Equitable Subrogation and Lender Options
In recent years, Arizona courts have decided a number of cases involving equitable subrogation, not all of which can be easily reconciled.
The doctrine of equitable subrogation probably
does not come up very often at pool parties, but it is a concept with which real
estate lawyers (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.
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
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.
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.