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Issue  18  Article  37
Published:  1/1/1997

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Smith v. Martin - Trustee's Responsibility for Wrongful Cancellation of Deed of Trust; Subordination Agreement Validity
Edmund T. Urban, Vice President and Corporate Counsel

The case of Smith v. Martin, ____ N.C. App. ___, ___ S.E. 2d ___ (Court of Appeals No. COA-95-551 Dec. 1996), should be noted by all attorneys and paralegals.

Smith sold property to Latta. A deed of trust securing an institutional lender in the amount of $50,000.00 was recorded first and a purchase money deed of trust for $35,000.00 securing the Smiths was recorded second. Attorney Martin (subsequently a defendant) closed the transaction and was trustee on both deeds of trust. Later, Smith obtained a new deed of trust in the amount of $55,000.00 to secure an additional $20,000.00 loan to Latta and the original $35,000.00 loan. The $55,000.00 deed of trust, prepared and recorded by the defendant attorney, was intended to replace Smith’s $35,000.00 deed of trust which was marked "paid in full" but the $35,000.00 deed of trust was not cancelled by the defendant attorney. Subsequently, the defendant attorney got an affidavit of payment of the $35,000.00 from Smith and cancelled the $35,000.00 deed of trust.

In June, 1990, UCB committed to loan Latta $245,433.00 if UCB could be secured by a first lien. Third party defendant, Attorney Hassell, was hired to close the loan. He hired Attorney Baker to do the title work. Baker hired Ragan, an independent paralegal, to do the title search. Ragan found the $55,000.00 deed of trust. Ragan testified that Ms. Latta told Ragan the lien should be cancelled since the debt had been paid off. Ms. Latta denied this and said that she told Ragan the $35,000.00 deed of trust should have been cancelled at the time the $55,000.00 deed of trust was recorded. Ragan told Hassell Ragan’s recollection of the conversation and then Ragan told Martin that Ragan thought the $55,000.00 deed of trust should be cancelled. Martin consulted with Hassell, who concurred. On June 7, 1990, defendant Martin, as trustee, cancelled the $55,000.00 deed of trust without consulting Smith. Martin confirmed this in a letter to Hassell but did not inform Smith. UCB’s $245,433.00 loan was closed and its deed of trust recorded. This resulted in the payment and cancellation of the original $50,000.00 first lien deed of trust.

Smith sued defendant Martin for breach of trustee’s duty, breach of fiduciary duty, negligence and professional malpractice. In turn, Martin sued Hassell for indemnification. The Court of Appeals held that Martin breached his duty as a trustee under Smith’s deed of trust because Martin cancelled the deed of trust without contacting Smith or otherwise verifying that the $55,000.00 indebtedness had been paid, or without having express authority in the deed of trust to make the questioned cancellation, citing Annot., 57 A.L.R. 477 (1928), 55 Am. Jur. 2d Mortgages Sec. 467 (1971) and Davenport v. Vaughn, 193 N.C. 646, 137 S.E. 174 (1927) as authority for saying that Martin could not rely on the "bare representation" of a third party.

Martin contended that he was not the proximate cause of Smith’s loss because Smith signed a "Deed of Subordination." After noting that this document might not have even applied to the UCB loan in question (among other reasons, the subordination was not recorded), the court held that the deed of subordination was unenforceable as a matter of law, citing MCB Limited v. McGowan, 86 N.C. App. 607, 359 S.E. 2d 50 (1987), discussed in our article on subordination agreements in our October, 1996 newsletter. "A subordination clause must state the matters which most directly affect the security of the seller’s purchase money mortgage - the maximum amount of the proposed loan and the maximum rate of interest permitted on the future obligation." MCB Limited v. McGowan, supra.

As a result, the court ruled as follows: "We agree with this reasoning. Therefore, we hold that subordination agreements and clauses which subordinate loan obligations secured by a deed trust to future loans must, at a minimum, include terms which state the maximum amount of the future loan and the maximum rate of interest permitted on the loan. This requirement serves to protect the security interest of the holder of the prior deed of trust." The court noted that, obviously, since the subordination was silent as to these terms, there resulted much confusion as to which UCB loan the Smiths were subordinating to.

Last, there was the issue of mitigation of damages, which involved whether Smith did too much to protect his rights or not enough.

While a full discussion of the mitigation issue is beyond the scope of this article, it is worth noting that the issue was resolved against defendant Martin because Smith’s attorney "from the beginning" advised the defendant and his insurance carrier of the steps to be taken and requested that the defendant and his carrier fund the mitigation activities, take over the activities, or release Smith from the duty to mitigate.

In conclusion, the case reaffirms case law, including that impacting upon subordination agreements. Also, it is interesting to ponder whether the reasoning of the cases, which apply to deeds of trust and mortgages, will be extended to automatic subordination agreement clauses in condominium or planned unit development declarations wherein assessment liens are subordinated to certain types of mortgages and deeds of trust.

For additional reading, see E. Urban and G. Whitney, North Carolina Real Estate, Sec. 21-80 (1996 Harrison Co.).

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