The Kentucky Court of Appeals ruled last week that a junior mortgagee may not force a judicial sale free and clear of a senior mortagee's interest even when the senior mortgagee defaults in the underlying foreclosure litigation.

In Mortgage Electronic Registration Systems v. Mainsource Bank, No. 2012-CA-001168 (Feb. 21, 2014), the junior lienholder had instituted a foreclosure suit, naming the senior lienholder as a defendant and properly serving it. The senior lienholder did not timely answer, and the Jefferson County Circuit Court entered a default judgment on January 13, 2012. The Master Commissioner set a sale date for March 6, 2012. On February 23, 2012, prior to the sale, the senior lienholder filed a motion seeking to subject the sale to its lien. The Court denied that motion, noting that default had already been entered. The property sold at auction as ordered, free and clear of the senior mortgage.

The Court of Appeals reversed, holding that, notwithstanding the default judgment, KRS 426.690 required that Court respect the existence of the senior lien when notice of it was given prior to the sale:

The plaintiff in an action to enforce a lien on real property shall state in his petition the liens, if any, which are held thereon by others, and make the holders defendants; and no sale of the property shall be ordered by the court prejudicial to the rights of the holders of any of the liens....

Relying on this language, the Court went on to state:

In other words, [the statute] forbids judicial sales prejudicing lienholders. Thus, property cannot be foreclosed by a junior mortgage lienholder and sold unencumbered by the senior mortgage lien of record, when the senior lienholder makes its claim known to the court before the judicial sale. The sale disposing of [the senior lienholder's] mortgage is clearly prejudicial to [its] rights as a lienholder. Notably, [the statute] permits a foreclosure sale at which the property is sold on petition of a senior mortgage holder 'notwithstanding the existence of inferior liens.' The statute differentiates a foreclosure sale by a holder of an inferior lien, since such sale is 'subject to a prior lien or liens thereon.' The contested property, therefore, shoudld have been sold subject to [the senior lienholder's] mortage.

Id.

While all lienholders should clearly endeavor to respond to foreclosure complaints to protect their interests, this opinion will provide senior liens a bit of added protection even in the event default judgment is entered. So long as the claim is asserted prior to the sale, the sale must be subject to the first lien.