Markham Contracting Co. v. FDIC – 8/9/2016
Arizona Court of Appeals Division One holds that equitable subrogation does not extinguish a second-position mechanic’s lien when the higher priority deed of trust is purchased at a trustee’s sale by a credit bid that exceeds the subrogation amount.
A contractor performed work on real property encumbered by a deed of trust. The property owner then obtained another loan, secured by a second deed of trust, which it used in part to pay off the original loan and deed. The contractor subsequently recorded a mechanic’s lien on the property.
The lenders eventually declared the second loan in default and noticed a trustee’s sale on the second deed of trust. The contractor notified the lenders that any purchaser would take the property subject to its mechanic’s lien, and filed a lien foreclosure action in January 2010. Meanwhile, the trustee’s sale noticed by the lenders moved ahead in February 2010. The lenders purchased the property with a $3.175 million “credit bid.”
Over eight months later, the lenders asserted for the first time in the lien foreclosure action that the doctrine of equitable subrogation, which allows a lender that pays off an existing loan and deed of trust to assume the priority position of the original deed, applied and thus that the trustee’s sale extinguished the contractor’s lien. The superior court agreed and held that the second deed of trust was equitably subrogated to first priority to the extent that the second loan was used to satisfy the first. The court further held that the trustee’s sale of the second deed extinguished the contractor’s lien.
The contractor appealed, arguing that application of equitable subrogation would prejudice it and that the trustee’s sale could not extinguish the lien.
The Court of Appeals, Division One, first clarified that the doctrines of equitable subrogation and replacement are materially the same. The lender had argued that the proper doctrine was replacement (applicable when the same lender issues both loans), not equitable subrogation (applicable when a different lender pays off the earlier loan), and that the standard for replacement is less strict. The Court explained that under either doctrine, a later deed of trust can assume the priority position of an earlier deed of trust; the only practical difference is the identity of the lender seeking priority. The Court further noted that both doctrines are premised on the theory that an intervening lienholder is not prejudiced when the lienholder remains in the same relative position, subordinate to a deed of trust. Accordingly, the Court held that the standards for applying equitable subrogation and replacement are the same.
Next, the Court agreed with the superior court that the second deed of trust was equitably subrogated to the first deed of trust to the extent that the second loan was used to satisfy the first loan and deed. Because the contractor was on notice when it began work that the property was encumbered by the original deed of trust, the Court held that the contractor was not prejudiced by the subrogation. The Court rejected that the lender’s delay in publicly asserting its intent to seek equitable subrogation established prejudice because the contractor remained in the same second-priority position regardless.
However, the Court disagreed that the trustee’s sale extinguished the contractor’s lien. Equitable subrogation gave the second deed of trust a first-priority position only up to the amount secured by the original deed, or $2.9 million. The lenders purchased the property at the trustee’s sale with a “credit bid” of $3.175 million. But A.R.S. § 33-801(5) limits a “credit bid” to the full amount of the contract secured by the trust deed – in this case, $2.9 million. The Court, therefore, held that the contractor should have received the excess portion of the bid price, and because it did not, its lien continued to encumber the property.
Judge Swann wrote for the Court; Judges Winthrop and Kessler joined.
Disclosure: Osborn Maledon attorneys were involved in this case.