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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 play.

Stephen Aron Benson  

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 – Sourcecorp v. 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 issue differently.

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 subrogation.

Steve Benson is a Certified Specialist in Real Estate Law (Arizona Board of Legal Specialization).