Understanding the Nuances of Post-Sale Collection Under Kentucky Law: Why First Mortgages May Not Get Paid from Proceeds in an Equity-Rich Market

Understanding Foreclosures in Kentucky

Kentucky is a judicial foreclosure state, and the legal process guiding foreclosures can be complex, especially when a second-priority lien initiates foreclosure while a first-priority mortgage remains in good standing. This article explores the intricacies of such cases, focusing on the right—or often, lack thereof—to sheriff's sale proceeds when a second-priority mortgage forecloses at a time when the first-priority mortgage is not in sufficient default to foreclose its own mortgage.

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The Role of Priority in Foreclosure Sales

When multiple mortgages exist on a property, the legal determination of respective priority positions generally dictates how proceeds from a foreclosure sale are distributed. However, issues may arise when a junior lien holder, often a second-priority mortgage, initiates foreclosure before a first-priority mortgage is in default. There is nothing preventing a second-priority lien holder from foreclosing its interest if the borrower is in default on the second-priority mortgage. In such cases, the second-priority mortgage must name all parties with an interest in the property—including the first-priority mortgage holder—as defendants in the foreclosure action.

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Protecting the First-Priority Mortgage

If the appropriate action is not taken, the first-priority mortgage risks defaulting on its priority position and could even lose its security interest entirely. The first-priority mortgage holder must respond to the foreclosure lawsuit to assert and protect its rights. Typically, this involves filing an answer to acknowledge the existence, priority, and validity of its lien, as well as stating the status of the mortgage debt and explaining why the mortgage cannot be foreclosed at the time of filing. The court should then recognize the first-priority mortgage as superior to and unaffected by the second-priority mortgage foreclosure.

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Surplus Proceeds and the Borrower’s Equity

When the court grants a foreclosure judgment to the second-priority mortgage holder, the property is sold subject to the first-priority mortgage. However, the first-priority mortgage does not have the right to claim surplus proceeds from the sale, even if the funds exceed the amount owed on the second-priority mortgage. Courts generally hold that surplus proceeds belong to the borrower or other judgment lien holders, not the first-priority mortgage, as long as the latter remains intact on the property. This ensures the borrower’s equity in the property is preserved and prevents unfair claims by the first-priority mortgage holder.

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Challenges for Sheriff Sale Purchasers

MDK has observed an increase in sheriff's sale purchasers who misunderstand the implications of “subject to” judgments. Some buyers have bid amounts exceeding the property’s equity, leading to potential windfalls for borrowers. These buyers often mistakenly believe that the first-priority mortgage should reduce its debt by applying the sheriff's sale proceeds. However, since the first-priority mortgage has not foreclosed its interest, it cannot mitigate the debt in this way. Sheriff’s sales are caveat emptor, and courts generally do not vacate sales due to knowledge gaps or bidding errors by purchasers.

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Seek Legal Guidance for Complex Foreclosure Issues

If this situation occurs, it is important to contact trusted counsel to review the facts and determine what steps may be taken to resolve the matter. Generally, the first-priority mortgage cannot obtain surplus sheriff's sale funds to settle the debt with the new owner or mitigate the debt owed by the borrower. A secondary foreclosure of the property is often the only available resolution.

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Key Takeaways

1. Protecting First-Priority Mortgages in Secondary Foreclosures
   In Kentucky, a second-priority lien holder can initiate foreclosure even when the first-priority mortgage is not in default. To safeguard their security interest, first-priority mortgage holders must respond to foreclosure lawsuits by asserting their lien's priority and explaining why it cannot yet foreclose.
2. Surplus Proceeds Belong to Borrowers, Not First-Priority Mortgages
   When a second-priority mortgage forecloses, surplus proceeds from the sheriff's sale go to the borrower or other judgment lien holders. Courts typically ensure borrowers retain their equity and prohibit first-priority mortgage holders from claiming these funds while their lien remains intact on the property.
3. Understanding Risks for Sheriff Sale Purchasers
   Misunderstanding “subject to” judgments can lead sheriff's sale purchasers to overbid, expecting the first-priority mortgage to absorb sale proceeds. Courts generally do not vacate sales due to purchaser errors, emphasizing the need for due diligence before bidding.