Equitable Subrogation: This blog is inspired by a recent decision from the Wisconsin Court of Appeals on Equitable Subrogation. See Countrywide Home Loans v. Schmidt, No. 2006AP002908 (http://www.wisbar.org/res/capp/2007/2006ap002908.htm).

Equitable Subrogation: This blog is inspired by a recent decision from the Wisconsin Court of Appeals on Equitable Subrogation. See Countrywide Home Loans v. Schmidt, No. 2006AP002908 (http://www.wisbar.org/res/capp/2007/2006ap002908.htm).

So what is “Equitable Subrogation”? Equitable subrogation is an equitable doctrine created by courts under which a new lender can assume the priority position of an old lender - the issue is one of priority.

Hypo:

(a) in 2000, Bob takes out a loan for $100,000, secured against his home, this 1^st mortgage is recorded on February 1, 2000,

(b) in 2002, Bob takes out a 2^nd loan for $50,000, also secured against his home, this 2^nd mortgage is recorded on April 1, 2002; and

(c) in 2004, Bob takes out a loan for $175,000 secured against his home, the proceeds from this 3^rd mortgage are used to pay off the 2000 loan (for sake of discussion, the payoff was $100,000) and the balance of the proceeds given to Bob. This 3^rd mortgage is recorded on June 4, 2004.

So what are the priorities? Based on “first in time, first in right” the priorities are, after satisfaction of the 1^st mortgage:

(i)                   First - the 2^nd Mortgage for $50,000 (recorded April 1, 2002), and

(ii)                 Second - the 3^rd Mortgage for $175,000 (recorded June 4, 2004).

What are the priorities if the doctrine of Equitable Subordination is applied?  

(i)                   First - the 3^rd Mortgage for $100,000 (the 3^rd mortgage assumes the priority of the 1^st Mortgage to the extent of the payoff ($100,000) and the recording date of the 1^st Mortgage (February 1, 2000)),

(ii)                 Second - the 2^nd Mortgage for $50,000 (recorded April 1, 2002), and

(iii)                Third - the 3^rd Mortgage for $75,000 (recorded June 4, 2004).

Whether the doctrine of Equitable Subordination will apply in any given transaction depends upon the laws of the State and the equities as decided by the court in its discretion. Further, the doctrine, if applied, is not always applied uniformly – for example whereas one court may include interest in the amount given priority another court may not. The question of whether the doctrine of equitable subrogation will apply and how in a given situation is never fully answered until the court decides.

So, given this legal mud, how can new lenders protect themselves? The answer is to take actual steps to subordinate the outstanding loans, rather than relying on the equitable doctrine created by courts. These steps include:

(a)                 Assignment of the Mortgage in 1^st Lien position. In the hypothetical, the lender for the 3^rd Mortgage would ask that the lender for the 1^st Mortgage assign the $100,000 1^st Mortgage to the new lender and the new lender would create a new mortgage for $75,000 (rather than $175,000 because of the assignment); or

(b)                 Subordinations by Intervening Lienholders. In the example, the new lender would ask the lender for the 2^nd Mortgage to subordinate the 2^nd Mortgage to all or part of the 3^rd Mortgage.

These steps will be needed if Knight-Barry is requested to insure the new lender’s 1^st lien priority position.