Word to the Wise: The Doctrine of Equitable Subrogation May Permit a Lender to Obtain Priority Over Earlier Perfected Mechanic’s Liens

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Contributed by Dana Hall

A recent decision in the United States Bankruptcy Court for the District of Arizona, In re Mortgages Limited, addressed the relative priority of mechanic’s liens dating from the commencement of construction in 2006 versus a later recorded deed of trust by a construction lender.  Although the bankruptcy court in Mortgages concluded that the lender’s deed of trust ordinarily would be junior to the mechanic’s liens, it also held that the doctrine of equitable subrogation might permit a lender to step into not only the shoes of a former lender whose deed of trust was discharged with the proceeds of the lender’s loan, but also the shoes of the former lender’s former lender, and so on, to the extent that each lender’s proceeds were used to discharge the previous lender’s deed of trust.

Mortgages Limited’s Bankruptcy and the Lien Claimants

Prior to its chapter 7 case, Mortgages Limited, as its name would suggest, was in the business of making real estate loans.  In July 2005, Mortgages Limited made an $8.5 million loan, secured by a deed of trust, to a hotel, $3 million of which was used to repay the existing secured debt on the hotel and obtain a release of the first lender’s deed of trust.  In November 2006, the hotel began construction of improvements.  One month later, the hotel obtained a new secured loan from Choice Bank and used $7.3 million of the proceeds to pay off the outstanding debt to Mortgages Limited and to obtain a release of Mortgages Limited’s deed of trust.  Mortgages Limited, however, was not out of the picture for long, though, because several months later the hotel repaid its $8.9 million loan from Choice Bank with a portion of a $75.6 million loan from Mortgages Limited.  In 2008, a second contractor, Summit, commenced work on the hotel and recorded its mechanic’s lien on the subject property.  The work performed by Summit was part of the same project that had begun in November 2006.

If You Could Only Stand in Their Shoes…

After the mechanic’s lienholders commenced proceedings to foreclose on their mechanic’s liens, Mortgages Limited asked its bankruptcy court to (1) invalidate one of the mechanic’s liens under Arizona law and (2) determine that, under principles of “equitable subrogation,” the priority of Mortgages Limited’s new deed of trust could relate back to the earlier deeds of trust on the hotel.  Although the bankruptcy court rejected Mortgages Limited’s first argument, it did conclude that equitable subrogation was available to establish a lien date of July 2005, which date was prior to the commencement of construction and attachment of the mechanic’s liens.  Accordingly, Mortgages Limited’s deed of trust could have priority over the mechanic’s liens to the extent of the amount of the original July 2005 debt ($7.3 million) that had been paid off in the refinancing.

Equitable subrogation is a widely recognized state law remedy that typically applies when a third party has agreed to discharge a lien or other encumbrance on property of another, when the third party is not a volunteer, and when the third party has provided payment pursuant to an agreement that he will be substituted in place of the former lienholder.  The Mortgages court, relying on a 2004 decision by the Court of Appeals of Arizona, determined that the “agreement” requirement could be satisfied by a showing that the second lender had intended to obtain first lien priority, notwithstanding that the second lender had not obtained an actual assignment of the first lender’s deed of trust.  According to the Mortgages court, the requirement that the title insurance policy show the new lender to have a valid first lien against the property provided sufficient evidence of Mortgages Limited’s intent to be subrogated to the rights of the prior lender.

Merely subrogating First Mortgages to the priority of the immediately preceding lender, Choice Bank, would not have benefited First Mortgages because the construction work on which the mechanic’s liens were premised had commenced one month prior to the recordation of Choice Bank’s deed of trust.  The court concluded, however, that Mortgages Limited could assert a right to equitable subrogation to the priority lien date of the first Mortgages Limited deed of trust.  Accordingly, the court determined that Mortgages Limited was entitled to partial summary judgment establishing a lien priority date of July 2005 to the extent of the $7.3 million portion of the Choice Bank loan used to discharge the first Mortgages Limited deed of trust and a May 2007 lien priority date to the extent of the $8.9 million portion of the second Mortgages Limited loan used to discharge the Choice Bank deed of trust.

Mortgages Limited carves out an interesting exception to the normal priority rules applicable to mechanic’s liens.  Although the decision arose in the foreclosure context, it highlights a potential tool that lenders may have under state law to obtain priority over mechanic’s liens relating to work commenced before the perfection of the lenders’ mortgages or deeds of trust.