On April 24, 2020, the Texas Supreme Court upheld a lender’s right to equitable subrogation for non-compliant home equity loans, ruling that lenders who fail to cure within the statutorily mandated 60-day period may recoup funds paid to satisfy prior liens. The court’s opinion in Federal Home Loan Mortgage Corp. v. Zepeda answered a certified question from the United States Fifth Circuit Court of Appeals, and gives some relief to home equity lenders in a notoriously complicated environment.
Texas has a long history of protecting the family homestead from foreclosure by limiting the types of liens that can be placed upon homestead property, being the last state to permit home equity loans by virtue of a constitutional amendment in 1997. These loans allow homeowners to use the equity in their home as collateral to refinance a prior debt and secure additional funds at rates that are typically lower than other types of consumer loans. Home equity loans are strictly regulated by article XIV, section 50(a)(6) of the Texas Constitution, which promulgates a large and often confusing number of rules and regulations regarding loan origination that frequently leads to subsequent consumer litigation. This same section also sets out a framework by which lenders are to be notified of alleged errors and cure any noncompliance (usually by correcting the error and paying a penalty). In the event a lender fails to cure the noncompliance within 60 days of being put on notice by the borrower, it forfeits all principal and interest on the loan in an eventual foreclosure action.
This decision comes against the backdrop of two recent decisions in which the Texas Supreme Court held that no statute of limitations applied to quiet title claims stemming from noncompliant home equity loans, a striking victory for borrowers. By way of example, a properly noticed noncompliance demand letter pursuant to Section 50(a)(6) can be sent at any time after closing, even in the 29th year of a loan.
Up until recently, lenders availed themselves of the doctrine of equitable subrogation to help ease the pain of failing to cure a noncompliant loan, which was expressly blessed by the Texas Supreme Court in the LaSalle Bank National Association v. White. Per LaSalle Bank (and consistent with long-standing general Texas commercial law), a lender who discharges a valid lien on the property of another can 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. Thus, though a lender is not made entirely whole, it is afforded some relief. The unaddressed issue in LaSalle Bank was whether a lender had clean hands if that lender failed to respond to a borrower’s notice of non-compliance, an argument that seemed to have some support.
Thus, the stage was set for Zepeda. The case, arising in the Southern District of Texas, involved a defective acknowledgement of fair market value, and the borrower brought suit against Freddie Mac to quiet title. The borrower raised claims for both contractual and equitable subrogation. The district court found in favor of the borrower, holding that Freddie could not avail itself of contractual subrogation due to the defective loan documents. The district court also rejected any claim for equitable subrogation because Freddie had supposedly been “negligent” in failing to cure the defective loan documents after being properly noticed of its noncompliance.
On appeal, the Fifth Circuit affirmed the district court’s holding on contractual subrogation. When it turned to the issue of equitable subrogation, however, the court was unable to find any Texas Supreme Court cases directly dealing with instances of constitutional defects that were solely the fault of the lender. Therefore, the Fifth Circuit issued a certified question to the Texas Supreme Court to clarify the issue.
The Texas Supreme Court found in favor of the lender’s right to equitable subrogation, and in reaching its decision, reviewed a century-long history of decisions addressing equitable subrogation in conjunction with the development of Section 50 of the Constitution. As reasoned by the court, because Section 50(a)(6) does not expressly displace the equitable remedy, such language should not be read into the Constitution.
While the Texas Supreme Court’s opinion affords relief to home equity lenders, the pitfalls that gave rise to this issue in the first place still exist. Home equity lending is complicated and the failure to comply can have drastic consequences. Further, equitable subrogation is truly a remedy of last resort as a lender can find itself severely under-secured and many times the cost to cure can be excessive. Given that many consumers will need to tap their equity in these times of the COVID-19 pandemic and high unemployment, lenders should expect Texas home equity loans to continue to be on the forefront of the Texas financial marketplace.