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Failure of A Lender to Correct a Curable Defect in Loan Documents May Result in Forfeiture of all Principal and Interest

The Fifth Circuit recently addressed the question of what happens when a lender fails to correct a curable defect in the loan documents that makes the loan unconstitutional in Texas. Sylvia Zepeda vs. Federal Home Loan Mortgage Corporation (5th Cir. No. 18-20336).

In Zepeda, a borrower refinanced her home with mortgage Company A to Company B. The refinance documents provided that Company B or any successors would stand in the shoes of Company A and would inherit the same rights and all contractual provisions under the deed of trust that originally belonged to Company A. Under the Texas Constitution, the refinance process required the execution of various documents, including one stating the fair market value of the home at the time of refinance. This fair market value document was necessary to ensure the process was complete and all rights properly transferred to Company B. The borrower, however, never received the fair market value document from Company B. After she discovered the deficiency, the borrower notified Company B. Under Texas law, Company B had 60 days to provide this fair market document to the borrower. It failed to do so. The borrower sued - at this point the loan was owned by Company C - claiming the deed of trust and mortgage were no longer valid and enforceable against her home. In other words, the borrower now wanted a clear title to the home and the mortgage vacated.

Company C responded to the suit on two grounds. First, it asserted contractual subrogation, meaning the documents signed with the borrower provided them with the same legal rights as Company A, irrespective of the one missing document. Second, it asserted equitable subrogation, meaning it simply would not be fair to allow the homeowner to have home free and clear of the mortgage based on this error.

The district court ruled against Company C on both grounds and it appealed. The Fifth Circuit affirmed the district court’s ruling that no contractual subrogation existed. The deed of trust was invalid based on the failure to state the property’s fair market value at the time of refinancing, and this error was not corrected within 60 days, as required under Texas law. As a result, the entire set of loan documents and the corresponding rights that Company C was relying on were unenforceable. In short, no valid deed of trust existed to enforce any rights against the homeowner.

Company C’s other ground for appeal, equitable subrogation, proved more challenging for the Fifth Circuit. Company C argued that it would not be equitable or fair to simply void all legal rights against the homeowner and give her free and clear title to the home based on a paperwork oversight, namely, failure to state the fair market value at the time of refinancing.

Although the Fifth Circuit cited a line of cases allowing for equitable subrogation to enforce invalid loan documents, those cases all involved mistakes by both parties to the transaction - the homeowner and the lender. The mistake at issue here was solely on the part of the lender. Moreover, the borrower, in this case, alerted the lender of the error and it still failed to cure it within the required 60-day period.

Because the issue before it involving equitable subrogation, where only one party was at fault, was one of first impression and involved interpretation of the Texas Constitution, the Fifth Circuit certified the following question to the Texas Supreme Court: Can Company C now ask the court to enforce the faulty loan documents to uphold its rights against the homeowner, even though it was at fault and negligently failed to cure the loan documents? The answer the Texas Supreme Court provides could change the equitable subrogation standard in Texas.

Authored by: Michael D. Gorman, Associate Attorney

Melissa Ditto