What should a lender do with surplus proceeds when there is a dispute between a subsequent lender and the borrower?

A recent case in the NSW Court of Appeal gives important clarification on the law in relation to surplus funds resulting from a mortgagee’s power of sale.

In Residential Housing Corporation v Esber [2011] NSWCA 25 the owners of two units granted a 1st registered mortgage, a 2nd registered mortgage and a 3rd unregistered mortgage. The first mortgagee sold the units, and released the balance to the 2nd mortgagee, who discharged the 2nd mortgage and held the surplus proceeds. A dispute arose between the owners and the 3rd mortgagee as to who was entitled to the surplus proceeds. Instead of paying the money into court the 2nd mortgagee unwisely paid the surplus proceeds to the third mortgagee in return for an indemnity for any loss it might suffer by doing so.

The trial judge found that nothing was owing under the 3rd mortgagee however the 3rd mortgagee was insolvent and unable to repay the owner. This also meant the indemnity given to the second mortgagee was worthless. The trial judge found that the 2nd mortgagee (even if not the mortgagee that had exercised the power of sale) owed both fiduciary obligations and obligations pursuant to section 58(3) of the Real Property Act to account for those surplus funds to the person entitled to them, that it did not act in accordance with those obligations and was obliged to compensate the owners. The trial judge gave judgment for the owners of the surplus proceeds plus interest from the date the funds were paid away and their costs of unsuccessfully pursuing the third mortgagee. The second mortgagee appealed.

The Court of Appeal considered section 58(3) of the Real Property Act and agreed with the trial judge. The Appeal Court agreed that section 58(3) applies to non-selling as well as selling mortgagees but went further and found that section 58(3) only authorises payment to subsequent registered mortgages, not unregistered mortgages, and if the amount currently owing is disputed or doubted, then the solution is to pay the surplus into court.

Uniform Civil Procedure Rule 43 contains a procedure whereby a stakeholder (such as a mortgagee with surplus proceeds) can pay the disputed amount of money into court, and the court can give notice to the rival claimants requiring them to litigate their claims. An alternative is available under section 95 Trustee Act 1925. That section empowers trustees to pay trust moneys into court. Once the procedures under section 95 Trustee Act or UCPR 43 have been availed of, section 171 Conveyancing Act exonerates the person making payment.

The Appeal Court found that equitable personal obligations (arising from unregistered mortgagees or those subrogated to a registered mortgagee’s rights) modify section 58(3) to prevent it being used to produce inequitable results. A mortgagee holding surplus proceeds owes an obligation to account as a constructive trustee and fiduciary not to harm the interest of the persons beneficially entitled to it.

The Court of Appeal thus found that the second mortgagee owed:

  1. a fiduciary obligation to both the owners and the 3rd mortgagee to account for the surplus proceeds in paying to each their respective entitlements; and
  2. an equitable obligation not to prejudice the right of the owners and the 3rd mortgagee to receive their respective entitlements.

Since the third mortgagee was owed nothing, each of these duties to the owners was breached when the surplus proceeds were paid to the third mortgagee and the owners were entitled to equitable compensation for each breach.



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