The California Court of Appeal, First District, recently reversed a lower court’s denial of a request for equitable subrogation by two lien holders over a third, where the third lien holder was initially the most junior lien holder on the subject property, but was able to advance to the priority position due to a series of refinances.
In so ruling, the Court held that equitable subrogation was appropriate under these factual circumstances where the doctrine would work to restore all the lien holders to a position reflecting the intentions of all the parties and the lien holders requesting equitable subrogation where not negligent.
A copy of the opinion is available at: http://www.courts.ca.gov/opinions/documents/A137140.PDF
The First Lien Holder extended a multi-million dollar loan to the borrower secured by a lien on the subject property. Subsequently, the Second Lien Holder with knowledge of the First Lien Holder extended another loan to the borrower secured by a lien on the subject property in second position. Finally, the Third Lien Holder extended a loan to the borrower secured by a lien behind both the First Lien Holder and Second Lien Holder.
The Third Lien Holder knew that its lien was a junior lien, but assumed that it was in the second position. However, the Court noted that the Third Lien Holder did not verify its lien’s priority. Additionally, due to errors made by the Third Lien Holder’s agent, the deed of trust recording its lien incorrectly provided that the amount of the loan as $100,000 and not $500,000.
Following the recording of the Third Lien Holder’s lien, the borrower refinanced its loan with the First Lien Holder and Second Lien Holder. Each of the respective refinancing agreements required that their lien positions be preserved.
The escrow agent for the refinance loans requested a payoff demand from the Third Lien Holder’s agent. The agent submitted to escrow a zero demand and request for reconveyance, along with the original note and deed of trust. The lower court found that the Third Lien Holder’s agent had forged his signatures on the zero demand and request for re-conveyance.
For unclear reasons, the Third Lien Holder’s lien was not reconveyed and remained on the record. Thus, when the First Lien Holder and Second Lien Holder refinanced their loans, the record title for the property reflected that the respective positions of the First and Second Lien Holders were now junior to the Third Lien Holder.
Eventually, the borrower defaulted on his loans, and the First Lien Holder began foreclosure proceedings. The Third Lien Holder then filed its complaint seeking the reformation of its lien amount from $100,000 to reflect the $500,000 of the amount of the actual loan, and judicial foreclosure of the subject property.
In the lower court, the First and Second Lien Holders argued that the doctrine of equitable subrogation applied to restore their lien positions, and that they were bona fide encumbrancers preventing the reformation of the Third Lien Holder’s deed of trust. The lower court rejected the First and Second Lien Holders’ arguments, and reformed the Third Lien Holder’s deed of trust and determined the Third Lien Holder was entitled to judicial foreclosure. The First and Second Lien Holder appealed.
The Appellate Court analyzed the underlying facts in the record and applied the doctrine of equitable subrogation. As you may recall, in California, the general rule of equitable subrogation provides:
“One who advances money to pay off an encumbrance on realty at the instance of either the owner of the property or the holder of the incumbrance, either on the express understanding, or under circumstances from which an understanding will be implied, that the advance is to be secured by a first lien on the property, is not a mere volunteer; and in the event the new security is for any reason not a first lien on the property, the holder of such security, if not chargeable with culpable and inexcusable neglect, will be subrogated to the rights of the prior encumbrancer under the security held by him, unless the superior or equal equities of others would be prejudiced thereby, and to this end equity will set aside a cancellation of such security, and revive the same for his benefit.”
Simon Newman Co. v. Fink, 206 Cal. 143, 146, 273 P. 565 (Cal. 1928). Thus, as the Court noted, equitable subrogation gives effect to the intentions of the parties.
The Court found that the First and Second Lien Holders refinance terms were subject to the maintenance of the lien positions. Additionally, the Court pointed out that the Third Lien Holder knew at the time of its loan was extended that its lien would be junior, and did not expect to receive a first-position lien.
The Court criticized the lower court’s determination that the First and Second Lien Holder’s knowledge of the Third Lien Holder’s lien at the time of their refinancing agreement prevented the application of the doctrine of equitable subrogation. The Court pointed out that the evidence reflected that while the First and Second Lien Holders were aware of the Third Lien Holder’s lien, they did not anticipate that it would remain on the property, and indeed, made the maintenance of their lien positions a prerequisite to the closing of the refinance transactions.
The Court also noted that any potential negligence by the escrow holder would not provide a basis for denying equitable subrogation. The Court explained that in California, as escrow holder is an agent and fiduciary of the parties to the escrow with the limited agency obligation to each in carrying out their respective instructions to the escrow. Thus, according to the Appellate Court, there was no basis to deny equitable subrogation based upon the actions of the escrow agent.
Finally, the Court rejected the Third Lien Holder’s argument that equities favored it because it had no knowledge of the refinance transactions, and if it had known, it would have asked for full repayment of its loan. The Third Lien Holder based its argument upon the fact that its agent had been found to have forged the Third Lien Holder’s signature on the reconveyance requests submitted to the escrow agent. However, as noted by the Court, the Third Lien Holder had been aware of similar actions by its agent in prior transactions, and by being placed in the third position, the parties each received what they expected.
Accordingly, the Court reversed the lower court’s determination, and held that under these circumstances, the fact that the Third Lien Holder’s trust deed was not reconveyed does not establish the type of “culpable and inexcusable neglect” by the First and Second Lien Holders to justify the denial of equitable subrogation.
After determining that the First and Second Lien Holders were entitled to equitable subrogation placing the Third Lien Holder’s lien in the junior position, the Court declined to address the lower court’s ruling on the reformation of the Third Lien Holder’s lien.
Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
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