consult.

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.

1 Rosenthal & Rosenthal v. Benunet al., 2016 WL 3919107 (NJ 2016)

2 The distinction between actual notice and constructive notice is significant in this context. Black’s Law Dictionary defines actual notice as “[n]otice given directly to, or received personally by, a party.” Constructive notice is defined as “[n]otice arising by presumption of law from the existence of facts and circumstances that a party had a duty to take notice of, such as a registered deed or a pending lawsuit; notice presumed by law to have been acquired by a person and thus imputed to that person.” Black’s Law Dictionary (10th ed. 2014). In the real estate context, constructive notice is provided when a deed or other interest is publicly recorded and may be discovered upon a diligent title search.

3 Lincoln Federal Savings & Loan Ass’n v. Platt Homes, Inc., 185 N.J. Super. 457, 466-67 (Ch. Div. 1982)(holding that optional future advances secured by a mortgage subordinated when senior construction lender had constructive notice of intervening lien).

i In other words, the first to record their mortgage has the first lien on the property.