In a recent issue of Probate & Property, Roger Bernhardt reported on Citizens State Bank of New Castle v. Countrywide Home Loans, Inc., 949 N.E.2d 1195 (Ind. 2011), in which the Indiana Supreme Court held that the doctrine of merger extinguished Countrywide’s previously foreclosed senior mortgage, notwithstanding the inadvertent omission of a junior judgment creditor, Citizens State Bank, from Countrywide’s judicial foreclosure action. Roger Bernhardt, Mortgages and Merger, Prob. & Prop., Nov./Dec. 2012, at 35. As a result, Citizens received a “windfall benefit of seeing its lien elevated into top position, a result that looks very much like unjust enrichment, because no real harm was ever done to it by virtue of its noninclusion in the senior foreclosure action.” Id. at 36.
Fannie Mae, which had purchased the subject property from Countrywide, was seeking to use the remedy of strict foreclosure against Citizens. Narrowly reading long-standing Indiana precedent, the court characterized strict foreclosure as “merely a mechanism to place before the court the question of whether the doctrine of merger should be enforced.” Citizens, 949 N.E.2d at 1200. Rejecting the “anti-merger” exception, which presumes an intention to preserve a mortgage lien whenever it is in the best interest of the mortgagee to do so, the court stated: “[W]e think this is an unnecessarily circuitous route to determine whether the doctrine of merger should apply under a given set of facts.” Id. at 1198. The court’s infatuation with merger dictated its conclusion: “[B]y conveying title to a third party by way of warranty deed, albeit limited, Countrywide demonstrated that it intended a merger of its interests. . . . Simply because in retrospect it might not have been in Countrywide’s ‘best interest’ to extinguish its mortgage lien when it conveyed the property to FNMA cannot change Countrywide’s intent after the fact.” Id. at 1201.
Professor Bernhardt’s article eloquently explains why, contrary to Citizens, “[i]f the competing doctrines of reforeclosure and of merger are weighed against each other, it seems obvious that merger should be the one to yield.” Bernhardt, at 38. That is the view of the Restatement (Third) of Property: Mortgages § 8.5, which the Indiana Supreme Court expressly “decline[d] to adopt.” Citizens, 949 N.E.2d at 1197−98. The rationale behind the Restatement (Third)’s view was thoroughly expounded by Ann M. Burkhart in Freeing Mortgages of Merger, 40 Vand. L. Rev. 283 (1987).
This article describes the Indiana legislature’s response to the Citizens decision. For the reasons discussed below, the state’s new Anti-Merger Statute offers a model for other states desiring to legislatively limit the courts’ use of merger in judicial foreclosure actions.
Citizens was not a unanimous decision. Justice Sullivan’s dissent cites a century of Indiana precedent contrary to the “result reached by the Court [that] ‘lend[s] sanction to an unjust enrichment of’ Citizens Bank.” Citizens, 949 N.E.2d at 1202 (Sullivan, J., dissenting). Opining that the Restatement (Third) correctly provides that the doctrine of merger does not apply to mortgages, the justice (since retired) found the following rationale from the Restatement (Third) to be “particularly apt for this case”:
Modern courts’ application of the merger doctrine to mortgages primarily results from the fact that at certain points in the early common law the paths of their legal development crossed. Because some early mortgage counterparts legitimately were subject to the operation of merger, it has clung tenaciously to mortgages ever since, although mortgages have evolved beyond the form to which merger applied. The law has grown up around merger, developing systems, such as the title records, that reflect modern practices and obviate the need for merger. Elimination of merger will strengthen this infrastructure.
Id. at 1204 (quoting from Burkhart, at 386−87, quoted in Restatement (Third) § 8.5, Reporters’ Notes, cmt. a). Justice Sullivan’s well-articulated dissent served as a springboard for the enactment of legislation in 2012 to prospectively overturn Citizens.
The Indiana Anti-Merger Statute
Ind. Code § 32-29-8-4 (the “Anti-Merger Statute”) is intended to eliminate the doctrine of merger from Indiana mortgage foreclosure law and statutorily reinstate the strict foreclosure remedy to resolve claims of omitted parties following mortgage foreclosures. Intent is one thing, however, and implementation is quite another; the devil is in the detail. Therefore, close examination of the Anti-Merger Statute is warranted.
Abolition of Merger
The keystone of the statute is the subsection expressly eliminating the doctrine of merger from Indiana mortgage foreclosure law:
The senior lien upon which the foreclosure action was based is not extinguished by merger with the title to the property conveyed to a purchaser through a sheriff’s deed executed and delivered under IC 32-29-7-10 until the interest of any omitted party has been terminated:
(1) through an action brought under this section; or
(2) by operation of law.
Until an omitted party’s interest is terminated as described in this subsection, any owner of the property as a holder of a sheriff’s deed executed and delivered under IC 32-29-7-10, or any person claiming by, through, or under such an owner, is the equitable owner of the senior lien upon which the foreclosure action was based and has all rights against an omitted party as existed before the judicial sale.
Ind. Code § 32-29-8-4(h). This provision prospectively overrules Citizens, precluding future application of the merger doctrine to foreclosed mortgage liens. It may be the first statute in the country to codify the lodestar of the Restatement (Third): that the merger doctrine has no place in mortgage foreclosure law. Without this subsection, a court might attempt to circumvent a strict foreclosure action under the Anti-Merger Statute by interpreting the operative provisions discussed below to apply only when no “merger of title” had occurred through the foreclosure or a subsequent sale.
The starting point of the strict foreclosure process under the Anti-Merger Statute is defining the classes of persons to which it applies. First, the subsection defines an “interested person” as follows:
(a) As used in this section, “interested person”, with respect to an action to foreclose a mortgage on an interest in real property in Indiana, means:
(1) the holder of the evidence of debt secured by the mortgage being foreclosed;
(2) a person:
(A) who purchases the property at a judicial sale after a judgment and decree of sale is entered in the action; and
(B) to whom a deed is executed and delivered by the sheriff under IC 32-29-7-10; or
(3) any person claiming by, through, or under a person described in subdivision (1) or (2).
Ind. Code § 32-29-8-4(a). Note that the statute applies only to an “action to foreclose a mortgage.” Other foreclosure proceedings, such as mechanics’ lien foreclosures, are excluded. Although there may be common issues, the economic dynamics and political constituencies are different. Significantly, the statute protects not only the foreclosure purchaser and the holder of the secured debt (which is not necessarily the mortgagee—for example, mortgages granted to MERS), but also includes subsequent buyers and their mortgagees: “any person claiming by, through or under [a holder or foreclosure purchaser].” In many instances, as in Citizens, the omitted junior is not discovered until after the foreclosure purchaser sells the property to a third party, who generally will have obtained a new mortgage.
Next, the Anti-Merger Statute establishes who is an “omitted party”:
(b) As used in this section, “omitted party”, with respect to an action to foreclose a mortgage on an interest in real property in Indiana, means a person who:
(1) before the commencement of the action has acquired in the property an interest that:
(A) is junior or subordinate to the mortgage being foreclosed; and
(B) would otherwise be extinguished by the foreclosure; and
(2) is either:
(A) not named as a party defendant in the action or, if named as a party defendant, is not served with process; or
(B) not served with a notice of sale under IC 32-29-7-3(d) after a judgment and decree of sale is entered in the action.
The term includes any person claiming by, through, or under a person described in this subsection.
Ind. Code § 32-29-8-4(b). The interest held by the omitted party must not only be “junior or subordinate” but also must be one that would otherwise be extinguished by the mortgage foreclosure proceeding. The definition intentionally excludes holders of easements preserved by statute or otherwise. The intent is to preserve a right of redemption for persons who were deprived of that right through lack of notice. Thus, the statute extends to a person not served with a notice of the foreclosure sale even if the person was a party to the foreclosure proceeding. In addition, as with interested persons, the definition includes assignees: “any person claiming by, through, or under a person described in this subsection.”
It is not entirely clear whether an unnamed subordinate lessee should be considered an “omitted party” under the statute. In Indiana, the foreclosing party has the option whether to name subordinate lessees in a foreclosure action, and the leases of unnamed lessees are not terminated by foreclosure. Technically, such lessees fall within the definition of one whose interest is junior and “would otherwise be extinguished by the foreclosure.” But a foreclosing party with knowledge of the existence of the subordinate lease, having elected not to name the lessee in the foreclosure action, arguably should not get another bite at the apple via strict foreclosure (even at the risk of having the lessee exercise a right of redemption). Also, a subordinate lessee could not intervene in a foreclosure action under prior law for the purpose of terminating its lease (or creating a right of redemption), so it would be anomalous to allow a lessee to invoke “omitted party” status to terminate its lease via strict foreclosure.
The Strict Foreclosure Process
Having defined “interested person” and “omitted party,” the statute limits the right to bring a strict foreclosure action to persons who meet those definitions:
(c) At any time after a judgment and decree of sale is entered in an action to foreclose a mortgage on an interest in real property in Indiana, an interested person or an omitted party may bring a civil action to:
(1) determine the extent of; and
the interest of an omitted party in the property subject to the sale.
Ind. Code § 32-29-8-4(c) (emphasis added). The statute thus provides a remedy to both the foreclosing party or purchaser (or their successors or assigns) and the omitted party.
Ind. Code § 32-29-8-4(d) through (g) outlines the nature of the action and provides guidance to the court, as well as some discretion, for the determinations to be made in reaching a final judgment. The general charge to the court is to determine the extent of and terminate the omitted party’s interest subject to a right to redeem “if the omitted party would have had redemption rights. . . . ” Ind. Code § 32-29-8-4(d). In doing so, however, the court must consider the following factors in deciding the terms of the redemption:
(1) Whether the omitted party:
(A) was given or had actual notice or knowledge of the foreclosure; and
(B) had opportunity to intervene in the foreclosure action or otherwise exercise any right to redeem the property.
(2) Whether any interested person in good faith has made valuable improvements to the property and, if so, the value of all lasting improvements made to the property before the commencement of the action under this section.
(3) The amount of any taxes and assessments, along with any related interest payments, related to the property and paid by the interested person or by any person under whose title to the property the interested person claims.
Ind. Code § 32-29-8-4(f). If a court were to determine that the omitted party had actual knowledge and could have intervened in the foreclosure action so as to have a right of pre-sale redemption, the time allowed for redemption by the omitted party might be shortened. If valuable improvements have been made or taxes paid since the foreclosure sale, the redemption price ought to take into account the added value or amounts so paid. After considering the foregoing factors, the statute provides that the court “shall grant redemption rights to the omitted party that the court considers equitable under the circumstances, subject to the following”:
(1) The amount to be paid for redemption may not be less than the sale price resulting from the foreclosure of the interested person’s senior lien, plus interest at the statutory judgment rate.
(2) The time allowed for payment of the redemption amount may not exceed ninety (90) days after the date of the court’s decree under subsection (d).
Ind. Code § 32-29-8-4(g). Might a court consider it “equitable under the circumstances” to disallow redemption entirely if an omitted party, knowing of the foreclosure and advised about its right to intervene, deliberately chose not to do so in the hope of extracting a post-sale payment on a worthless junior lien? The mandatory words, “shall grant redemption rights,” suggest not.
Note that the redemption price may not be less than the foreclosure sale price rather than the amount of the foreclosed senior lien (which is what the omitted party would have had to pay to redeem if made a party to the foreclosure action). This was a conscious choice by the drafters, considering that the interested person bringing the action might be a foreclosure purchaser or subsequent purchaser who paid less than the amount of the foreclosed lien and has no equitable claim to the difference. Using the sale price for strict foreclosure also may provide incentive to foreclosing lenders to bid the full amount of their lien, or at least the fair market value.
Of course, the foreclosure sale price sets the floor, not the ceiling, and the redemption price may be significantly higher than the foreclosure sale when interest is added at the statutory judgment rate (currently 10% per annum in Indiana), together with real estate taxes paid and the value of any improvements added since the foreclosure sale. These provisions should ensure that the redemption price will not be a bargain price and should make the redemption seller whole.
The 90-day maximum redemption period is not unreasonably short or long, and the court can shorten it if there are equitable reasons to do so, such as the omitted party’s knowledge of the foreclosure proceedings, as noted above, or delay by an omitted party in bringing an action after learning of the foreclosure.
Right to Proceeds
The Anti-Merger Statute also provides for the currently unlikely occurrence when an omitted party would have been entitled to excess foreclosure sale proceeds: “[T]he omitted party’s interest in the property is not subject to termination by an action brought under this section unless the proceeds that the omitted party would have received at the judicial sale are paid to the omitted party.” Ind. Code § 32-29-8-4(e). The statute is silent on who is responsible for the payment.
Obviously, no simple solution fits all cases. In theory, payment should be made by the person who erroneously received the excess proceeds—another junior lienholder or the former owner—and that person could be joined (if available and solvent) as a defendant in the strict foreclosure proceeding. Otherwise, the parties will have to negotiate a settlement. Of course, if title was insured in the foreclosure sale or a subsequent sale, the payment likely will come from the title insurer, who would then be subrogated to the omitted party’s rights against the erroneous recipient or the negligent title searcher whose pre-foreclosure search report failed to disclose the omitted party. Another possibility is a court-ordered re-foreclosure sale, which could again produce excess proceeds to pay the omitted party.
A final subsection expressly makes the Anti-Merger Statute the sole means of terminating an omitted party’s interest in the foreclosed property. In addition, it protects institutional lenders and title insurers against disparate treatment under the statute:
An interested person’s rights under this section may not be denied because the interested person:
(1) had actual or constructive notice of the omitted party’s interest in the property;
(2) was negligent in examining county records;
(3) was engaged in the business of lending; or
(4) obtained a title search or commitment or a title insurance policy.
Ind. Code § 32-29-8-4(i). Thus, companies in the business of lending or title insurance are insulated from several oft-employed attacks to differentiate them from unsophisticated persons for whom courts historically have more sympathy. See, e.g., First Fed. Sav. Bank of Wabash v. United States, 118 F.3d 532, 534 (7th Cir. 1997) (denying equitable subrogation to a lender because, in the eyes of the court, the negligent title insurer should suffer the cost of paying the intervening lienholder whose lien the title searcher missed: “We believe that there is an additional factor that weighs against applying equitable subrogation on the facts of this case. In response to questioning at oral argument, counsel for First Federal acknowledged that the bank’s title insurer was paying the costs of this litigation. This acknowledgment lends credence to the government’s argument that the title insurer, and not First Federal, is the real party in interest here.”).
Why Other Jurisdictions Should Consider Adopting an Anti-Merger Statute
Absent preventive legislation, no state is immune to judicial adoption of Citizens’s inapt merger analysis in preference to the more equitable Restatement (Third) rule. As Citizens illustrates, the merger doctrine provides a facile, superficially logical solution to what Prof. Bernhardt calls the “silly quandary” of reconciling an omitted junior’s surviving lien with the notion that a foreclosed senior lien must disappear for the foreclosure purchaser to acquire “clear title.” Bernhardt, at 38. Moreover, many judges share the Citizens’s majority’s lack of sympathy for negligent title searchers: “[T]he outcome of this case very well may have been different” if the lienholder had been omitted because of an indexing error by the clerk instead of a “mistake or inadvertence” by Countrywide. Citizens, 949 N.E.2d at 1202 (distinguishing a hypothetical case posed in an amicus curiae brief).
Profs. Bernhardt and Burkhart have presented a solid case for eliminating the doctrine of merger from mortgage law, particularly in the foreclosure context, as contemplated by the Restatement (Third) § 8.5 and its corollary, § 7.1 cmt. b (concerning the relative rights and remedies of omitted parties and senior foreclosure purchasers). The Anti-Merger Statute enacted in Indiana is intended and expected to accomplish that objective for all Indiana foreclosure proceedings (nonjudicial foreclosure is prohibited in Indiana). With possible adaptations in jurisdictions that allow nonjudicial foreclosure or post-sale redemption (not available in Indiana), Indiana’s Anti-Merger Statute is a prototype for any jurisdiction desiring to legislatively preempt any judicial decision adopting Citizens’s merger rationale over that of the Restatement (Third).