Equitable Subrogation in a Down
Real Estate Market
When property value is less than the face amounts of multiple liens, leading to
fights over who gets paid first, the concept of equitable subrogation can come into
In the past few years we have seen a significant
increase in the number of cases involving “equitable subrogation.” This term,
and the concept of equitable subrogation generally, is one that only a real
estate lawyer could love. Essentially, it means that, in certain situations, a
party who provides funds that pay off an existing lien will step into that
lienholder’s position and be deemed to have a higher priority than any liens
that were junior (at the time) to the lien being paid off.
Equitable subrogation often comes up in the context of mechanic’s liens: A new
lender wants to be in the same position as the previous lender with respect to
possible mechanic’s liens, and equitable subrogation is often applied to allow
the new lender’s lien to take priority over any mechanic’s liens.
With the recent broad decline in the real estate market, we have seen equitable
subrogation arise in other real estate contexts. The values of many properties
no longer support the face amounts of multiple liens, leading to fights over who
gets paid first; thus, even though mechanic’s liens are not necessarily
involved, the concept of equitable subrogation comes into play.
Recently, the Arizona Supreme Court decided an important case –
Norcutt – that involved equitable subrogation. In that case, the original
transaction was not unusual; the Norcutts purchased their residence with cash
and paid off the seller’s loan on the property. However, two months before the
sale to the Norcutts, a judgment had been entered against the sellers by another
party, Sourcecorp. Sourcecorp recorded its judgment against the sellers and
therefore had a perfected judgment lien against the property. The Norcutts’
title insurance examiner did not pick up the judgment lien. After the Norcutts
closed on the purchase of their new home, Sourcecorp, which held the judgment
lien, claimed that it was in first position on the property and sought to
foreclose. In effect, Sourcecorp claimed that it had “moved up” its position
when the old first mortgage lien had been paid off, and the Norcutts were out of
luck – and would be out of their new home.
The Norcutts sought relief in the courts. After eight years of litigation, the
Arizona Supreme Court held in their favor, applying equitable subrogation and
placing the Norcutts in the position of the seller’s lender (i.e., “ahead” of
Sourcecorp). In this particular case, there was no evidence that the new
homeowner knew about the judgment lien. The court was concerned that, if
equitable subrogation did not apply, Sourcecorp would have received a windfall,
and the court applied equitable subrogation to prevent that result.
Issues of Concern
The court’s reasoning is certainly understandable, but there are
at least three points of concern
that warrant further comment.
The first involves title insurance. The court seemed to dismiss that factor as
irrelevant to the legal issue of equitable subrogation (i.e., who should be in
first position). In effect, the court seemed to be saying that it was not
persuaded by the fact that the homeowner could be made financially whole by its
title insurance claim. If a residence was not involved – for example, if the
property had been an office building – perhaps the court would have viewed this
The issue of title is also troubling because the Sourcecorp lien was not paid
off or eliminated; it would stay on the title, but Sourcecorp would be unable to
foreclose. That result makes the property essentially unmarketable, meaning that
the Norcutts would now have to make a claim against their title insurance policy
– and might be met with policy limits that would be less than the amount of the
problematical judgment lien.
In addition, there is the issue of knowledge. If the new homeowner knew that
there was a lien in place but did not take what would appear to be the ordinary
business approach of ensuring that the lien was either paid off or legally
subordinated, the result may have been different. In other words, a new owner or
lender should not be able to take advantage of a situation that could have been
addressed with ordinary diligent business practices. To some extent, this whole
approach also conflicts with the fact that many consider Arizona to be a “record
state” – i.e., if something is of record, then you have constructive notice of
the problem, whether or not you “actually” knew about it. Under that theory, the
Norcutts really did “know” about the problem (or least their agent, the title
insurance company, should have known), and it is uncertain how this knowledge
issue will play out in similar cases.
Although the downturn may be mostly behind us, cases of lien and ownership
priority will be making their way through the court system for years to come. I
suspect that the final word has not yet been written on the subject of equitable
Steve Benson is a Certified Specialist in Real Estate Law
(Arizona Board of Legal Specialization).