The legal doctrine of "equitable subrogation" has recently become familiar to lenders who refinanced or will be refinancing existing loans secured by real property.

"Subrogation" is the substitution of one person in the place of an existing creditor relating to debt and its corresponding lien priority. Mortgages can have various priorities against real estate. The lien priority of a particular creditor may be superior to, or be more advantageous than, the liens of other creditors with recorded liens.

It is the lien priority that establishes which lien holder has a greater right of enforcement against the real estate collateral. To simplify, when the substitute individual pays the previous creditor, the substitute individual may then be able to receive the previous creditor's lien priority for purposes of enforcing the terms of the loan.  Essentially, "subrogation" involves (i) ownership of a valuable right, (ii) a person seeking to be substituted into that ownership, (iii) a claim or obligation against a debtor, and (iv) a person who has an interest to protect.

From a refinancing lender's perspective, the four elements may seem relatively easy to satisfy. An existing lender has a valuable right of enforcement against the borrower. The refinancing lender expects to be substituted in place of the old lender; and once the refinanced loan is made, the refinancing lender has an interest to protect.   However, the inquiry does not stop at the four elements. The principle of equitable subrogation-allowing the refinancing lender to jump ahead of other subordinate lienholders- only applies if the purpose of the doctrine will be served. The purpose of equitable subrogation is to prevent an injustice. It is the mode adopted by courts to compel the ultimate payment of a debt by one who in justice, equity and good conscience ought to pay it.

Arizona recognized the doctrine of equitable subrogation in the context of a tax lien foreclosure in 1935 in the case of Mosher v. Conway. The party seeking to be subrogated in Mosher was barred from recovering because the action was filed too late.  However, the Arizona Supreme Court determined that, as a general rule, 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 (i.e., steps into the shoes) of the person paid.

Innumerable complications of business and the facts and circumstances of each case will determine the outcome. However, there are several factors that must be satisfied before the doctrine will apply. First, because equitable subrogation is an equitable doctrine applied by the courts, the party seeking to impose the doctrine must be acting in good faith; otherwise stated, the party must have "clean hands." Second, and as importantly, the money paid by the party to be substituted into the superior lien position must go to pay off that particular lien in question.

In the case of Brimet II, LLC v. Destiny Homes Marketing, LLC, an Arizona Appellate Court rejected a superficial inquiry of whether refinanced funds were used to pay off a prior lien to gain priority status over intervening lienholders or an optionee in that instance. The Arizona Appellate Court determined how much money had actually been paid to the lender with the superior lien priority and concluded that the superior lien was fully paid with money that did not come from the refinancing lender. Thus, the refinancing lender seeking to step into the shoes of the lien with the highest priority was actually found to be subordinate to the optionee, even though the refinancing lender paid money to the previous lender.

Lesson learned:  To achieve the lien priority intended by the refinancing lender, it is essential to conduct a thorough review of the loan payment history and calculation of interest owed and repaid on the priority lien to confirm that the lien has not been fully satisfied. If it has been fully satisfied, the refinancing lender will not jump ahead of other lienholders and interest holders, and will take subject to their rights.

About the author: Valerie L. Marciano is an attorney at the Phoenix law firm of Jaburg Wilk. She assists clients with real estate, foreclosure , bankruptcy and litigation issues. Val frequently writes on Arizona's foreclosure and anti-deficiency statutes and is a board member of AZCREW - Arizona's premier commercial real estate professional association for women. Val can be reached at 602.248.1025 or vlm@jaburgwilk.com.