TX Supreme Court Rules Lenders Entitled to Equitable Subrogation Where They Fail to Correct Curable Constitutional Defects in Loan Documents

On April 24, 2020, the Texas Supreme Court answered a certified question from the U.S. Circuit Court of Appeals for the Fifth Circuit, ruling that under the Texas Constitution, a lender is entitled to equitable subrogation where it failed to correct a curable constitutional defect in the loan documents.  This decision represents a positive shift of case law in favor of Texas home-equity lenders on the issue of subrogation.

This case concerned a borrower who obtained a home loan from a lender and refinanced her mortgage with a home-equity loan from another lender years later.  The second lender paid the balance of her mortgage to the first lender.  The borrower then sent a letter to the second lender, claiming that the home-equity loan did not comply with Article XVI, § 50(a)(6)(Q)(ix) of the Texas Constitution because the second lender did not sign a form “acknowledging the home’s fair market value on the date the loan was made.”  The borrower’s letter requested that the defect be cured within 60 days, but the lender did not cure the defect.  When the home-equity loan was sold to the Federal Home Loan Mortgage Corporation (Freddie Mac), she again sent a letter providing notice of the defect and requesting that Freddie Mac attempt to cure it.  However, Freddie Mac did not respond to the letter or cure the constitutional defect.  The borrower sued in federal court to quiet title, arguing that Freddie Mac does not possess a valid lien on her property because it did not respond to or cure the defect within 60 days of her notification.  Freddie Mac argued that it is subrogated to the first lender’s original lien on the property, because its predecessor—the second lender—paid off the balance of the borrower’s initial loan. Both parties moved for summary judgment, and the district court granted the borrower’s motion and denied Freddie Mac’s motion. 

The district court concluded that Freddie Mac had been negligent in failing to cure the constitutional defect in the loan documents, and thus, it was not entitled to equitable subrogation.  Freddie Mac appealed to the Fifth Circuit, and the appeals court certified the following question to the Texas Supreme Court: “If the party seeking equitable subrogation could have satisfied the requirements of § 50(a)(6)(Q)(ix) but failed to do so, does that failure preclude it from invoking equitable subrogation?”

The Texas Supreme Court found that, “[u]nder Texas law, a lender who discharges a prior, valid lien on the borrower’s homestead property is entitled to subrogation, even if the lender failed to correct a curable defect in the loan documents under §50 of the Texas Constitution.”  In the court’s opinion, Chief Justice Nathan Hecht explained that it is well-established law in Texas that “a lender’s right to subrogation is ‘fixed’ when the prior, valid lien is discharged,” and that in previous cases the court has “honored equitable subrogation claims against homestead property when a refinance, even though unconstitutional, was used to pay off valid liens.”  Further, the court quoted its past opinions, which opined that subrogation helps homeowners, because without it, “lenders would be hesitant to refinance homestead property due to increased risk that they might be forced to forfeit their liens.”  The court stated that this decision accords with its previous historical and procedural record, and it determined that the court’s previous consideration of the issue of subrogation should not be altered.