The following information accompanies a presentation Mike gave to members of the Arizona Commercial Mortgage Lenders Association (ACMLA) on October 10, 2017.
Arizona Case Law – Late Fees and Liquidated Damages Provisions
Dobson Bay Club II, DD v. La Sonrisa De Siena (AZ Supreme Court 4-25-2017)
I discussed this case a few months ago after the Arizona Court of Appeals issued its decision and before the case had been heard by the Arizona Supreme Court.
Dobson Bay signed a $28.6 million note and DOT to CIBC. The note required interest-only payments with a final balloon payment at maturity; it also included a provision requiring payment of a 5% late fee on any unpaid installment, including the final balloon payment due at maturity. Dobson Bay failed to make the balloon payment. CIBC sent out a notice of default and thereafter sold its note and DOT to La Sonrisa. La Sonrisa demanded payment of all amounts due under the loan, including a $1.4 million late fee (5%) on the balloon payment and started a trustee’s sale about one week after acquiring the loan from CIBC. Dobson Bay thereafter obtained new financing and paid La Sonrisa the outstanding loan balance, except for the late fee, which it deposited with the Superior Court pending litigation over whether La Sonrisa was entitled to collect the late fee as a condition of releasing its DOT. The trial court held that the late fee was enforceable as liquidated damages, and Dobson Bay appealed. The Court of Appeals reversed the trial court and held that a 5% late fee on the balloon payment was an unenforceable penalty.
The Arizona Supreme Court looked to the Restatement Second of Contracts1 for guidance on the enforceability of a liquidated damages provision (a “liquidated damages” provision is an advance agreement by the parties as to the amount of damages for a breach of the contract). The Supreme Court noted that, while parties can agree to liquidated damages, they do not have free rein in doing so, and a term fixing unusually large liquidated damages will be unenforceable as a penalty. The Restatement Second provides that a liquidated damages provision is enforceable, but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. This test requires courts to consider (1) the anticipated or actual loss caused by the breach, and (2) the difficulty of proof of loss; whether a fixed amount constitutes a penalty turns on the relative strengths of those factors.
The Supreme Court determined that the late fee, as applied to the balloon payment, did not forecast the anticipated damages that were likely to result from an untimely balloon payment, nor did it reasonably approximate the actual costs of handling and processing the late balloon payment or the loss of use of that payment (which were the reasons the promissory note specified for the imposition of the late fee). The Supreme Court also noted that La Sonrisa would have had no difficulty proving that it sustained a loss if a loss had in fact occurred. The Supreme Court determined that, while La Sonrisa was not precluded from seeking actual damages it incurred if it had not already been compensated for that loss by other fees and costs (including $600,000 to $700,000 of default interest it had already received), the 5% late fee was an unenforceable penalty. _______________ 1The Restatement is a legal treatise that seeks to set forth and clarify generally accepted principles of contract common law (case law) and occasionally suggests new rules that contradict existing law.
Lender takeaway: Borrower’s counsel often ask the lender to agree to limit the late fee to monthly installment payments and not apply it to the balloon payment due at maturity or upon acceleration; in my experience, lenders routinely accommodate such a request. If your documents allow you to charge a percentage late fee on the balloon payment, you should not simply assume that it will be enforceable, even if negotiated with a knowledgeable borrower or borrower’s counsel. If the balloon payment late fee issue is important to you, consider (i) specifying a smaller percentage late fee/liquidated damages payment to apply to the balloon payment, or (ii) expressly identifying as many legitimate reasons as possible (i.e., reputational risks, regulatory risks, the expense of preserving the collateral, etc.) to justify the late fee.
Arizona Case Law – Survival of Deed of Trust Obligations Following Trustee’s Sale
ZB, N.A. v. Hoeller (AZ Court of Appeals 4-25-2017)
In 2004, the borrowers (then California residents) financed their purchase of commercial real estate in Missouri with a loan from ZB, which was secured by a DOT. The promissory note and the DOT stated they were governed by Utah law, but the DOT also provided that “procedural matters related to the perfection and enforcement of [ZB’s] rights and remedies against the property” were to be governed by Missouri law. In 2012, the borrowers defaulted on the loan and ZB conducted a trustee’s sale, leaving a deficiency of about $150,000. In 2014, ZB sued the borrowers, who had since moved to Arizona, for the deficiency.
The borrowers argued that the deficiency action was time-barred by Arizona’s 90-day limitations period. The trial court concluded that Missouri’s five-year statute of limitations applied and denied the borrowers’ motion. The borrowers filed a second motion to dismiss, arguing that Utah law (which also contained a 90-day limitations period) should apply. The trial court also denied that motion. The Court of Appeals determined that, under the rules in the Restatement of Conflicts, the court must look to the promissory note for the choice of law that will govern a deficiency action. Doing so, the Court of Appeals held that Utah law applied and barred the deficiency action. ZB argued that, regardless of its right to recover a deficiency through the promissory note, the parties created an additional remedy for ZB in the DOT, which stated that the law of whichever relevant jurisdiction that would uphold ZB’s right to recover a deficiency would apply. The Court of Appeals held the DOT serves only to secure the performance of the loan, and that once a trustee’s sale occurs, the DOT has no further effect.
Lender takeaway: While I disagree with the Court’s conclusion that the entire DOT (as opposed to the lien of the DOT) is extinguished after the trust property has been sold at the trustee’s sale, lenders should include any important obligations that are intended to survive the trustee’s sale in a document other than the DOT and expressly provide that those obligations will survive foreclosure, so that borrowers cannot argue that the lender’s rights to enforce those provisions ended when the trustee’s sale occurred.
Pending Arizona Case Law – GPLET Leases
Englehorn v. Stanton (Maricopa County Superior Court, filed 3-01-2017)
In March 2017, the Goldwater Institute sued the City of Phoenix and a number of its elected officials on behalf of the Englehorn family (the proprietors of Angel’s Trumpet Ale House in downtown Phoenix) to invalidate a pending GPLET transaction entered into before HB 2213 became effective. The City and Denver-based Amstar/McKinley, LLC signed GPLET documents in 2016 relating to the construction of a $36 million, 19-story high rise micro-housing (units containing just 400 to 500 square feet) apartment tower to be known as The Derby Roosevelt Row just south of Angel’s Trumpet. The Goldwater Institute has challenged the Amstar/McKinley transaction as an illegal $8 million developer subsidy by the taxpayers under several provisions of the Arizona Constitution, as well as a violation of statutory limits on GPLET and the City’s failure to follow competitive bidding requirements2.
Arizona Case Law – Arbitration Agreements
Gullett v. Kindred Nursing Centers West (AZ Court of Appeals 2-15-2017)
In January 2013, Gullett was admitted to Hacienda Care and Rehabilitation Center. He signed an ADR Agreement providing that all claims arising out of any stay at Hacienda would be submitted to arbitration. Gullett remained at Hacienda until he died in February, 2013. Gullett’s son brought suit against Kindred (doing business as Hacienda) alleging that it had abused and neglected Gullett in violation of Arizona statutes, resulting in his death. Kindred then moved to compel arbitration pursuant to the ADR Agreement, and the son opposed the motion, claiming that the ADR Agreement was substantively unconscionable. The trial court granted Kindred’s motion to compel arbitration.
The son argued on appeal that the ADR Agreement was substantively unconscionable because it severely limited discovery, required that arbitration be administered by an administrator who lacked neutrality, required the forfeiture of non-waivable remedies and did not impose mutual obligations on the parties.
The ADR Agreement allowed the parties to take six lay and two expert witness depositions, and allowed limited written discovery. The parties could agree to more discovery or the arbitrator could order additional discovery if deemed necessary and proper. The Court of Appeals held that limits on discovery in arbitration are only unfair if the permitted amount of discovery is so low and the showing of a need for more discovery is so high that the claimant’s ability to vindicate his or her right is impeded. The Court of Appeals found that the amount of discovery permitted in the Kindred ADR Agreement was fair and did not render the ADR Agreement unenforceable. _______________ 2The Goldwater Institute contends, among other things, that the proposed GPLET transaction violates the following clauses of the Arizona Constitution: (a) the gift clause, which provides that neither the state nor any city may give or loan its credit in the aid of, or make any donation or grant, by subsidy or otherwise, to any individual, association or corporation; (b) the uniformity clause, which requires the government to uniformly tax all properties within the same class of property in the territorial limits of the taxing authority; (c) the special law clause, which prohibits a city from enacting any local or special laws in cases involving the assessment and collection of taxes, or granting any special or exclusive privileges, immunities or franchises, if a general law can be made applicable; and (d) the conveyance clause, which provides that no property that has been conveyed to evade taxation shall be exempt. The suit also contends that the property is not located in a “Central Business District” as required by the current GPLET statute and is not located in an area that has recently been determined to be slum or blighted (the City allegedly relied on a 1979 declaration to that effect). Finally, the Goldwater Institute contends that the City did not publish an invitation for bids or post notices as required by Arizona’s competitive bidding statute in entering into the Development Agreement and the GPLET lease with the developer.
The ADR Agreement also provided that the parties might use the services of a particular arbitration administration service, but allowed the parties to choose a different administration service and also allowed them to select the arbitrators. The court also found that the ADR Agreement imposed mutual obligations on the parties with respect to all claims under the ADR Agreement.
Lender takeaway: Arbitration is still favored in Arizona and many lenders still use it in their loan documents, at least with respect to smaller credits. To be enforceable, your arbitration provision should allow sufficient discovery, or permit the arbitrator to set fair discovery parameters, ensure that the manner in which arbitrators are selected results in the arbitrator being neutral, and requires both sides to arbitrate their disputes.
Arizona Case Law – Leases (Medical Marijuana Dispensary Lease Enforceability)
Green Cross Medical v. Gally (AZ Court of Appeals 4-18-2017)
In 2012, Gally leased his commercial property in Winslow, Arizona, to Green Cross for use as a medical marijuana dispensary. The lease contained an “application first term” allowing Green Cross to lease the property until the State of Arizona issued a dispensary operating license to it. Less than two weeks after entering into the lease, Gally’s attorney sent Green Cross a letter revoking the lease from its inception on the basis that a prior month-to-month tenant who wanted to operate a medical marijuana dispensary on the property supposedly had a superior interest in the property. Green Cross had not obtained the necessary permission under the Arizona Medical Marijuana Act (“AMMA”) to operate a medical marijuana dispensary prior to the lease termination. The Superior Court issued a TRO and later a preliminary injunction barring Gally from revoking the lease. Galley argued that he was entitled to revoke the lease because it was illegal and therefore unenforceable. The Superior Court held that the lease violated both Arizona law and the federal Controlled Substances Act (the “CSA”), and was therefore void for illegality.
This is the first Arizona appellate decision (among very few nationally) to consider whether a lease of real property to a party applying to operate a medical marijuana dispensary is void for illegality. The Court of Appeals noted that, at the time Gally terminated the lease, Green Cross had not received the necessary permission to operate a dispensary, but the lease permitted Green Cross to sublease the property – a commercial right that existed independent of any concerns over the legality of medical marijuana. The lease did not state that it would be void or voidable if Green Cross did not receive a dispensary operating license. The Court of Appeals concluded that the lease was not illegal (and the tenant could maintain an action for damages against the landlord) under Arizona law because: (1) the AMMA protects the rights of dispensaries to enter into leases and contracts if they are in compliance with the AMMA, and a court may not void or refuse to enforce a dispensary’s lease simply because the dispensary would be supplying marijuana in compliance with the AMMA; (2) a landlord leasing property to a dispensary that complies with the AMMA has immunity against arrest and prosecution in the same way as qualifying patients, caregivers, physicians, etc.; (3) even though the CSA prohibits the sale and use of marijuana, and even though it is illegal under the CSA for a landlord to lease property that it knows will be used for the illegal production or distribution of controlled substances, the federal illegality does not render the lease unenforceable under all circumstances, as a court must balance the federal government’s interest in enforcing the federal law with the state’s interest in permitting the medical use of marijuana; (4) the federal government has lacked interest in prosecuting individuals who are in compliance with the AMMA and Arizona public policy has favored enforcement of a lease that is compliant with state law; and (5) refusing to enforce leases would undermine the medical marijuana program approved by Arizona voters, and does not place the federal government in a worse position than it has already chosen with respect to medical marijuana in Arizona. The Court noted that (a) federal government enforcement against state-compliant marijuana operators had been in flux for years, (b) in 2009 (prior to the execution of this lease), the Department of Justice had instructed U.S. Attorneys not to prosecute individuals acting in compliance with the “Cole Memo”, and (c) Congress had prohibited the Department of Justice from using funds to prosecute people distributing marijuana in compliance with state law. A petition for review has been filed with the Arizona Supreme Court.
Lender takeaway: Lenders should exercise caution in interpreting this decision to authorize all dispensary-related activities and the ability to enforce contractual relationships relating to those activities to the extent that they violate federal law. Judicial scrutiny of this area is in its early stages and case law guidance is likely to be very fact-specific (and perhaps state-law specific).
Arizona Case Law – Community Property
Digital Systems Engineering v. Moreno (AZ Court of Appeals 4-18-2017)
In 2007, DSE filed a lawsuit against its former employee Bernadette Bruce-Moreno, and her husband John. DSE alleged that from 2001 to 2005, Bernadette committed fraud, which caused DSE $300,000 in damages. DSE sued both Bernadette and John in their individual capacities and their marital community. The trial court determined that John was not individually liable and entered judgment in 2009 against only his undivided one-half interest in his marital community with Bernadette. John appealed the judgment and the Court of Appeals reversed the trial court’s damages award and remanded the case to the trial court.
Back in the trial court in 2011, DSE asked the Court to take judicial notice that the Morenos had entered into a marital settlement agreement and that their marriage was dissolved in 2009, shortly after judgment had been entered against John. DSE and John entered a stipulated judgment in 2011 providing that judgment was entered in favor of DSE against John’s undivided one-half interest in his marital community with Bernadette and dismissing the claim against John’s sole and separate property with prejudice. The Morenos remarried two years later and, in 2015, DSE served a writ of garnishment on John’s employer. The Morenos objected to the garnishment on the grounds that: (1) the stipulated judgment was by its terms limited to recovery from John’s interest in the prior marital community; (2) under Arizona law, the Morenos’ remarriage after divorce did not “resume” their prior marital community, but instead created a new and distinct community beyond the reach of the stipulated judgment; (3) John’s current wages were property of the new community, but not the prior community; and (4) Arizona law supports limiting an innocent spouse’s liability to the community property that existed at the time of any tortious acts. DSE contended that the stipulated judgment was a community debt that the Morenos could not discharge in divorce and that John’s wages were garnishable after divorce and remarriage. The trial court affirmed that the writ of garnishment and held that John’s wages were garnishable.
The Court of Appeals noted that the Morenos were divorced two years prior to the stipulated judgment and that evidence did not compel the conclusion that they divorced to avoid liability pursuant to the stipulated judgment. The Court further noted that: (a) the stipulated judgment limited DSE’s recovery from John to his undivided one-half interest in the only marital community that had existed prior to the stipulated judgment; and (b) under Arizona case law, when one spouse did not participate in the tort of the other, the innocent spouse may be held liable for the tort only as a member of the community, with such liability limited to the extent of the community property as it existed at the time of the tort. The Court determined that the marital community created by Bernadette and John’s 2013 remarriage was a new and distinct marital community that was not subject to the stipulated judgment. John’s earnings after divorce were his separate property, which DSE could not have reached under the stipulated judgment while John remained divorced. Therefore, DSE could not garnish John’s wages, which constituted community earnings of the marital community created in 2013, to satisfy the community liabilities of the marital community that ended in 2009.
Lender takeaway: While the facts of this case are unlikely to present themselves very often, lenders should bear in mind that an obligor’s remarriage to his or her former spouse likely creates a new marital community, rather than resuming the old one, at least absent abusive intent behind the divorce and remarriage. [Bear in mind that the Arizona statutes were amended in 1973 to provide that community property is liable for premarital separate debts of a spouse incurred after September 1, 1973, to the extent of the value of that spouse’s contribution to the community property that would have been such spouse’s separate property, if single (see A.R.S. § 25-215).]
Arizona Case Law – Guaranties and Choice of Law
First-Citizens Bank & Trust v. Morari (AZ Court of Appeals 6-15-2017)
In 2010, Sun Sky borrowed $3,737,000 from First-Citizens’ predecessor in interest, United Western Bank, to purchase property in Cochise County, and signed a promissory note and DOT. In January 2012, the borrower principals signed personal guaranties for the loan, but their spouses did not. In November 2012, Sun Sky defaulted and First-Citizens sued Sun Sky, the guarantors and the guarantors’ spouses. The guarantors and their spouses were California residents. The spouses moved to dismiss the action against them because they had not joined in the guaranties. First-Citizens argued in its response that California law (rather than Arizona law) applied, and that California law allows the signature of only one spouse to bind a marital community. First-Citizens also included in its response three supplemental guaranties that contained California choice of law provisions, which were signed by the borrower principals, but not their spouses.
The Court of Appeals noted that the Restatement Second of Conflict of Laws, which the Arizona courts follow to determine the applicable law, provides that the validity of a contract of suretyship (including a guaranty), in the absence of an effective choice of law by the parties, is determined by the law governing the principal obligation to which the contract of suretyship relates unless, with respect to the particular issue, some other state has a more significant relationship to the transaction and the parties, in which event the law of the other state will be applied. The original guaranties sued upon contained no choice of law provision, but the loan agreement between Sun Sky and United Western provided that it would be governed by Arizona law and federal law. The Court of Appeals also noted that, under the Restatement, the principal obligation would be governed by the law of Arizona given Arizona’s contacts with the transaction, the property and the parties. The Court of Appeals determined that Arizona had a more significant relationship than California with the transaction and that Arizona law would therefore apply.
Arizona law requires the joinder of both spouses to bind the marital community to any transaction of guaranty or suretyship. The spouses did not sign the supplemental guaranties that included a California choice of law and were therefore not bound by the California choice of law in the supplemental guaranties.
Lender takeaway: California developers often protest an Arizona lender’s request for their spouses to join in a guaranty that will either expressly or implicitly be governed by Arizona law. This decision illustrates why the lender should request the spouse to join in the guaranty to make sure the marital community is bound. Given the increasing attention that courts are giving to choice of law provisions (or choice of law analysis in the absence of choice of law provisions) in a loan enforcement context, lenders may wish to opt for a more customized choice of law provision than Laserpro provides if the transaction involves out-of-state parties or properties.
Arizona Case Law – Replacement and Subrogation
US Bank v. JPMorgan Chase Bank (AZ Court of Appeals 6-29-2017)
In 1997, the Loepers obtained a $200,000 HELOC from Bank One, which was secured by a DOT on their home. In 2001, Bank One increased the available commitment under the HELOC to $250,000. In 2004, the Loepers signed a $387,000 note and DOT in favor of First Magnus Financial (“FMF”), and Bank One subordinated its HELOC DOT to the FMF DOT. In 2005, the Loepers signed a $682,000 note and DOT in favor of FMF, and used about $384,000 of the 2005 FMF loan proceeds to pay off the 2004 FMF loan, and FMF released the 2004 FMF DOT. The closing statement also allocated about $211,000 of the 2005 FMF loan proceeds to pay off the HELOC (which was then held by Chase). However, Chase did not close the HELOC or release the HELOC DOT because the payoff was about $3,500 short of the payoff amount. Chase advised the title company of the shortfall, but no corrective action was taken. The Loepers thereafter continued to request advances on the HELOC, increasing the unpaid balance of the HELOC to more than $203,000 by 2013.
The Loepers thereafter defaulted on the 2005 FMF note, and US Bank (which then held the 2005 FMF note) started a trustee’s sale. The TSG obtained by the trustee conducting the trustee’s sale showed the HELOC DOT as superior to the 2005 FMF DOT. Chase also started its own trustee’s sale under the HELOC DOT, and US Bank filed an action for a declaratory judgment as to lien priority. Both lenders agreed to postpone their trustee’s sales until the court determined their respective lien priorities. The trial court, applying both the replacement doctrine and equitable subrogation, found US Bank’s lien superior to Chase’s lien.
The court analyzed the equitable doctrines of replacement and subrogation, each of which might allow a later recorded DOT to assume priority over an earlier DOT. While similar, the doctrines apply in different situations (i.e., subrogation applies when there are two different lenders, while replacement applies to a refinancing by the same lender).
The replacement doctrine holds that if a senior DOT is released of record, and is replaced with a new DOT as part of the same transaction, the new DOT retains the same priority as the senior DOT, except to the extent that any change in the terms of the DOT or the obligation it secures is materially prejudicial to the holder of a junior interest in the real estate. The rationale behind the replacement doctrine is that the intervening lienholder suffers no prejudice because its lien maintains the same position it occupied before the subsequent lender satisfied the pre-existing obligation. The Court noted that the Loepers used the 2005 FMF note proceeds to satisfy and replace the 2004 FMF note and 2004 FMF DOT, making application of the replacement doctrine appropriate. The subordination agreement gave the 2004 FMF DOT priority over the HELOC DOT; therefore, under the replacement doctrine, the 2005 FMF DOT, which replaced the 2004 FMF DOT, also had priority over the HELOC DOT to the extent of $384,000 (the amount paid on the 2004 FMF note from the proceeds of the 2005 FMF loan). Chase suffered no prejudice from application of the replacement doctrine because the HELOC DOT maintained the same lien priority it had before the 2005 FMF DOT replaced the 2004 FMF DOT. Therefore, the Court concluded that the 2005 FMF DOT took priority over the HELOC DOT to the extent of $384,000.
Chase then argued that, even if the replacement doctrine applied, equitable subrogation does not apply because FMF was aware of Chase’s lien and failed to take proper steps to insure that the HELOC DOT was satisfied and released. The Court noted that the equitable subrogation doctrine as adopted in Arizona permits one who fully performs an obligation of another secured by a DOT to become the owner of the obligation and the DOT to the extent necessary to prevent unjust enrichment (the doctrine allows a subsequent lender who applies funds to a primary and superior encumbrance to be substituted in the priority position of the lienholder). However, Arizona law does not permit partial subrogation to a DOT, which would have the effect of dividing the security between the original oblige (lender) and the subrogee (later lender), imposing unexpected burdens and potential complexities of division of the security and marshaling upon the original obligee. The Court noted that FMF did not fully discharge the HELOC or obtain a release of the HELOC DOT; therefore, the doctrine of equitable subrogation did not apply and the HELOC DOT obtained priority over the 2005 FMF DOT for any amount above and beyond $384,000.
Bank of America v. Felco Business Services (AZ Court of Appeals 8-29-2017)
In 2007, two property owners borrowed $200,000 from Countrywide Home Loans, which was secured by a DOT recorded against their Sedona property in February 2007 (“DOT 1”). They then borrowed $1,500,000 from Felco to improve the Sedona property, and secured $600,000 of the Felco loan with a DOT recorded against the Sedona property in June 2007 (“DOT 2”). Countrywide Bank (an affiliate of Countrywide Home Loans) refinanced Countrywide Home Loans’ $200,000 loan, and secured its new loan with a DOT recorded against the Sedona property in June 2008 (“DOT 3”). $200,000 of the June 2008 loan proceeds were used to pay off and release Countrywide’s original loan and DOT 1 in July 2008.
The borrowers defaulted on the Felco loan, and in February 2009, Felco scheduled a trustee’s sale under DOT 2 for May 2009. Felco obtained a TSG showing DOT 3 in a position subordinate to DOT 2. Felco sent notices of its trustee’s sale to Countrywide Bank, which failed to respond to the notice and did not seek to enjoin the trustee’s sale.
Felco entered a credit bid at its May 2009 trustee’s sale in the full amount it calculated was owing under its promissory note and DOT 2. Felco recorded its trustee’s deed and thereafter leased out the property and paid property taxes, insurance and maintenance expenses.
BofA thereafter acquired all Countrywide entities, including Countrywide Home Loans and Countrywide Bank. In August 2009, DOT 3 was assigned to BofA as Countrywide’s successor in interest. Four months later, BofA sent a letter to Felco inquiring about the status of its DOT after the foreclosure sale and notifying Felco that BofA was investigating the notice of foreclosure sale. After completing its investigation, BofA informed Felco that DOT 3 had seniority over DOT 2 prior to the trustee’s sale and that Felco’s trustee’s sale did not extinguish DOT 3.
In May 2011, BofA sued Felco and the borrowers, seeking a declaratory judgment that DOT 3 was the senior lien, through either the doctrine of equitable subrogation or replacement, and requesting any excess proceeds from Felco’s trustee’s sale. Felco contended that equitable subrogation was improper, as it would prejudice Felco as an intervening lienholder, and because BofA failed to review the chain of title and therefore did not expressly assert that it intended DOT 3 to be subrogated to DOT 1. Felco also alleged that BofA failed to notify Felco of its reliance on equitable subrogation when it recorded DOT 3 or upon receiving notice of the trustee’s sale under A.R.S. § 33-811(C) [see footnote 3 below].
The trial court held that A.R.S. § 33-811(C) required BofA to assert its lien priority as a “defense or objection to the trustee’s sale,” and that its failure to enjoin the sale and assert its priority constituted a waiver. The trial court did not reach the issue of whether the doctrine of equitable subrogation applied.
BofA argued in its appeal that the doctrine of equitable subrogation is not a waivable defense under A.R.S. § 33-811(C). The Court of Appeals agreed that equitable subrogation and lien priority disputes do not fall within A.R.S. § 33-811(C), as the defenses and objections described in that statute refer only to defenses and objections to the sale itself, but not claims independent of the trustee’s sale. Whether BofA held a junior or senior lien is not determined by or contingent upon the occurrence of the trustee’s sale, and the assertion of equitable subrogation rights would not challenge any claims or title to the property or the validity of the trustee’s sale. Felco was entitled to proceed with and conduct the trustee’s sale, regardless of whether BofA’s lien was senior or junior to Felco’s DOT, and even if BofA had asserted the subrogation rights before the trustee’s sale. _______________ 3A.R.S. §33-811(C) provides that the trustor, its successors or assigns, and all persons to whom the trustee mails a notice of a trustee’s sale, waives all defenses and objections to the sale not raised in an action that results in the issuance of a court order granting relief pursuant to Rule 65 of the Arizona Rules of Civil Procedure entered before 5:00 p.m. MST on the last business day before the scheduled date of the sale, and that a copy of the order, the application for the order and the complaint must be delivered to the trustee within 24 hours after the order is entered.
The Court of Appeals remanded the equitable subrogation issue to the trial court to determine whether and to what extent it applied, and instructed the trial court to consider, among other things, whether the loan secured by DOT 3 fully paid the obligation related to DOT 1 and whether equitable subrogation was needed to prevent Felco from becoming unjustly enriched by a promotion and lien priority. The Court of Appeals expressly noted that any amount of DOT 3 in excess of DOT 1 would not be equitably subrogated.
Lender takeaway: The replacement and equitable subrogation doctrines apply only to the extent that a prior lien existed, and cannot be used to expand the priority of a subsequent lien beyond the scope of the prior lien.