The “loss before foreclosure rule” provided for in the Restatement (Third) of Property (Mortgages) §4.8 specifies that when improvements on secured property are destroyed by fire and the loan is due and payable, where a mortgagee has a right to foreclose and is entitled to insurance proceeds, the mortgagee may either: (i) recover from the insurance proceeds; or (ii) foreclose on the real estate and recover from the insurance proceeds to the extent that the proceeds of sale are insufficient to satisfy the debt. In Celink v. The Estate of William R. Pyle, the Appellate Court of Maryland concluded that the loss before foreclosure rule applied to a reverse mortgage that prohibited the mortgagee from obtaining a deficiency judgment.

In Celink, William R. Pyle had obtained a loan from Urban Financial Group, Inc. secured by a “reverse mortgage,” actually a deed of trust consistent with Maryland practice, on his residence. Celink was engaged to service the loan.

The reverse mortgage required Mr. Pyle to maintain casualty insurance on his home. Section 3 provided that if restoration of the property after a loss was not economically feasible, the insurance proceeds were to be applied first to the balance due on the loan, with the remaining proceeds being paid “to the entity legally entitled thereto.”  Section 10 of the reverse mortgage provided that it could be enforced only against Mr. Pyle’s home and that the lender was prohibited from obtaining a deficiency judgment.

Mr. Pyle’s home was destroyed by fire. Mr. Pyle died in the fire. His death resulted in his loan being fully due and payable. Celink foreclosed on what remained of the home. The sale price was less than half the balance outstanding on the loan.  Because Mr. Pyle’s home was owner-occupied residential property, had the lender been entitled to seek a deficiency judgment, its exclusive method of doing so under Maryland law would have been to file a motion for a deficiency judgment in the foreclosure case. Because Section 10 of the reverse mortgage prohibited the lender from seeking a deficiency judgment, Celink filed no such motion.

The insurance company issued a check for the policy proceeds payable to Celink and Mr. Pyle’s Estate. The Estate filed suit against Celink, alleging that the Estate was entitled to all of the insurance proceeds. Celink contended that it was entitled to recover the unpaid balance of the loan from the insurance proceeds and that the Estate was the “legal entity” entitled only to the excess proceeds.

The trial court sided with the Estate. It reasoned that since the lender was entitled to enforce the loan only against the mortgaged property, once Celink foreclosed, the debt ceased to exist. Accordingly, it held that the Estate was entitled to all of the insurance proceeds and ordered Celink to endorse the insurance company’s check to the Estate. Celink appealed.

On appeal, the Estate argued, as it had in the trial court, that since Maryland law provided that the exclusive method of obtaining a deficiency judgment on a loan secured by owner-occupied real property is to file a motion for a deficiency judgment in the foreclosure case within 3 years after final ratification of the auditor’s report and Celink had not filed such a motion, there was no remaining debt to which the insurance proceeds could be applied. The Appellate Court of Maryland rejected this argument, noting that Celink could not have moved for a deficiency judgment because Section 10 of the reverse mortgage terms prohibited it from doing so. It concluded that the Rule providing that the exclusive method for obtaining a deficiency judgment on a loan secured by owner-occupied real property simply did not apply because “this action is not one in which Celink is seeking a deficiency judgment.”  “Instead, the parties are seeking a declaration of their respective rights to the proceeds of the insurance policy.”

The Appellate Court of Maryland viewed the respective rights of the parties to the insurance proceeds as being governed solely by Section 3 of the reverse mortgage which required Mr. Pyle to maintain insurance and provided that insurance proceeds were to be applied first to the loan balance if restoration of the insured property was not economically feasible. Citing a series of cases dating back to 1834, the Appellate Court of Maryland said that the majority view was clearly that if a mortgagor was required by the mortgage to maintain casualty insurance for the benefit of the lender and the collateral is destroyed, the lender has an “equitable lien” on the insurance proceeds “to the extent of the mortgagee’s interest in the property [is] destroyed.”

The Estate apparently argued that the line of cases relied upon by the Appellate Court was distinguishable because Mr. Pyle’s mortgage was a reverse mortgage. The Court said:

We note that the parties do not identify, nor have we been able to find, appellate decisions applying the loss before foreclosure rule in cases involving reverse mortgages and deeds of trust. Nonetheless, application of the loss before foreclosure rule makes sense in this case…[W]e see no reason that the legal principles that were first articulated by the Supreme Court of Maryland nearly two centuries ago to protect a lender’s interests when the collateral is damaged by fire should not apply in this case.

Several points about the Celink decision are worthy of note. First, the loss before foreclosure rule only applies when the mortgagor is obligated to maintain insurance for the lender’s benefit. Had Section 3 of Mr. Pyle’s mortgage not required him to maintain insurance and that proceeds were to be applied to the loan balance if restoration of the property was not economically feasible, Celink would have been limited by Section 10 to recovering only what the remains of the property were worth at foreclosure.

Second, the loss before foreclosure rule provides that the lender may either recover under the insurance policy or foreclose on the damaged property and then recover the deficiency from the insurance proceeds. In Celink, the loan balance before the proceeds of the foreclosure sale were applied was approximately $383,000. The insurance proceeds were only $287,531.47. Had Celink not foreclosed and elected to recover under the insurance policy, Mr. Pyle’s loan would not have been paid in full.