Equitable Subrogation and Lender Options

August 14, 2016 Stephen Aron Benson James S. Samuelson Real Estate Law

In recent years, Arizona courts have decided a number of cases involving equitable subrogation, not all of which can be easily reconciled.

The idea is that when a lender makes a loan that takes out an existing loan on a piece of real estate, the new lender gets to slide into the old lender’s priority position. For example, the concept comes into play when a “permanent” lender takes out a construction lender and, at least theoretically, takes over the construction lender’s first position ahead of any “junior” loans or mechanics’ liens that were subordinate to the construction lender’s first lien position (of course, in that scenario, most permanent lenders do not want to simply rely on the legal concept of equitable subrogation; they look for additional ways to solidify their position). The purpose of the doctrine is to prevent unjust enrichment by the junior lienholders.The doctrine of equitable subrogation probably does not come up very often at pool parties, but it is a concept with which real estate attorneys (and lenders) should be familiar. Simply put, equitable subrogation is the substitution of another person in the place of a creditor, so that the “substituted” person succeeds to the rights of the former creditor with respect to the debt.

In recent years, Arizona courts have decided a number of cases involving equitable subrogation, not all of which can be easily reconciled. A recent Arizona Court of Appeals case, Markham Contracting Co., Inc. v. Federal Deposit Insurance Corporation, involved a fairly common set of facts. Lender B made a loan that was used in part to pay off Lender A’s first lien position, giving Lender B priority over Markham’s second position mechanics’ lien on the project. Lender B’s loan went into default, and Lender B held a trustee’s sale, “winning” the trustee’s sale by submitting a credit bid equal to the balance of Lender B’s loan. Lender B took the position that the mechanics’ lien was subordinate to Lender B’s first position loan and had been foreclosed out.

The Markham court recognized that equitable subrogation applied and that Lender B was in first position – with the following exception: Equitable subrogation allowed Lender B to get priority only to the extent of the balance of the old (Lender A) loan (in this case, the Lender B loan was larger than the Lender A loan). The court decided that, since the credit bid by Lender B was larger than the balance of the old Lender A loan, Lender B would have to pay to the junior lienholder the difference between the balance of the Lender A loan and the credit bid submitted by Lender B, despite the fact that no cash changed hands at the trustee’s sale.

The Markham case illustrates that, while a lender is permitted to bid up to the full amount of the outstanding indebtedness (the principal balance of the loan plus interest and certain costs), a lender is not obligated to bid its entire available credit bid – and, perhaps given this case, should not bid higher than the balance of the loan that had been “replaced” with the new loan. Unless there is a dramatic difference between the balance of the prior loan and the balance of the new loan, the practical result in the Markham case (i.e., Lender B “winning” the trustee’s sale) would probably have been the same, with the mechanics’ lien being foreclosed out.

Practice Point

A new lender who has taken out an old lender and, under the doctrine of equitable subrogation, gained first position, should carefully analyze his options if and when the new loan goes into default.