State Street Bank & Trust Co. of Boston v. Heck's, Inc.
1998 WL 79143, 963 S.W.2d 626 (1998)
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Rule of Law:
Under a race-notice statute, a prior equitable mortgage, created from a legally defective instrument, has priority over a subsequent validly recorded mortgage if the subsequent mortgagee had actual or inquiry notice of the prior interest before recording its own.
Facts:
- On July 1, 1978, Heck's, Inc. mortgaged its leasehold interest to Girard Trustees (predecessor to State Street Bank) to secure a large debt.
- The mortgage instrument was improperly executed, with signatures placed at the end of a supplemental schedule rather than at the end of the main mortgage document.
- On August 9, 1978, the defective mortgage, along with an assignment of lease and a fee subordination agreement from the property owners (the Kecks and Robertses), was recorded in the county clerk's office.
- On June 5, 1985, the property owners mortgaged the larger parcel of land, including the Heck's tract, to First National Bank.
- The 1985 mortgage to First National Bank contained an explicit exception for the portion of land "encumbered to Girard Bank, et al., by mortgage dated July 1, 1978, recorded in Mortgage Book 107, page 1..."
- On December 31, 1991, the property owners executed a second mortgage on the same property to First National Bank, which did not contain the exception for the Girard Bank mortgage.
- Heck's subsequently defaulted on the loan secured by the 1978 mortgage.
Procedural Posture:
- State Street Bank, as assignee, filed an action in Whitley Circuit Court for a judicial sale of the mortgaged property.
- First National Bank asserted that its 1991 mortgage had priority over State Street Bank's defective 1978 mortgage.
- The Whitley Circuit Court, the trial court, held that State Street's instrument created an equitable mortgage but gave priority to First National's 1991 mortgage, finding no proof of actual notice.
- State Street Bank appealed to the Kentucky Court of Appeals.
- The Court of Appeals, an intermediate appellate court, affirmed, holding that an equitable mortgage is not 'created' until a court declares it so and does not relate back to defeat intervening liens.
- The Supreme Court of Kentucky, the state's highest court, granted discretionary review.
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Issue:
Does a legally defective but recorded mortgage, which creates an equitable mortgage, have priority over a subsequent validly recorded mortgage if the subsequent mortgagee had actual knowledge of the prior interest?
Opinions:
Majority - Cooper, Justice.
Yes, a prior equitable mortgage takes priority over a subsequent legal mortgage if the subsequent mortgagee had actual notice of the equitable interest. Kentucky's recording statute, KRS 382.270, protects subsequent purchasers or creditors 'without notice,' which the court interprets as meaning without actual or inquiry notice, not merely constructive notice. This establishes a 'race/notice' priority system. In this case, First National Bank had actual notice of State Street's interest, as evidenced by the explicit reference to the 1978 mortgage in its own 1985 mortgage document. An equitable mortgage exists from the moment it is created (ab initio), not from the date a court declares it to exist; the court's role is to recognize and enforce the pre-existing lien. Therefore, State Street's equitable mortgage, being first in time and known to First National, has priority.
Dissenting - Wintersheimer, Justice.
No, the subsequent validly recorded mortgage should have priority. The entire dispute arose from the failure to execute the original mortgage correctly in accordance with the Statute of Frauds. A document that is not properly signed and acknowledged is not recordable and does not provide notice to subsequent creditors. The trial court correctly found no valid evidence that First National had actual notice of a valid first mortgage. An equitable mortgage should only be enforceable from the date a court adjudicates its existence and should not 'relate back' to defeat the rights of an intervening creditor like First National.
Analysis:
This decision solidifies Kentucky as a 'race-notice' jurisdiction, emphasizing that actual knowledge of a prior unrecorded or defectively recorded interest can defeat a subsequent creditor's claim to priority. The court's overruling of precedent (Borg-Warner) clarifies that an equitable mortgage is not a judicial creation but arises at the time of the transaction, existing 'ab initio.' This provides greater protection for parties whose security interests are technically flawed but are known to subsequent lienholders, reinforcing the equitable principle that one cannot knowingly take property free of a claim they were aware of.
