When “First In Time” Isn’t Early Enough: California Court of Appeal Reaffirms the Doctrine of Equitable Subrogation

I.        INTRODUCTION

Breaking California’s general “first in time, first in right” system of lien priorities, equitable subrogation permits a new lienholder to leapfrog the secured priority positions of other lienholders.  In J.P. Morgan Chase Bank, N.A. v. Banc of America Practice Solutions, Inc.[1] the court of appeal published its first equitable subrogation opinion in sixteen years, reaffirming California’s unique test for the application of the doctrine, first invoked over eighty-four years ago.

II.        EQUITABLE SUBROGATION

Generally, “different liens upon the same property have priority according to the time of their creation. . . .”[2]  However, under the doctrine of equitable subrogation, a new lender that pays off a senior secured lien can “step into the priority shoes” of that senior lienholder, while other liens remain in their junior position even though they are prior in time to the new, subrogated lien.  This substitution of the new lender for the senior lienholder has been called “a sort of assignment by operation of equity.”[3]  The effect is just as if the senior lienholder, upon receiving payment from the new lender, made an express assignment of its security rights in the collateral.[4]  The discharged lien and underlying obligation is, in this legal fiction, revived and assigned to the new lender permitting the new lender to be paid before the junior lien holders.

The purpose of the doctrine is not to reward the new lender or to punish the existing lienholders (who will effectively lose priority).  Equitable subrogation is meant to place the parties in the priority position that they expected to receive, and that they bargained for.[5]

The most basic example is the refinance of a home loan.  Suppose a borrower purchases a home with a $500,000 loan from lender A, secured by a first priority deed of trust.  Borrower then takes out a $75,000 second loan for home improvements from lender B, which is secured by a junior deed of trust encumbering his home.  Several years later, borrower refinances his purchase loan with a $500,000 loan from lender C with similar (or better) terms than the original purchase loan.  Lender C does not have actual knowledge of lender B’s junior trust deed.  Lender C’s funds are disbursed, lender A’s purchase loan is paid off, its deed of trust is reconveyed, and a new deed of trust is recorded in favor of lender C.  According to the “first in time, first in right” recording rules,[6] the home equity lender (lender B) now holds a first priority deed of trust, and lender C holds a junior position.  Applying equitable subrogation, however, lender C (the refinancing lender) is placed in the senior priority position of the discharged purchase loan.  Lender B (the home equity lender) does not suffer any prejudice (assuming that the amount and terms of the new loan are not more onerous than the obligation to lender A)[7] as a result of this priority reordering because it remains in the same junior position that it held at the time it extended credit.  Permitting it to be elevated to senior position merely as a result of the refinance would result in a windfall to lender C.

As a practical matter, in most situations the lender will first obtain a preliminary report, an escrow will be opened with instructions that recordation of a deed of trust in first priority position is a precondition to disbursement of the funds, and then a title policy is issued in favor of the lender.  So in lender C’s scenario, typically lender C would lack actual knowledge of lender B’s intervening security interest only if it was missed by its title insurer.  If equitable subrogation is not applied, lender C would likely tender a claim under its title policy, and assuming no exclusions or exceptions applied, lender C would be made whole by its title insurer.  When equitable subrogation is applied, however, the title insurer will not need to indemnify lender C because there is no loss under the title policy.  Thus, as a practical matter, one of the beneficiaries of equitable subrogation is likely the title insurer who did not identify an intervening security interest as part of its title search.

California’s convoluted test for the application of the doctrine as typically described by the courts is as follows:

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 encumbrance, either on the express understanding, or under circumstances from which an understanding will be implied, that the advance made 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. [Citations.][8]

Unpacking this dense recitation of the law into plain English, equitable subrogation may be applied in favor of a lender when:

(1) the lender advances money to discharge an existing encumbrance;

(2) at the request of the borrower or holder of the encumbrance;

(3) with the understanding that the loan is to be secured by a senior lien on the property;

(4) the lender has not committed culpable or inexcusable neglect; and

(5) the superior or equal equities of others are not prejudiced.[9]

An additional requirement is that the new lender cannot be a “volunteer,” but this requirement is satisfied if the lender’s loan is secured by a deed of trust, so this requirement is virtually never disputed.[10]

1. The Superior or Equal Equities of Others Are Not Prejudiced. 

In most cases, courts focused on the last two elements (culpable or inexcusable neglect; and superior or equal equities), since the other elements are fairly straightforward.[11]

The court’s requirement that “the superior or equal equities of others” must not be “prejudiced” means that a judicial re-ordering of the priorities must not place an existing junior lienholder in a worse position then it bargained for and expected to receive at the time it made its loan.  Although there are multiple prerequisites for applying equitable subrogation, this element is usually outcome determinative.  This makes sense because, at base, the purpose of equitable subrogation is to restore the parties’ security interests to the priority positions they expected to receive, and that they bargained for.[12]  Thus, “prejudice” is determined based on the expectations and intent of the lienholders.[13]

However, the existing junior lienholder is not entitled to a windfall, and there are few scenarios where the existing junior lienholder is prejudiced by equitably subrogating a new lender into the priority position of the senior lien that it paid off and discharged.  The holder of a junior lien or interest is generally put in no worse situation if a third party who pays off the senior debt is equitably subrogated to the senior lien’s priority (up to the amount of the discharged debt and so long as on substantially the same terms).[14]  The junior lienholder did not rely on the absence of the senior lien when it first extended credit or transferred value, and would receive a windfall if the doctrine were not applied.[15]  Accordingly, where subrogation does not change the secured position that the subordinated lender originally bargained for when advancing money in exchange for its real property security interest, and where the terms and amount of the new loan is substantially the same as the discharged loan, the subordinated lender is not unfairly prejudiced.[16]

In Smith v. State Savings & Loan Assn.[17] the court of appeal held that a refinance lender was entitled to be equitably subrogated into the priority position of senior deeds of trust, which it retired, and that the holder of the fourth deed of trust, of which the refinancing lender had no actual knowledge, would not be prejudiced.[18]  After applying equitable subordination, the holder of the fourth deed of trust remained in the same priority position it held before the refinancing of the senior deeds of trust.[19]  If equitable subrogation was denied, however, the holder of the fourth deed of trust would have received a windfall, moving up to a better position than it originally bargained for.[20]

An interesting problem exists when the new lender makes a new loan in a greater amount (or on materially different terms) than the senior secured debt that it seeks to discharge (and be equitably subrogated to).  If the new loan is in a greater amount than the existing senior secured debt, allowing the new lender to enforce the entire loan as senior to the junior lienholders will prejudice the junior secured lienholders.[21]  The increased principal will increase the risk of default and the equity in the property available to satisfy the junior lienholder’s obligation, resulting in injustice to junior security holders.[22]  However, the court can order the new loan be equitably bifurcated, whereby the new lender is subrogated only up to the amount of the original loan, and the excess amount of the loan is secured as a junior lien.[23]  Under this scenario, the existing junior lienholders retain the same position it held prior to the equitable subrogation.[24]  A court could similarly bifurcate a new loan with a different interest rate than the senior secured loan that it seeks to replace, by calculating the excess amount of the new loan, and bifurcating that amount in a junior secured position.[25]

A more difficult question is how to treat a new loan on materially different terms – such as an accelerated maturity date.  An accelerated maturity date, under certain circumstances, may be beneficial to the junior lienholder because the senior obligation is extinguished earlier and often at a reduced interest rate.  However, where the maturity date is drastically accelerated while the principal value and monthly payment obligations are significantly increased, an accelerated maturity date may be prejudicial as it raises the likelihood of default on the senior lien.  Practically, it may be difficult for the court (or the parties) to figure out how to equitably bifurcate a loan with such drastically different terms.  Similarly, what would a court do if the original security interest in the new loan did not contain the power of sale clause, but was being replaced with a loan that did?  Could the new lender non-judicially foreclose the new debt based on the provisions of the discharged loan?  While this is just theoretical and unlikely, it illustrates potential problems created by a new lienholder stepping into the shoes of an existing senior lienholder.

Indeed, in Lawyers Title Ins. Corp. v. Feldsher,[26] one of the little discussed reasons for the court’s denial of equitable subrogation was due to the differing terms of the new loan – more specifically, its extended maturity date.  In that case, the junior secured lender testified that he accepted a fourth priority position lien because he was aware that more senior priority deeds of trust were on the verge of maturing.[27]  At the time he took a fourth priority lien, only nine months remained on certain senior deeds of trust, and the junior lender had an expectation that the senior priority deeds of trust were merely temporary.[28]  To allow a new lender to essentially revive a senior lien when it was on the verge of maturing, would run contrary to the expectation of the holder of the fourth priority lien, and deprive him of the benefit of his bargain.[29]

The court in Feldsher does not identify the maturity date of the new loan, nor does it acknowledge that an extension of the maturity date in the paying loan is not generally prejudicial because it typically reduces the likelihood of foreclosure of a senior lien.  In other words, typically, the reason the borrower obtains the new loan with an extended maturity date is because he cannot pay the existing loan that is set to expire.  Thus, absent the new loan, the borrower will default, and the existing senior lienholder will foreclose on his security, extinguishing the debt of the junior lienholders.  The junior lienholders may be better off with an equitably subrogated senior lien with an extended maturity date, than face imminent default and foreclosure.

2. The Lender Has Not Committed Culpable and Inexcusable Neglect.

            The greatest uncertainty in litigating an equitable subrogation case is determining whether the new lender is guilty of “culpable and inexcusable neglect” in failing to protect the senior priority position of its security interest.  “Culpable and inexcusable neglect” typically requires the new lender to have actual knowledge of an intervening lien, but still fail to take any affirmative steps to protect its desired senior secured status.[30]  Constructive knowledge of an intervening lien is not sufficient.[31]  Thus, even the failure to search the public records does not constitute the type of culpable and inexcusable neglect which justifies the denial of equitable subrogation.[32]

            Although this element is widely cited and discussed, in practice, where the intervening lienor does not suffer any prejudice, equitable subrogation is rarely denied, even if the new lender has some actual knowledge of the intervening lien.[33]  Indeed, California is fairly unique in even having this “culpable and inexcusable neglect” requirement.  Under the Restatement approach, the subrogee’s actual knowledge of the intervening lien is irrelevant, so long as the subrogee intended to receive a security interest with a priority equal to the mortgage being paid.[34]  This makes sense because if the intervening lienholder is not prejudiced, it should not matter whether the new lender’s sloppy lending or title practices necessitate its application of the doctrine.  In effect, the “culpable and inexcusable neglect” element adds an additional layer of judicial discretion that creates uncertainty for the parties.

            For instance, in Copp v. Millen[35] the California Supreme Court permitted equitable subrogation even though the refinancing lender had some actual knowledge of the possibility of an intervening lien claimant, because the Court reasoned that the intervening lienholder would not be prejudiced.[36]  In that case, the defendant purchased land and recorded a security instrument in favor of the plaintiff.[37]  A few months later, the defendant sold the property to a third party.[38]  Later, the plaintiff refinanced and extended the maturity date on his loan to the defendant, even though he had actual knowledge that the defendant had sold the property to a third party.[39]  The Court determined there was no prejudice to the intervening lien claimant (the third-party buyer), since the buyer’s priority position was not materially changed by judicially placing the refinancing loan into the priority position of the original mortgage and deed of trust.  The new buyer remained in the same priority position as when he purchased the property (i.e., subject to a first priority deed of trust).[40]  The Court reasoned:

[S]ome knowledge or means of knowledge of the existence of other person's rights in the property does not in every case preclude the court from granting the relief sought. So that if, notwithstanding the mortgagee had some knowledge or notice, the intervening lienholder is not prejudiced by the continuance of the priority of the original mortgage and is in no different position than he would have been had the release not been recorded, equity will place the parties in their original position.[41]

In other words, in Copp, the Court effectively held that equitable subrogation is an available remedy, so long as it does not prejudice the intervening lien claimant.[42] And, the Court ignored the “culpable and inexcusable neglect” requirement.

Likewise, a subrogee is entitled to equitable subrogation and not deemed charged with “culpable and inexcusable neglect” where its agent has actual knowledge of an existing recorded junior lien.[43]  In Han v. United States the appellate court noted that “by statute, knowledge that is imputed by action of law is constructive knowledge, not actual knowledge.”[44]  Accordingly, the knowledge imputed from a purchaser’s agent to the purchaser is merely constructive knowledge, and constructive knowledge does not bar equitable subrogation.[45]

            By contrast, in Lawyers Title Ins. Corp. v. Feldsher[46] equitable subrogation was denied based on the subrogee’s “culpable and inexcusable neglect.”  In Feldsher, an experienced commercial lender had actual knowledge of four deeds of trust recorded against a residential property.[47]  The proceeds of the commercial lender’s loan were used to discharge the second position lien, but the commercial lender mistakenly believed that that his loan would then exist in place of the second deed of trust.[48]  In fact, his new security interest was recorded in last place.[49]

            The borrower subsequently defaulted on his obligation to the holder of the lien (previously) in fourth priority position, who then nonjudicially foreclosed his deed of trust, which extinguished the commercial lender’s last place security instrument.[50]  The holder of the fourth priority position lien only learned of the commercial lender’s deed of trust after the trustee’s sale.[51]

            Plaintiff, a title company, had previously issued a title insurance policy to the commercial lender, which erroneously identified the commercial lender’s deed of trust as senior to the fourth priority position lien, when in fact, the commercial lender’s deed of trust was in last place.[52]  The lender sought to recover his loss under the title policy and the title company then sued the foreclosing lender (who was previously the holder of the fourth priority position lien), seeking to impose an equitable lien on the property (based on the commercial lender’s payoff of what was then the second priority position deed of trust).[53]

The court of appeal concluded that the doctrine of equitable subrogation could not be applied under the facts of this case because the commercial lender was chargeable with inexcusable neglect.[54]  The court noted that the commercial lender had both actual and constructive knowledge of the deeds of trust encumbering the property, and he knew that his new loan would be in last priority position unless he obtained a written subordination agreement from the other security holders.[55]  The court also considered that the commercial lender continued with the transaction without taking any affirmative steps to ensure his interest would be protected, despite the fact that he was an experienced lender and should have realized that the loan documents did not include a written subordination agreement.[56]  The court concluded that this “failure demonstrates negligence far more culpable than a mere failure to search records for an intervening lien.”[57]

The plaintiff title insurance company argued that the commercial lender’s actual knowledge of the intervening liens should not preclude equitable subrogation.[58]  The court considered Copp v. Millen, acknowledging that in Copp, equitable subrogation was applied despite actual knowledge of the intervening lien.[59]  The court reasoned that the commercial lender in Feldsher had more knowledge than the subrogee in Copp, but unlike Copp, the intervening lien claimant in Feldsher would be prejudiced by the judicial reordering of the priorities (further supporting the argument that prejudice is the true test for whether equitable subrogation will be applied).[60]

III.       CHASE v. BANC OF AMERICA PRACTICE SOLUTIONS

            The latest equitable subrogation decision, Chase v. Banc of America Practice Solutions, Inc.[61] is a relatively straightforward case where the court applied the doctrine without breaking any real new ground.  Like most cases, the court focused on the last two elements (culpable or inexcusable neglect; and superior or equal equities), since the other elements are fairly straightforward.[62]  And like most cases, the outcome was largely determined based on the expectation of the parties – i.e., based on a determination of whether the intervening lien claimant would suffer prejudice.

            In Chase, the borrowers’ residence was initially encumbered by two deeds of trust, one securing a $2 million loan from Chevy Chase Bank, and a second securing a $1 million debt to Bay Area Financial Corp.[63]  In 2006, the borrowers sought to refinance the two loans and discharge the two deeds of trust with a single $3.2 million loan from Chase.[64]  Chase obtained a preliminary report from First American Title Company, dated August 16, 2006, identifying the two existing deeds of trust that were to be refinanced, and its escrow instructions to First American conditioned the close of the transaction on Chase obtaining a first priority deed of trust.[65]  The transaction closed on October 25, 2006.[66]  Chase made the loan, the holders of the first and second deeds of trust were paid off, and Chase’s deed of trust was recorded.[67]

            Meanwhile, apparently unbeknownst to Chase, the borrowers agreed to secure a business loan from defendant Banc of America Practice Solutions, Inc. with a deed of trust encumbering the property.[68]  Banc was aware of the two existing deeds of trust held by Chevy Chase Bank and Bay Area Financial Corp., and it expected to receive a deed of trust in third priority position.[69]

            Banc’s deed of trust was recorded on April 24, 2006, eight days after the date of Chase’s preliminary report.[70]  Thus, when Chase made its loan, it had no actual knowledge of Banc’s deed of trust (though of course it had constructive notice, since the deed of trust was recorded).[71]  Neither its preliminary report or title insurance policy contained any reference to Banc’s deed of trust.[72]

            The borrowers later defaulted on their Banc loan in December 2009, and Banc commenced judicial foreclosure proceedings.[73]  Chase cross-complained, seeking an equitable lien on the property and declaratory relief.[74]  The superior court granted summary judgment in favor of Chase, and established two equitable liens in favor of Chase, in an amount equaling the two loans Chase had discharged.[75]

            In affirming the superior court’s decision, the court first considered whether Chase was chargeable with culpable and inexcusable neglect.  It was not.[76]  Chase had no actual knowledge of the Banc deed of trust since it did not show up on Chase’s preliminary report or title insurance policy.[77]  Further, the court reasoned that since it is established that failure to search the public records does not constitute culpable and inexcusable neglect, then reliance on a preliminary report and title insurance policy (dated two months prior to the close of the transaction) should not constitute culpable or inexcusable neglect either.[78]  Perhaps inadvertently creating a new standard for culpable and inexcusable neglect, the court writes:

As Chase did not have actual knowledge of Banc’s deed of trust, did not breach any duty owed to Banc, and has not been shown to have engaged in any misleading conduct, Chase is not chargeable with culpable and inexcusable neglect.[79]

            It will be interesting to see if this statement will become a new standard for determining culpable and inexcusable neglect.

            The court then examined, whether Banc, as the intervening lienholder, will be prejudiced by the equitable subrogation.[80]  The court correctly determined that it will not be prejudiced.[81]  With a heavy emphasis on the intention of the parties, the court noted that Banc expected to hold a junior secured position.[82]  At the time it made its loan it expected to be junior to the two senior liens in a total amount of $3.2 million.[83]  If Chase was permitted to be equitably subrogated, Banc would be junior to a single lien in a total amount of $3.2 million.[84]  By contrast, Chase expected to hold a senior secured debt.[85]  The escrow company was instructed not to disburse the loan funds if Chase’s deed of trust would not be in first position, and Chase did not know of Banc’s deed of trust at the time it made the loan.[86]  Accordingly, the court held that applying equitable subrogation will place the parties in the positions that the each intended to receive.[87]

            Interestingly, the court noted that the fact that Chase might have a claim against its title insurer for failing to identify Banc’s deed of trust does not affect the equitable subrogation analysis.[88]  The court reasoned that, first, there is no guarantee of success in that lawsuit.[89]  Second, if Chase is equitably subrogated, there is no loss for the title company to indemnify.[90]  And third, there is the question of whether the title insurance company would have standing to assert Chase’s right to equitable subrogation.[91]  The discussion of title insurance is significant because many equitable subrogation lawsuits involve title insurance companies, with intervening lien claimants protesting that the title insurance company should bear the cost of a missed encumbrance on a preliminary report or title policy, as was the case in Chase. The court’s analysis may provide some insulation for title insurance companies, and bolster their argument that title insurance companies should not be responsible for paying for an intervening lienholder’s windfall.

IV.  CONCLUSION

            Although Chase did not break any new ground, it is the court’s first published opinion on the topic in sixteen years, and it illustrates the powerful and important effect of equitable subrogation in California.  While equitable subrogation remains an effective tool, practitioners may avoid reaching for that equitable relief by careful diligence, use of title insurance, and written subordination agreements with known existing lenders.

This article was originally published in the California Bar Association's California Real Property Journal, Summer 2013.