In re Gen. Receivership of EM Prop. Holdings, LLC

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NOTICE: SLIP OPINION (not the court’s final written decision)

IN THE SUPREME COURT OF THE STATE OF WASHINGTON

MADSEN, J.—This case concerns the priority of mortgage liens, the scope of

RCW 60.04.226, and whether to adopt certain sections of the Restatement (Third) of

Property: Mortgages (Am. Law Inst. 1997). The principal issue before us is whether a

senior mortgage holder’s future advances clause maintains priority over an intervening

junior mortgage on the same property. A future advances clause states that the security in

question applies to a present obligation as well as certain future obligations. Historically,

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at common law this court has distinguished between obligatory and optional future

advances. The legislature abrogated that distinction in the construction context when it

adopted RCW 60.04.226.

Here, the senior mortgage holder, Epic Solutions Inc., argues that RCW 60.04.226

applies to this case. However, the language and context of the statute plainly demonstrate

it applies only to construction liens. Instead, we are guided by common law, which

distinguishes between obligatory and optional future advances. Under that rule, any

advances that are optional lose priority to any intervening liens.

We are also asked to decide whether or not Restatement § 7.3 should be applied in

its entirety for modifications of a mortgage. One of our previous cases, Hu Hyun Kim v.

Lee, 145 Wn.2d 79, 31 P.3d 665 (2001), adopted Restatement § 7.3(a) and (b), but did not

discuss subsections (c) or (d). Given the facts of Kim, we hold that only Restatement §

7.3(a) and (b) have been adopted by this court.

The parties and the Court of Appeals have referred to future advances and

modification of mortgages interchangeably throughout this case. Though similar, these

are different mortgages provisions, they carry different legal consequences, and they are

governed by different provisions of the Restatement. Restatement § 7.3 is principally

concerned with the modification of mortgages. But the parties and the court below

applied Restatement § 7.3 to the future advances clause in the instant mortgage

documents. Restatement § 2.3 is the provision that governs future advances while

Restatement § 7.3 governs mortgage modifications. Moreover, applying both

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Restatement § 7.3 and RCW 60.04.226 to a future advances clause creates a conflict

because the statute does not provide a “stop-notice” protection while the Restatement

does.

For the reasons discussed below, we read RCW 60.04.226 as applying only in the

construction context. We reverse the Court of Appeals and remand to the trial court to

determine the correct priority of claims by applying the common law rules outlined in our

cases for both future advances and modifications.

FACTS

In 2015, Epic was hired to provide consulting services to TTF Aerospace Inc., EM

Property Holdings (EMP), and the owners of these companies. 1 The owners and Epic

signed an amended and restated service agreement on August 7, 2015. The agreement

did not state an end date but included a termination clause stating the agreement could be

terminated by mutual agreement or upon 30 days’ written notice by either party.

On April 19, 2017, the owners issued a promissory note to Epic for $344,762.50.

The note was secured by a deed of trust to a property in Auburn, also dated April 19,

which was recorded on April 21. The deed of trust stated:

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Clerk’s Papers at 98.

The owners amended the original promissory note on September 30, 2017,

increasing the principal amount to $546,737.50, and granted an amended deed of trust on

October 5. The amended deed was recorded on October 6 at 8:49 AM.

On October 2, Elite Aviation Interiors made a loan of $1.5 million to TTF, who

issued a promissory note secured by a deed of trust for the Auburn property. The parties

also signed a management agreement, which stated that Elite would appoint an Elite

employee to work for TTF and support its operations. The deed of trust securing the loan

was recorded on October 6 at 12:13 PM.

The owners amended the promissory note a second time in November, increasing

the principal amount owed to Epic to $731,580.99. The deed of trust was also amended a

second time on November 8 and recorded on November 13.

On November 9, the owners, through EMP, granted a deed of trust to a different

entity, Commencement Bank. The deed secured prior loans granted by Commencement,

up to a maximum of $1.5 million with the Auburn property as collateral.

Commencement recorded its deed of trust on November 27. When it obtained its security

interest, Commencement signed a subordination agreement with Elite, giving

Commencement a priority position over Elite.

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On February 26, 2019, the owners issued a third amendment to the original

commercial promissory note, increasing the principal owed to Epic to $1,515,000.00.

The deed of trust was not amended a third time. On August 7, 2019, the owners issued a

declaration, unrecorded, stating that the current amount owed by TTF to Epic totaled

$1,788,406.64.

In February 2020, a general receiver was appointed to take control of EMP’s

assets, including the Auburn property. Both Commencement and Epic filed claims in the

receivership. Epic claimed $2,127,073.06 plus interest and attorney fees for services

rendered. Commencement objected to Epic’s claim. The Auburn property sold for

$10,500,000.00. After the receiver paid other debts owed by TTF, the net proceeds from

the sale of the property remaining for Epic’s and Commencement’s claims were

$2,908,493.00.

The trial court ruled that Epic had priority over Commencement for the full

amount it claimed, based on RCW 60.04.226 and Kim, noting that the priority of the

future advances clause related back to the original deed of trust. The Court of Appeals

affirmed in an unpublished opinion. In re Gen. Receivership of EM Prop. Holdings,

LLC, No. 81686-1-I (Wash. Ct. App. July 26, 2021) (unpublished),

https://www.courts.wa.gov/opinions/pdf/816861%20orderandopinion.pdf.

Commencement appealed to this court, and we granted review. In re Gen. Receivership

of EM Prop. Holdings, LLC, 501 P.3d 150 (2022).

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ANALYSIS

Since neither party disputes the facts in this case, our task of determining lien

priority is a question of law, subject to de novo review. Kim, 145 Wn.2d at 85-86.

The common law rule for mortgage priority is that the first party to obtain a

mortgage has first priority if multiple parties seek to realize upon their security during a

foreclosure, also known as “first in time, first in right.” See, e.g., Hollenbeck v. City of

Seattle, 136 Wash. 508, 514, 240 P. 916 (1925). However, Washington has a “race-

notice” recording act, which grants priority to a party who obtains a mortgage later in

time as long as that party records the mortgage first and had no actual or constructive

notice of the previous mortgage. RCW 65.08.070.

At issue here is the impact of a future advances clause on the priority of the

parties’ liens. A future advances clause in a mortgage secures a loan or extension of

credit that the lender will disburse at a future date. 18 WILLIAM B. STOEBUCK &

JOHN W. WEAVER, WASHINGTON PRACTICE: REAL ESTATE: TRANSACTIONS § 17.16 at

299 (2d ed. 2004). This type of mortgage is “one that contains a clause stating that it is

security, not only for a present obligation, but for all or a certain class of obligations the

mortgagor may incur in the future.” Id. Most commonly used in the construction

context, these mortgages can “cause some interesting and complex priorities disputes

between the . . . lender and other lien creditors.” Id. For example, this type of mortgage

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raises a question of lien priority when a borrower obtains an intervening loan before the

initial lender loans additional funds under the future advances clause.

Historically, our courts have applied a distinction between two types of future

advances: optional advances and obligatory advances. See, e.g., Elmendorf-Anthony Co.

v. Dunn, 10 Wn.2d 29, 116 P.2d 253 (1941); Nat’l Bank of Wash. v. Equity Inv’rs, 81

Wn.2d 886, 506 P.2d 20 (1973). Pursuant to this distinction, any advances that are

obligatory maintain priority over the intervening loan, but any advances deemed optional

lose priority. Elmendorf-Anthony, 10 Wn.2d at 37.

The optional/obligatory distinction was at issue in National Bank. In National

Bank, a construction lender included a protective clause in the mortgage stating the bank

could withhold progress payments “‘in the judgment of the Lender’” if it determined the

construction was not done in a “workmanlike manner.” 81 Wn.2d at 898. This court

held that the protective clause gave the bank so much discretion that any future advances

would be considered optional. Id. This meant that any future payments distributed by

the lender would lose priority to any subsequent liens on the property of which the lender

had knowledge. Id. at 901. This decision left construction lenders in a difficult position

as it was common for such lenders to use future advances clauses as a way to protect

against inefficient use of funds by contractors by conditioning future payments on

satisfactory performance. 18 STOEBUCK & WEAVER, supra, § 18.25 at 351-52.

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In response to National Bank, the legislature passed an act adding new sections to

RCW 60.04. SUBSTITUTE H.B. 264, 43d Leg., 1st Ex. Sess. (Wash. 1973); 2 see Richard

Paroutaud, Mechanics’ Liens: The “Stop Notice” Comes to Washington, 49 WASH. L.

REV. 685 (1974) (explaining the legislative history of the act). Section 3 of this act

abrogated the optional/obligatory distinction, stating that all sums secured by the

mortgage or deed of trust maintain priority regardless of whether they are obligatory.

Former RCW 60.04.220 (1973). 3 Section 2 created a “stop-notice” mechanism for

potential lien claimants. Former RCW 60.04.210 (1973). 4 Under this provision,

potential lien claimants who have not received payment in a timely manner can file notice

of the nonpayment with the construction lender. The lender must then withhold the

amount owed to the lien claimant from subsequent payouts to the borrower. If the lender

fails to withhold funds, the mortgage or deed of trust securing the lender’s loan loses

priority to the lien claimant to the extent of the funds wrongfully disbursed.

Turning to the case at hand, Epic contends that RCW 60.04.226 applies to its

mortgage and Commencement disagrees. Epic argues that under a plain reading, RCW

60.04.226 broadly applies to any mortgage or deed of trust, including those outside the

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construction context. Epic’s Suppl. Br. at 11-18. Commencement argues that RCW

60.04.226 does not apply outside of the construction lending context and that the

optional/obligatory distinction is still applicable outside that context. Suppl. Br. of

Appellant at 11-17. The Court of Appeals agreed with Epic, holding that the

unambiguous language of the statute applies to all deeds of trust. EM Prop. Holdings,

slip op. at 10.

When interpreting a statute, we begin by examining the statute’s plain meaning.

Dep’t of Ecology v. Campbell & Gwinn, LLC, 146 Wn.2d 1, 9, 43 P.3d 4 (2002). We

ascertain the “plain meaning” by examining the provision itself, related statutes or other

provisions of the same act in which the provision is found, and the statutory scheme as a

whole. Id. at 10.

RCW 60.04.226 states:

Financial encumbrances—Priorities.

(Boldface omitted.)

Epic urges that the use of “any” and “all” requires a broader reading of the statute

beyond the construction context. However, the statutory scheme and related provisions

do not support Epic’s argument.

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First, chapter 60.04 RCW, titled “Mechanics’ and materialmen’s liens,” is a

statutory creation in derogation of the common law. Dean v. McFarland, 81 Wn.2d 215,

219-20, 500 P.2d 1244 (1972); Tsutakawa v. Kumamoto, 53 Wash. 231, 236, 101 P. 869,

102 P. 766 (1909). Statutes in derogation of the common law are construed strictly to

apply only to those who fall within the terms of the statute. Williams v. Athletic Field,

Inc., 172 Wn.2d 683, 695, 261 P.3d 109 (2011). The chapter’s section requiring liberal

construction, RCW 60.04.900, is applicable only once it has been determined that the

persons at issue come within the operation of the act. Id. (quoting De Gooyer v. Nw. Tr.

& State Bank, 130 Wash. 652, 653, 228 P. 835 (1924) adhered to on reh’g, 132 Wash.

699, 232 P. 695 (1925)).

Chapter 60.04 RCW applies to liens from “any person furnishing labor,

professional services, materials, or equipment for the improvement of real property.”

RCW 60.04.021. The entirety of the chapter focuses on the effects of such liens. See,

e.g., RCW 60.04.061 (priority of lien), .071 (release of lien rights), .091 (contents of

lien), .121 (assignment of lien). Therefore, the placement of RCW 60.04.226 in chapter

60.04 RCW suggests the statute applies more narrowly to construction loans.

Moreover, in order to encourage lending, it is important that potential lenders have

notice and the opportunity to make informed decisions. A potential lender outside of the

construction context is unlikely to check chapter 60.04 RCW when considering the

potential priority implications of providing a loan. Given the surrounding provisions, it is

clear that RCW 60.04.226 is intended to apply only to construction loans.

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Second, as noted above, the predecessors to RCW 60.04.226 and RCW 60.04.221

were adopted in the same bill. Viewed together, these two statutes balance the equities

between senior lenders, junior lenders, and borrowers. RCW 60.04.226 protects

construction lenders by allowing them to maintain the priority of future advances whether

those advances are optional or obligatory. However, applied alone, this provision could

have a consequential impact on borrowers. Junior lenders may be hesitant to provide a

subsequent mortgage secured by the borrower’s property because they are at risk of

losing priority to any future advances provided by the senior lender. In the construction

context, a subcontractor with a potential lien would always be lower in priority to the

primary construction lender and may find difficulty enforcing their lien. The stop-notice

provision in RCW 60.04.221 addresses this problem by allowing an intervening lien

claimant to give the construction lender notice of their claims. By doing so, the claimant

can be assured of receiving payment directly from the lender or gaining priority over the

lender.

By enacting these provisions, the legislature struck a balance between the interests

of construction lenders and intervening claimants. However, RCW 60.04.221 provides a

stop-notice provision only when the lender is providing interim or construction financing.

When viewing the provisions together, we conclude the legislature intended RCW

60.04.226 to apply narrowly to the construction context. To conclude otherwise would

lead to the very concerns that led the legislature to adopt RCW 60.04.226.

We hold that RCW 60.04.226 does not apply in this case.

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In addition to urging application of RCW 60.04.226 to the present case, Epic

argues that this court implicitly adopted Restatement § 7.3 in its entirety in Kim. In Kim,

this court applied Restatement § 7.3(a) and (b), which applies to the replacement and

modification of mortgages, in a case involving subrogation. The Kim court cited this

section to support its adoption of the principal of equitable subrogation as a matter of first

impression. 145 Wn.2d at 88-89.

In Kim, the Changs obtained a loan from lender A to purchase a home for their

daughter and son-in-law, the Lees. Id. at 82. Two years later, Kim obtained a judgment

lien against the Lees and properly recorded his lien. Id. at 82-83. Soon after, the Changs

gifted the house to the Lees, who decided to refinance the original loan to take advantage

of lower interest rates. Id. at 83. The Lees obtained a new loan from lender B, lowering

their interest rate and stretching the maturation date from 6 years to 30 years. Id. at 87-

88. One of the questions presented to the court was whether or not lender B should

maintain lien priority over the intervening judgment lien. Id. at 85-86. 5

On review, this court started by discussing the doctrine of equitable subrogation,

a doctrine that allows a mortgage refinance lender to maintain priority position if equity

allows. Id. at 87-88. The court then stated, “We adopt the principle of subrogation in the

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mortgage loan context as set forth in the Restatement (Third) of Property: Mortgages §

7.3, as follows . . . .” Id. at 89.

Some examples of the intended application of Restatement § 7.3 include a

construction lender who releases an existing mortgage and immediately records a new

mortgage or a farmer who receives a one-year mortgage then subsequently “renews” the

mortgage with the same lender. Restatement § 7.3 cmt. a. Essentially, the Restatement

authors intended this section to apply to cases where a senior lender has an existing

mortgage and then chooses to modify or renew that mortgage under new terms with the

same borrower. This section was not meant to apply to refinancing situations where a

new lender seeks to maintain the priority of the original lender when the borrower seeks

to refinance the original loan, as was the case in Kim.

Restatement § 7.6, on the other hand, directly relates to equitable subrogation,

which was the issue in Kim. 6 Under § 7.6(a), a new lender can maintain the priority of

the initial lender through subrogation to the extent necessary to prevent unjust

enrichment. The Kim court acknowledged these equitable concerns and cited to the

comments of Restatement § 7.6 multiple times. 145 Wn.2d at 88-90. The court also

explicitly noted that it was applying the equitable principles behind the Restatement’s

rules for replacement and modifications, as set forth in Restatement § 7.3(a) and (b), to

support its application of equitable subrogation. Id. at 89.

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The court applied Restatement § 7.3 because the terms of the new loan obtained

by the Lees were modified from the initial loan. Id. at 90. The court also referenced the

fact that although the borrower changed (from the Changs to the Lees), the rules of

modification apply because the intent of both parties was always for the Lees to obtain

the home. Id.

The parties here argue over how much of Restatement § 7.3 Kim adopted. The

Court of Appeals held that Kim impliedly adopted subsection (c) because of the reference

to that subsection in subsection (b). 7, 8 EM Prop. Holdings, slip op. at 6.

Commencement argues that Kim adopted only subsections (a) and (b) and that the

Court of Appeals’ decision undercuts Kim’s holding by allowing a modified mortgage to

maintain priority despite material prejudice to a junior lienholder. In contrast, Epic

argues that Restatement § 7.3 attempts to balance the equities between the parties and

makes the most sense when read as a whole.

As noted above, Kim adopted the principles of Restatement § 7.3(a) and (b) to

support its application of equitable subrogation. The court did not analyze or discuss the

implications of adopting Restatement § 7.3 as it applies to the modification of a

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mortgage. 9 We reject the argument that Kim implicitly adopted Restatement § 7.3(c) and

(d). 10 We hold that Restatement § 7.3 applies narrowly to the facts of Kim and instead

apply the common law in this case as it pertains to modifications. 11

Under the common law rule, if a mortgage secures future advances that the

mortgagee is not obligated to make—and thus are optional—any future advances are

subordinate to any intervening encumbrance made between the initial mortgage and the

advance when made with actual knowledge of the intervening encumbrance. Elmendorf-

Anthony, 10 Wn.2d at 36.

This rule was intended to protect both borrowers and junior lenders and to

promote efficiency in the lending market. If a mortgage includes a future advances

clause that allows the mortgagee use of property to secure future loans, then the

mortgagor would find it difficult to obtain additional financing from other lenders

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because those lenders would not be willing to offer a loan that risks losing priority to any

future advances offered by the senior mortgagee. In contrast, if the future advances are

obligatory, then future lenders can be assured that there is a maximum limit to the future

advances and can calculate with certainty the potential risk involved when deciding

whether to provide a mortgage.

Under a rule where future advances that are optional lose priority, once the initial

mortgagee has notice of an intervening encumbrance, they can decide whether or not to

advance the additional funds, knowing those subsequent loans will be lower in priority to

the intervening encumbrance. Thus, we hold that the common law optional/obligatory

distinction for future advances applies outside of the construction context.

We are skeptical as to whether there is a future advances clause in the contract at

issue. However, this is a fact-finding issue, and we leave it to the lower court to apply

common law principles for future advances and modifications to determine the proper

lien priority.

We need not reach the issue of whether or not a future advances clause needs to

directly reference the service agreement or state the maximum obligation secured in order

to resolve this case. The common law rule is that any future advance that is optional

loses priority to any subsequent mortgages that come before the optional advances are

distributed. This means that even if Epic’s deed of trust secured subsequent future

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advances, those advances would lose priority to Commencement’s intervening claims to

the extent that the advances were optional.

Commencement states that the language in Epic’s deed of trust was too broad and

that the deed of trust should have directly referenced the underlying security agreement.

Commencement argues that allowing such a broad reading of the deed of trust is unfair

because it does not give sufficient notice to junior lienholders that they may lose priority

to such advances. However, the common law optional/obligatory distinction resolves this

issue and protects junior lienholders by giving those lienholders priority over optional

future advances. Thus, under our current common law rule, it is unnecessary to decide if

a future advances clause is required to contain a statement of the maximum amount that

may be secured by the mortgage.

5. Attorney fees

Epic argues here, as it did in the Court of Appeals, that it is entitled to attorney

fees based on the service agreement and promissory notes it entered into with TTF. But

Commencement was not party to either of these contracts, and so we deny attorney fees

based on the contracts. Epic also argues that it is entitled to fees based on equitable

grounds because it would not have been subject to litigation but for Commencement’s

objection. Our court may award attorney fees on equitable grounds when a third party is

subject to litigation as a natural and proximate consequence of another party’s wrongful

act. Wells v. Aetna Ins. Co., 60 Wn.2d 880, 882, 376 P.2d 644 (1962). However, Epic

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does not point to any wrongful acts by Commencement that were the proximate cause of

this litigation. We deny attorney fees on equitable grounds.

CONCLUSION

RCW 60.04.226 is inapplicable to this case, and so the common law

optional/obligatory distinction for future advances clauses applies. We also decline to

extend the application of Restatement § 7.3 and instead find that the common law rules

for both future advances and modifications should apply. We reverse the Court of

Appeals and remand this case to the trial court to determine the correct priority of claims

consistent with this court’s conclusions.

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WE CONCUR:

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