In The Weitz Company LLC v. Heth, No. CV-13-0378-PR (Ariz. Sup. Ct., Aug. 26, 2014), the Arizona Supreme Court reversed the Court of Appeals, holding that lenders can once again rely upon the doctrine of equitable subrogation in mechanic’s lien priority disputes with contractors.
First National Bank of Arizona provided a construction loan to Summit at Copper Square for the development of a 165-unit, mixed-use commercial and residential condominium project in downtown Phoenix, recording a deed of trust to secure Summit’s payment obligations. Summit later contracted with The Weitz Company, which served as the general contractor on the project. As the project neared completion, however, Summit still owed Weitz for billed work. Nevertheless, Summit began selling individual units in the project and applied the earnings toward its loan with First National. Residential lenders provided financing for most of the unit sales.
Weitz complied with the statutory requirements in Arizona to obtain a mechanic’s lien on the project. After recording its lien, Weitz filed a complaint seeking to foreclose its lien and named as defendants the unit owners and the lenders who provided the funds used to finance the purchases of the units. Weitz argued that its mechanic’s lien was superior to the lenders’ security interests, based on Arizona’s mechanic’s lien statutes: A.R.S. §§ 33-981, et seq. The lenders argued that they were equitably subrogated to the first lien position held by First National because the financing provided by the lenders was used to pay off Summit’s loan with First National.
It seemed the lenders were on solid legal ground, based on prior decisions of the Arizona Court of Appeals, but the Court of Appeals in Weitz ended up rejecting its earlier rulings and sided with Weitz, holding that the doctrine of equitable subrogation was not available in mechanics lien priority disputes.
The Arizona Supreme Court reversed, however, siding with the lenders and holding that the doctrine of equitable subrogation was available in mechanics lien priority disputes.
The Supreme Court first noted that the Court of Appeals decision represented a departure from previous case law allowing subsequent lienholders to have priority over mechanic's liens through equitable subrogation. Relying on the Restatement (Third) of Property: Mortgages § 7.6(a), the Supreme Court characterized equitable subrogation differently than the Court of Appeals did. Rather than describing equitable subrogation as a means of jumping ahead of an intervening lien, the Supreme Court described equitable subrogation as allowing a party to replace a priority lienholder through substitution or assignment.
In addition, the Supreme Court noted that nothing in A.R.S. § 33-992(A) — which grants priority to a mechanic’s lien over subsequently recorded liens — “suggests that the legislature intended to preclude equitable subrogation in the mechanics’ lien context.” In any event, the Supreme Court explained that mechanic’s lienholders suffer no prejudice when equitable subrogation comes into play, because “[w]hen a lien that is superior to a mechanic’s lien is assigned to another through equitable subrogation, the mechanic’s lien remains in the same position it occupied before subrogation.” The court also based its holding on A.R.S. § 33-723, which allows junior lienholders to assume a superior lien position by discharging the superior lien in a foreclosure action, regardless of any intervening mechanic’s liens.
Weitz alternatively argued that the owners and lenders could not be equitably subrogated to First National’s position because they did not fully pay off Summit’s obligation to First National. The Supreme Court initially noted that partial equitable subrogation is not permitted because it “splits” the obligation between the original and subsequent obligor. However, the Supreme Court sided with the lenders, holding that “when a single mortgage burdens multiple parcels, a third party may be entitled to equitable subrogation when that party has paid a pro rata amount of the obligation and obtained a full release of the parcel at issue from the mortgage.”
What This Means for Lenders and Contractors
The Supreme Court’s reversal of the Court of Appeals decision returns Arizona law to its status quo prior to the Court of Appeals decision, where equitable subrogation could be relied upon in mechanic’s lien priority disputes to allow subsequent lienholders to take a superior position over mechanic’s liens. This final pronouncement from the Arizona Supreme Court likely settles the issue in Arizona for good. While lenders (and their title companies) should continue to be extra diligent in confirming whether any liens encumber the property being purchased by their borrowers, they can again rely on the doctrine of equitable subrogation in any mechanic’s lien priority dispute. Contractors, on the other hand, have to be aware of this important limitation on their mechanic’s lien rights.