Lenders, title insurance companies and their agents should be aware that on April 21, 2011, the Supreme Court of Kentucky issued a decision that could have a significant effect on Kentucky courts’ application of the doctrine of equitable subrogation in Kentucky. Wells Fargo Bank, Minnesota, N.A. v. Commonwealth, --- S.W.3d ---, 2011 WL 1620578 (Ky. Apr. 21, 2011). While not often litigated at the appellate level (in part because of its widely accepted application), the doctrine of equitable subrogation has long been a reliable tool used by lenders and their title insurance companies to ensure that mortgage loans intended to have first priority actually receive that first priority position. But the Wells Fargo decision limits the doctrine’s application to such an extent that it could threaten the viability of equitable subrogation in Kentucky on a going-forward basis.
What is Equitable Subrogation?
In the real estate lending context, equitable subrogation is a doctrine that permits a lender whose loan proceeds are used to satisfy a prior lien against real property to step into the shoes of that first lienholder for purposes of determining priority. As an example, suppose a homeowner has a $100,000 first mortgage (first priority lien) and a $20,000 balance on a revolving line of credit secured by a lien on the home (second in line). If the homeowner later refinances the first mortgage and takes out a $130,000 loan secured by the home, the refinancing lender will generally insist on a subordination agreement with the line of credit lender, thereby securing first priority. But if through oversight the refinancing lender does not do so, the doctrine of equitable subrogation would generally give the refinancing lender first priority up to $100,000 (the amount of loan proceeds used to pay off the first mortgage), and third priority (behind the HELOC lender) for the balance of the loan. A Kentucky Court of Appeals decision that predated Wells Fargo by a few months described the doctrine well:
The doctrine of equitable subrogation is long established in Kentucky and holds that one who satisfies a prior lien against real property steps into the shoes of that first lienholder, or to use the language of the cases, is “equitably subrogated” to the rights of the first lienholder, and so holds a prior, and superior lien. The basis for this doctrine is that it would not be equitable, and a form of unjust enrichment, for a second lienholder to be promoted to a position of priority when only the identity of the first lienholder to be promoted to a position of priority when only the identity of the first lienholder has changed but the debt owed has not. The “payoff” of the first lien is equivalent to an assignment of the lien to a different creditor by operation of law and does not extinguish the priority.
Application of the doctrine of equitable subrogation merely maintains the status quo and preserves the lien of Community Trust in the same priority as when it was created. The application of equitable subrogation in no way impairs the expectations or rights of Community Trust. However, it does do equity to meet the expectations of [Specialty Mortgage] and Floyd that [Specialty Mortgage's] mortgage would be a first, prior, and superior lien on Floyd's residence when the only known encumbrances, Community Trust's first mortgage, delinquent taxes and mechanics liens, were paid from [Specialty Mortgage's] loan proceeds. Had that not been the expectation, the loan by Ameriquest would never have been made and the first mortgage of Community Trust would not have been paid in full.
W.M. Specialty Mortg., LLC v. Community Trust Bank, Inc., --- S.W.3d ----, 2011 WL 558655, *2 (Ky. Ct. App. Feb. 18, 2011) (quoting appellant’s brief).
The decision most often cited by Kentucky courts in the context of equitable subrogation is Louisville Joint Stock Land Bank v. Bank of Pembroke, 9 S.W.2d 113 (Ky. 1928), in which the Court summarized equitable subrogation as follows:
Subrogation is a creature of equity, and rests upon principles of natural justice. Without attempting a comprehensive classification of cases in which the doctrine of subrogation may be applied, it is generally held that the right of subrogation will arise where the party claiming it has advanced money to pay a debt which, in the event of default by the debtor, he would be bound to pay; or where the one making the payment had some interest to protect; or where the money advanced to pay the debt was under an agreement with the debtor, or the creditor, express or implied, that he should be subrogated to the rights and remedies of the creditor.
Id. at 115.
The Wells Fargo Decision
The Wells Fargo decision was issued in a consolidated appeal of two different cases in which the priority of general tax liens of the Commonwealth of Kentucky was at issue. Wells Fargo at 2-6. In one case, the tax lien predated a purchase money mortgage that later resulted in foreclosure, and in the other case, the tax lien was recorded after a purchase money mortgage but before a refinance mortgage that paid off the purchase money mortgage was recorded. Id.
After reaching the fairly unremarkable conclusion that general tax liens enjoy priority “over subsequent holders of security interests, including purchase money lenders” pursuant to KRS 134.420, the Court turned to the issue of equitable subrogation. Id. at 7-11. The Court’s opinion, authored by Special Justice Lawrence L. Jones II – a plaintiff’s personal injury attorney – first discussed the three approaches that courts around the country take with respect to equitable subrogation:
- The majority rule – actual knowledge of an existing lien precludes the application of equitable subrogation but constructive knowledge does not.
- The minority rule – barring equitable subrogation where the subsequent lienholder has actual or constructive knowledge of an existing lien.
- The Restatement rule – permitting the application of equitable subrogation even if the subsequent lienholder actually knows or should know about the prior lien as long as the prior lienholder will not be prejudiced by application of the doctrine.
See generally Wells Fargo at 12-13.
The Court then found that “a balancing of the equities favors the second approach.” Id. at 13. In describing this “balancing,” the Court reached a number of conclusions that should give lenders, title agents and title insurers pause:
- “[P]rofessional mortgage lenders should be held to a higher standard for purposes of determining whether the lender acted under a justifiable or excusable mistake of fact in failing to duly investigate prior liens.” Id. at 13-14.
- “Equity also demands that the responsibility for a defective title examination be allocated to the party who is most culpable.” Id. at 14.
- Equitable subrogation must not be used to “bail out a negligent title insurer.” Id. at 15.
- “Those title insurers are engaged in the very profitable business of assuring that their lending institution customers receive a clear title by insuring such.” Id. at 15.
- Describing a lender’s decision not to make a loan if it must first satisfy a tax lien as “the sound lending practices that our society deserves, especially in the aftermath of this nation’s 2008 financial meltdown.” Id. at 19.
The Wells Fargo Court’s holding was narrowly limited to a conclusion that “a professional lender who has actual or constructive knowledge of an earlier recorded general tax lien may not benefit from an equitable reordering of the liens.” Wells Fargo at 19. The holding does not expressly affect equitable subrogation in the context of competing “professional lenders,” for example, so the ramifications of the decision could be limited. But the above-quoted language could easily lead to further erosion of equitable subrogation, something that would significantly affect lenders, title insurers and their agents.