Although the case law in the home equity lending context has been relatively slow in developing, there is a seesawing area of that law that should have an impact on the fate of some problem home equity loans.   Equitable subrogation is a well established theory of recovery available to a traditional refinance lender.   Unlike traditional refinance loans, a Texas Home Equity loan is limited by certain non-recourse requirements.  A significant question remains regarding whether the theory of equitable subrogation is applicable to a home equity loan that was used to pay existing indebtedness.  The ultimate outcome of an appeal to the Texas Supreme Court, if accepted for review, should have a significant impact on options available to lenders faced with a home equity loan that is alleged to have violated provisions of the Texas Constitution.

The various requirements for a valid home equity loan in Texas are set forth in Article XVI, Section 50 of the Texas Constitution.  If a home equity loan does not comply with those detailed requirements, and the lender does not timely cure an actual violation within 60 days after notification by the debtor, the lien is void.   An uncured violation puts the lender in a situation in which: (1) foreclosure of the collateral is precluded, (2) the lender forfeits all principal and interest previously paid by the debtor; and (3) the lender may not file suit against the debtor for the amount of the debt due to the non-recourse requirements of the loan in the Texas Constitution.  Accordingly, a home equity loan that violates any of the many requirements of the Texas Constitution and is not timely cured after proper notice arguably leaves the lender with no remedy against the home equity debtor and the lender is required to refund all principal and interest paid by the debtor.

Given the harsh result sought to be imposed by debtors who actually received an irrefutable benefit, i.e. the satisfaction of the debtor’s existing mortgage, equitable remedies would seem appropriate in the context of a home equity loan that was made to refinance existing indebtedness of the debtor, but was originated with a technical violation due to inadvertence.

In the traditional refinance lending context, under the doctrine of equitable subrogation, a third party lender that pays an existing debt at the request of the debtor may, under certain circumstances, be subrogated to the previous creditor’s security interest for the debt which has been discharged[1]. The purpose of the doctrine is to prevent the unjust enrichment of the debtor who owed the debt that was paid[2].

In an attempt to avoid the harsh result of forfeiture when faced with a home equity loan that does not meet the requirements of the Texas Constitution, counsel for lenders have begun to assert the theory of equitable subrogation in response to claims by debtors that the home equity lien is void and unenforceable. The equitable subrogation theory in the home equity context was first discussed in Texas in LaSalle Bank Nat. Ass’n v. White[3].

The trial court in LaSalle held that the loan violated the provision of the Texas Constitution that prohibits “homestead property designated for agricultural use as provided by statutes governing property tax” from being pledged to secure a home equity loan unless the property “is used primarily for the production of milk[4].”  The trial court also held that the equitable subrogation theory asserted by the lender as an alternative mechanism for recovery of the loan proceeds was not legally viable.[5]

The San Antonio Court of Appeals initially reversed the trial court and held that equitable subrogation theory was a viable theory, however in response to the debtor’s motion for rehearing, the San Antonio Court of Appeals, did an about face, and in an en banc opinion, held that the equitable subrogation theory was not viable in the context of home equity lending[6].  The opinion effectively held that allowing recovery via the equitable remedy of subrogation would conflict with the non-recourse requirements of the Texas Constitution relating to home equity lending.

Of note is the fact that the recent LaSalle opinion contains a strong dissent in favor of the application of equitable subrogation in this context. Based on the strong dissent and the fact that the discussion involves the Texas Constitution, this issue should eventually be accepted for review by the Texas Supreme Court, either via LaSalle case, or in the course of an appeal of another refinance home equity case with alleged constitutional violations. LaSalle has in fact petitioned for review by the Texas Supreme Court and the issue of whether the case will be accepted is pending.

Based on the current flux in the status of the law in this area, a counterclaim based on equitable subrogation should still be asserted by counsel for home equity lenders, in a situation where a home equity loan has allegedly failed to comply with the Texas Constitution, where the proceeds of the loan were used to satisfy existing indebtedness of the debtor.

Michael F. Hord, Jr. mhord@hirschwest.com is a shareholder with the firm of Hirsch & Westheimer, P.C. and specializes in complex commercial litigation, including the representation of financial institutions.

This is merely a general discussion of developing case law in this area and nothing in this article is intended to be legal advice. 

[1] First Nat’l Bank of Kerrville v. O’Dell, 856 S.W.2d 410, 415 (Tex.1993).

[2]First Nat’l Bank of Kerrville, 856 S.W.2d at 415.

[3]LaSalle Bank Nat. Ass’n v. White, 2006 WL 1152337 (Tex.App.-San Antonio May 03, 2006)

[4] See LaSalle, 2006 WL 1152337; Tex. Const. art. XVI, § 50(a)(6)(I)

[5] Id.

[6] < LaSalle Bank Nat. Ass’n v. White, 2006 WL 2871278 (Tex.App.-San Antonio Oct 11, 2006)