Equitable Subrogation and the Replacement Doctrine
All real estate professionals and investors are familiar with the concept of the priority of liens. As a general rule, when there are multiple liens recorded against a property, the one that is recorded first is "superior" to the one that is recorded later, which, in turn, is "subordinate" to the one that is recorded first. This "ranking" of liens becomes critical if a lien is foreclosed, as upon the completion of the foreclosure all liens that are subordinate to the foreclosed lien are eliminated.
When Lien Priority Exceptions
A notable exception to the general rule set forth above is when the related, but distinct, doctrines of "equitable subrogation" and the "replacement doctrine" apply. Equitable subrogation is "the substitution of another person in the place of a creditor, so that the person in whose favor it is exercised succeeds to the rights of the creditor in relation to the debt." Sourcecorp Inc., v. Norcutt,229 Ariz. 270 (2012). The Court in Sourcecorp explained that the remedy of equitable subrogation is "designed to avoid a person's receiving an unearned windfall at the expense of another," and that "the general rule is that a person having an interest in property who pays off an encumbrance in order to protect his interest is subrogated to the rights and limitations of the person paid."
In that equitable subrogation is an "equitable remedy," the courts will focus on the specific factors of each case in determining whether to apply it, including whether the purpose of the payment of the debt was to protect that party's interest in the property. Again, as noted by the Court in Sourcecorp, equitable subrogation "does not turn on contractual principals, but instead on the concern to prevent unjust enrichment."
When Equitable Subrogation Applies
In order for equitable subrogation to apply, the payor must be paying off the debt of another. In a situation where a lender is paying off its own loan, equitable subrogation does not apply, but rather, the replacement doctrine applies to achieve the same result. The replacement doctrine is most often applied in the context of the refinancing of an existing loan, so that the refinancing lender maintains the priority that it originally held as against any junior lienholders.
The following example will illustrate both of these concepts. Say that Homeowner has a loan from Bank A in the amount of $300,000 secured by a first trust deed in favor of Bank A; a loan from Bank B in the amount of $200,000 secured by a second trust deed in favor of Bank B; and a home equity line of credit from Bank C, secured by a third trust deed, which is in third position by virtue of it having been recorded after the Bank A and Bank B trust deeds. In order to consolidate its debts and to achieve an overall lower interest rate, Homeowner borrows $500,000 from Bank B, which is used to pay off both of the existing Bank A and Bank B loans. Even though the new trust deed which secured the new $500,000 Bank B loan is recorded after the Bank C third trust deed, it nevertheless is deemed to be in a superior position to the Bank C trust deed, in that equitable subrogation applies to the first $300,000 of the new money lent by Bank B that was used to pay off Bank A loan, and the replacement doctrine applies to the next $200,000 of the new money lent by Bank B that was used to pay off its own prior loan.
About the Author: David Allen, a partner in the Phoenix law firm of Jaburg & Wilk, has been representing clients in both transactional and litigation real estate and business related matters for over thirty years. He is licensed as an attorney in both Arizona and California, and is also a licensed Arizona real estate broker.