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Subrogation: Promoting Fairness in Mortgage Prioritization

Mortgages

Consider the following hypothetical scenario:

X owns property and executes a first priority mortgage to A, which A records. Subsequently, X executes another, subordinate mortgage to B, which B records. X later asks C to refinance A's mortgage. C agrees to do so, intending to take A's place as a first-priority lien-holder. C loans X the money to satisfy A's mortgage under the same terms as provided in X's original mortgage agreement with A. The proceeds of the loan are used to satisfy A's mortgage. A then records a release of that mortgage.

Should C be allowed to step into the shoes of A, so to speak, and to obtain a first priority mortgage on the property? Or should B, the junior lien-holder, move into A's position? This is a simplified version of a problem that Illinois courts have grappled with repeatedly. Depending on the factual details of the transaction, C may be allowed to step into A's shoes; in other words, C may be subrogated to the rights of A. This article will discuss the doctrine of subrogation and how it relates to mortgage prioritization under Illinois law.

Subrogation Generally

To explain how subrogation affects mortgage prioritization in Illinois, it is necessary first to briefly discuss Illinois' law of mortgages. In Illinois, a mortgage must be recorded to provide constructive notice to prospective lenders.Firstmark Stnd. Life Ins. Co. v Superior Bank FSB, 271 Ill App 3d 435, 649 NE2d 465, 468, 208 Ill Dec 409 (1st D 1995). This requirement is meant to ensure that subsequent lenders are aware of superior liens on the property in which they will be acquiring an interest. See Federal Nat'l Mortgage Ass'n v Kuipers, 314 Ill App 3d 631, 732 NE2d 723, 726, 247 Ill Dec 668 (2nd D 2000). Ordinarily, courts follow the doctrine of first in time, first in right to determine the order of mortgage priority. Aames Capital Corp. v Interstate Bank of Oak Forest, 315 Ill App 3d 700, 734 NE2d 493, 496, 248 Ill Dec 565 (2nd D 2000). Consequently, as a rule a mortgage recorded first in time has first priority status. If a first-priority mortgagee releases, or extinguishes, its lien on the property, then the second priority lien-holder moves into the first-priority position.

However, courts have carved out some exceptions to the first in time, first in right doctrine. This is because, in the words of the Aames court, "blind adherence to the . . . doctrine is sometimes insufficient to determine lien priority." Id. at 496-97. This court argued that refinancing can help a debtor to avoid foreclosure, which is good for everyone and should be promoted. The court noted that it is very difficult for a debtor to get refinancing of a first priority mortgage without promising the refinancing mortgagee a first priority lien as well. Thus, courts enforce certain exceptions for policy reasons, and as will be discussed, to promote fairness.

One exception to the first in time, first in right doctrine is the doctrine of subrogation. "Subrogation" is defined as follows: "a method whereby one who ha[s] involuntarily paid a debt of another succeeds to the right of the other with respect to the debt paid." Home Savings Bank v Bierstadt, 168 Ill 618, 48 NE 161, 162 (Ill 1897). Within the real estate context, that debt is often a mortgage, and that right is typically the right to assert a first-priority lien on the encumbered property. Subrogation is an "equitable remedy" that is meant to prevent one party from receiving a windfall at another party's expense. Therefore, subrogation only applies when application of the doctrine would be just and when no innocent party would be injured by the application of the doctrine.

To decide whether an innocent party would be injured, courts generally determine whether, if the doctrine is applied, other lien-holders will remain in the same position in which they would have been had the party seeking subrogation never satisfied the prior lien. For example, in Detroit Steel Products Co. v Hudes, a foreclosure action, an Illinois appellate court held that the Bank of Marion was subrogated to the rights of materialmen whose known liens it had satisfied. 17 Ill App 2d 514, 151 NE2d 136, 137-40 (4th D 1958). The court reasoned in part that Edward Gaskins, another materialman who challenged the subrogation, would have been required to share the proceeds from the foreclosure with the other materialmen if the bank had not satisfied their liens. If the doctrine were applied, then Gaskins would still have to share the proceeds, but he would share them with the bank. Thus, Gaskins would not be harmed by application of the doctrine of subrogation.

Similarly, in LaSalle Bank v First American Bank, also a foreclosure action, another Illinois appellate court held that LaSalle Bank, N.I. (LaSalle) was subrogated to the rights of prior mortgagee Parkway Bank and Trust Co. (Parkway), whose recorded first priority mortgage it satisfied. LaSalle Bank v First American Bank, 316 Ill App 3d 515, 736 NE2d 619, 625, 249 Ill Dec 425 (1st D 2000). The court reasoned in part that the lien of Daniel Lopez, a junior lien-holder who challenged the subrogation, would have been subordinate to the Parkway mortgage if LaSalle had not refinanced it. Thus, Lopez would not be harmed by the application of the doctrine of subrogation.

Besides requiring that application of the doctrine of subrogation would not injure an innocent party, courts require that the creditor whose debt the party seeking subrogation satisfied possessed a right that the creditor could enforce against the debtor before them. In re Pearce, 236 B R 261, 265 (Bankr SD Ill 1999). For example, in In re Pearce, an Illinois bankruptcy court held that C.P. Burnett & Sons, Bankers (Burnett) was not subrogated to the rights of the prior mortgagee whose lien it satisfied. The court reasoned in part that the debtors (the Pearces) had purchased the encumbered property subject to a mortgage in favor of Fleet Mortgage Corporation (Fleet). Fleet (the creditor whose debt Burnett satisfied) could only enforce its lien on the property against the prior owners, the Ambergers, with whom it had conducted the mortgage transaction. Therefore, Burnett did not acquire a right that it could enforce against the Pearces, who "were strangers to the transaction between Fleet and the Ambergers." Consequently, Burnett was not subrogated to the rights of Fleet in an action against the Pearces.

Finally, although the Illinois Supreme Court has applied the doctrine of subrogation only in situations involving a party who satisfies the debt of another, it should be noted that an Illinois appellate court recently found that the doctrine may apply to a situation in which a party refinanced the party's own mortgage. In Union Bank v Thrall, land owner Tracy Thrall executed mortgages on her property in favor of Eureka Savings Bank (Eureka), which were recorded in 1996. 374 Ill App 3d 785, 872 NE2d 542, 313 Ill Dec 559 (2d D 2007). In 1999, Thrall executed junior mortgages in favor of Union Bank (Union), which were recorded at that time. Two years later, Eureka refinanced the 1996 mortgages and released them. The court stated that although the Illinois Supreme Court and the Restatement (Third) of Property have applied a different doctrine to situations like this, two appellate decisions suggest that the doctrine of subrogation encompasses such situations. Thus, the court found that the scope of the doctrine of subrogation is unclear, and subrogation may apply to the facts at issue.

Therefore, courts will not apply the doctrine of subrogation in any form if an innocent party would be injured by such application or if a creditor whose debt the party seeking subrogation satisfied did not possess a right that the creditor could enforce against the debtor before them. In addition, they may apply it in a situation involving a party that satisfies that party's own prior mortgage.

Conventional Subrogation

In addition to the guidelines that Illinois courts follow when deciding whether to apply the doctrine of subrogation generally, they also adhere to more specific guidelines according to the type of subrogation they are considering employing. Courts recognize and apply two types of subrogation: conventional and equitable, or legal, subrogation. Aames, 734 NE 2d 498. They normally apply the doctrine of conventional subrogation when they can find evidence that a party seeking subrogation made an "express agreement" with a debtor that the party would satisfy a prior lien, "in full force and effect," in exchange for the ability to assert the rights of the prior lien-holder. See, for example, Aames, 734 NE 2d at 501; Bierstadt, 48 NE at 162; Firstmark, 649 NE2d 465 at 469. This express agreement demonstrates that the party did not satisfy the prior lien in the capacity of a "mere volunteer" but to protect the party's rights in the property. Bierstadt, 48 NE at 162.

Courts have held that provisions in a mortgage or other contract between a debtor and a party seeking subrogation, that party's communications with a title company providing its title insurance in the transaction, and oral communications between the debtor and party seeking subrogation can serve as evidence of an express agreement. For example, an appellate court found in the Aames case that refinancing mortgagee Pacific Thrift and Loan Company (Pacific) made an express agreement with debtors Patrick and Diane Wangler. Aames, 734 NE 2d at 500. The agreement was demonstrated by the parties' mortgage document, which provided that the "Wanglers were to discharge any lien that had priority over the [Pacific] mortgage." The document further stated that "Pacific [could] pay any sums secured by a lien that had priority over its mortgage and that any such sum paid would become additional debt secured by the mortgage." Id.

Likewise, another appellate court ruled in Union Planters Bank, N.A. v FT Mortgage Co. that refinancing mortgagee FT Mortgage Companies (FT) made an express agreement with debtors Charles and Theresa LaFore.Union Planters Bank, N.A. v FT Mortgage Co., 341 Ill App 3d 921, 794 NE2d 360, 365, 276 Ill Dec 465 (5th D 2003). That agreement was also shown by the parties' mortgage document, which stated that the LaFores would discharge all liens that had priority over the FT mortgage. In addition, FT's instructions to its title company, Reliable Research, to "pay off all existing liens" on the LaFore property served as additional evidence that FT intended to be subrogated. Id. at 362. The written instructions contained the phrase "NO SUBORDINATE LIENS TO REMAIN OPEN AT CLOSING." Therefore, in Aames and Union Planters Bank, the party seeking subrogation proved an express agreement using written evidence.

However, in Kaminskas v Cepauskis, the Illinois Supreme Court found an express agreement without citing any written evidence of that agreement. Kaminskas v Cepauskis, 1369 Ill 566, 17 NE2d 558, 559-61 (Ill 1938). It appears that the court considered only oral testimony from the parties that such an agreement existed. In addition, in Firstmark Stnd. Life Ins. Co. v Superior Bank FSB, an Illinois appellate court stated that an "express agreement" does not necessarily need to be written. Firstmark, 649 NE2d at 468-69. Therefore, a party seeking subrogation under the doctrine of conventional subrogation must present written evidence or testimony showing that both that party and the debtor intended that the party would be subrogated to the rights of the prior lien-holder.

Courts also adhere to other rules when applying the doctrine of conventional subrogation. For example, some courts refuse to apply the doctrine if the party seeking to be subrogated was grossly negligent. See Bierstadt, 48 NE at 162; Union Planters Bank, 794 NE2d at 364. However, these courts have neither defined "gross negligence" nor actually found a party seeking subrogation grossly negligent. See generally Bierstadt; Union Planters Bank. The only guidance that they have given is that a refinancing mortgagee is not grossly negligent simply because one fails to discover intervening liens when one makes the refinancing loan. Bierstadt, 48 NE at 162. Thus, it remains unclear how this gross negligence standard will be applied in practice.

In addition, courts will apply the doctrine of conventional subrogation when a party seeking subrogation loaned more money than necessary to satisfy previous liens. Aames, 734 NE2d at 501; Union Planters Bank, 794 NE2d at 366. However, they hold that the doctrine only applies to the extent that the loan proceeds were used to satisfy those previous liens. Aames, 734 NE2d at 501; Union Planters Bank, 794 NE2d at 366. For example, in Union Planters Bank, FT loaned the LaFores nearly $4,000 more than needed to satisfy two first priority mortgages.Union Planters Bank, 794 NE2d at 362. The court found that FT could be subrogated only to the extent of the loan proceeds that were used to pay off the previous mortgages.

Moreover, courts will apply the doctrine if a party seeking conventional subrogation knew of intervening liens at the time one satisfied a first priority lien. Kaminskas, 17 NE2d at 561. In this situation, the party is not required to obtain consent from a junior lien-holder to be subrogated to the rights of a first priority lien-holder. LaSalle, 736 NE2d at 625. For example, in LaSalle Bank, LaSalle was aware of Lopez's payment to Brandess but did not request consent from Lopez to subordinate Lopez's lien. The court stated that "LaSalle's knowledge of Lopez' purchase contract with Brandess [was] immaterial to the application of the doctrine" of conventional subrogation. Furthermore, the court held that notwithstanding LaSalle's failure to obtain Lopez's consent, LaSalle was subrogated to the rights of Parkway.

Therefore, courts apply the doctrine of conventional subrogation when the general requirements discussed above are satisfied, and a party, who was not grossly negligent, made an "express agreement" with a debtor that the party would be subrogated, regardless of whether the party knew of intervening liens at the time the party satisfied the prior lien. However, courts will only allow subrogation to the extent that loan proceeds were used to satisfy previous liens.

Equitable Subrogation

In addition to the doctrine of conventional subrogation, Illinois courts also apply that of legal, or equitable, subrogation. Rules and cases involving the doctrine of equitable subrogation in relation to mortgage priority in Illinois are scarce. In fact, the Illinois Supreme Court has stated that "there is 'no general rule which can be laid down to determine whether a right of subrogation exists [because] this right depends upon the equities of each particular case.'" Mortgage Elec. Registration Sys., Inc. v Phylactos, 2005 U.S. Dist. LEXIS 6295, *15 (ND Ill 2005) (citing Mutual Insurance Co. v LaFramboise, 149 Ill 2d 314, 597 NE2d 622, 624, 173 Ill Dec 648 (Ill 1992)). Thus, the doctrine is somewhat elusive.

However, basic principles of equitable subrogation can be gleaned from the few cases available that analyze the doctrine. Courts state that "equitable subrogation" is a "right of subrogation which springs from the mere fact of the payment of a debt." Bierstadt, 48 NE at 162. Thus, in deciding whether to apply the doctrine of equitable subrogation, courts do not search for evidence of an "express" agreement that a party would be subrogated. Rather, they look for evidence demonstrating that the party seeking to be subrogated intended to be subrogated at the time that party satisfied a prior lien. Detroit Steel, 151 NE2d at 140.

To decide whether a party intended to be subrogated, courts look to whether that party inquired about prior liens and stipulated that its loan proceeds be used to satisfy a first-priority lien. For example, in Detroit Steel, the court held that the bank intended to be subrogated to the rights of the materialmen. The court reasoned that when making the loan, the bank inquired about all prior unpaid liens and inspected the encumbered property. It then required that Hudes satisfy those liens, using part of the loan proceeds. Thus, the bank clearly had an "expectation that it was discharging all prior liens" and intended to be subrogated.

Similarly, in In re Cutty's-Gurnee, Inc., the court found that Great American intended to be subrogated to the rights of Greyhound Leasing (Greyhound), whose prior recorded mortgage it satisfied. In re Cutty's-Gurnee, Inc., 133 B R 934, 963 (Bankr ND Ill 1991). It reasoned that the final mortgage agreement between Kenneth Bailey (debtor-owner of Cutty's-Gurnee) and Great American contained a stipulation by both parties that required that some of Bailey's loan proceeds be used to pay off the Greyhound mortgage. Great American demanded this provision after learning of the mortgage and other prior liens. Furthermore, Great American sent a written communication to Bailey implying that Great American desired to obtain a first-priority lien on Bailey's property so that Great American would have "an asset that would have great value to [Great American's] people." Id. at 941. Therefore, Great American intended its mortgage to take a first priority position.

Furthermore, it should also be noted that at least one court has applied the doctrine of equitable subrogation even though the party seeking to be subrogated had actual knowledge of an intervening lien at the time of refinancing.In re Cutty's-Gurnee, 133 B R at 940. That court quoted Kaminskas, stating that knowledge of the intervening lien was immaterial. No courts have refused to apply the doctrine due to such knowledge. Thus, it appears that a party who had actual knowledge of an intervening lien at the time of refinancing may be equitably subrogated.

Therefore, courts apply the doctrine of equitable subrogation when the general requirements discussed above are satisfied, and a party can show that the party intended to be subrogated, regardless of whether the party knew of intervening liens at the time the party satisfied the prior lien.

Concluding Remarks

Consequently, conventional subrogation differs from equitable subrogation mainly because courts will not apply it unless the party seeking to be subrogated can show that he made an express agreement with the debtor to that effect. Thus, parties often seek subrogation generally, arguing that both doctrines apply to the facts of their cases. It is useful to remember that subrogation in general is an "equitable remedy" that courts employ to correct any injustice caused by strict adherence to the doctrine of first in time, first in right.

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[Last update: 5-30-08]