DD 3/23/06 New Colorado subrogation decision continues focus on subrogee's knowledge of intervening lien

Daily Development for Thursday, March 23, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

MORTGAGES; SUBROGATION; SUBROGEE’S KNOWLEDGE OF INTERVENING LIEN:  Equitable subrogation will sometimes operate as an exception to the Colorado Recording Act to permit purchasers and lenders to have higher priority than a judgment creditor despite the judgment creditor properly obtaining a lien well before the purchaser and lender acquired any interest in the property. 

Hicks v. Londre, 125 P.3d 452, (Colo. 2005).

In 2001, Judgment Creditor obtained a judgment for $413, 773.73 against Seller and properly recorded the transcript of judgment, giving Judgment Creditor a lien on Seller’s property.  Judgment Creditor’s lien was the fourth lien in priority on the property.  The first priority lien was a deed of trust securing a loan of $1.6 million held by Lender 1.  Lender 2 occupied the second and third priority positions. 

In 2002, Seller conveyed the property to Buyer for $1.5 million.  The sale was financed by a purchase money loan from Lender 3 for $1 million and Buyer contributed approximately $500,000.00.  Judgment Creditor was not present at the sale.  Because the purchase price was less than the value of the first lien on the property, Lender 2 received none of the proceeds of sale, and was conspicuously absent from most of the court’s discussion.  Although Buyer obtained a title commitment, the title insurance company failed to discover Judgment Creditor’s lien.  Soon after the sale, Judgment Creditor notified Buyer of his intent to foreclose his lien and asserted priority over Lender 3 and over the warranty deed obtained by Buyer.  Buyer and Lender 3 responded with a defense based on equitable subrogation.

The trial court held for Judgment Creditor, reasoning that because Judgment Creditor’s lien was validly recorded before Lender 3 or Buyer received their interest in the property, Judgment Creditor could foreclose.  The trial court found that Lender 3 and Buyer were presumed to have actual knowledge of Judgment Creditor’s lien.

The Court of Appeals reversed, holding that Buyer and Lender 3 had only constructive knowledge of the lien and allowed Buyer and Lender 3 to be equitably subrogated to a higher lien priority than Judgment Creditor.

The Colorado Supreme Court upheld the Court of Appeals, in a thoughtful opinion that evaluated the various approaches taken elsewhere, and carefully delineating where Colorado fits on the spectru.  It started by referring to a Massachusetts case that stated a “five-factor test” to determine whether equitable subrogation applied.  As stated by the Colorado Supreme Court, the factors are:  1) the subrogee made the payment to protect his or her own interest; 2) the subrogee did not act as a volunteer; 3) the subrogee was not primarily liable for the debt paid; 4) the subrogee paid off the entire encumbrance; and 5) subrogation would not work injustice to the rights of a junior lienholder. 

All of these factors militated in favor of recognizing subrogation here.  And the court does state that these factors state the Colorado test.  But the court went on to note that in Colorado an additional test of “good equitable standing”  would be imposed.  Typically, the question of equitable standing is resolved by looking to the degree of notice the party seeking subrogation had of the intervening lien over which it now seeks priority.

“With regard to knowledge, the majority of courts that have considered the issue hold that ‘actual knowledge’ [of an intervening lien] precludes the application of equtiable subrogation, but constructive knowledge does not. . . . [A] minority of jurisdictions hold that either actual or constructive knowledge of an intervening lien bars equitable subrogation . . . An alternative . . . is offered by the Restatement (third) of Prop.: Mortgages. . . . The Restatement does not hinge application of the doctrin on the potential subrogee’s knowledge of the intervening lien, but rather on the subrogee’s expectations and the liklihood of prejudice to an intervening lienholder.”

Although the court acknowledged that “Colorado law on this point is closer to the Restatement.,” it indicated that tradition in Colorado compelled that the doctrine be applied narrowly, and therefore “the potential subrogee’s knowledge and potential negligence” will be factors in determining whether subrogation will apply.  “The right of subrogation is never granted as a reward for negligence.”

But the court then proceeded to conclude that the potential subrogees had no actual knowledge of the Judgment Creditor’s lien and that they sought a title report before proceeding to make their loan.  “[Even for a sophisticated lender], reliance upon a title insurance company is not evidence of negligence.”

The court stressed that the fact that the Judgment Creditor was recorded was not of controlling significance, as it characterized equitable subrogation as an “exception to the recording acts.”

As for Judgment Creditor, the court found no prejudice to his rights. He argued that if he had been informed of the closing (by being notified by the escrow or the junior lenders) he would have tried to negotiate for some payment on his lien, as otherwise he might have blocked the closing.   But the court noted that, because the property sold for less than the sum of its encumbrances, Judgment Creditor would not have received any funds from the sale had he attended. 

Reporter’s Comment:  The court choosing to allow equitable subrogation in this case is striking for a number of reasons.  First, both Buyer and Lender 3 probably could have claims against their title insurance company.  The court’s decision really took the title insurance company off the hook more so than Buyer and Lender 3.  Second, the court found no prejudice to Judgment Creditor, in part, because of a lack of evidence on the record regarding facts such as a higher interest rate on the new loan, a higher loan amount, or longer maturity date.  For the court to assume a lack of evidence actually meant no prejudice is somewhat confounding, because Judgment Creditor, Lender 3, and Buyer seem to be equally innocent as to any wrongdoing here.  Last, one wonders, what could have Judgment Creditor done any differently?

Editor’s Comment 1: The case is probably consistent with the majority approach here.  Judgment Creditor has already filed, and did not take any action in reliance on the release of Lender 1.  Consequently, even if Colorado follows the approach that treats judgment lien creditors as BFP’s under the recording act, Judgment Creditor did not “rely on the record”  here. 

Editor’s Comment 2: Of course, it is noteworthy that the court considered and rejected the Restatement test that one can obtain subrogation even with actual knowledge of an intervening lien.  This is also the “Jack Murray test,” which Jack has frequently espoused on DIRT.  The editor prefers the rule as stated by the court.  The editor favors regularity (to the extent practicable)  in all things real estate - especially lending.  Lenders should not be encouraged to rely upon equitable intervention instead of negotiation with known senior lienholders.

Editor’s Comment 3: The court purports to state that the lender here was reasonable in failing to discover the intervening lien.  But note that the real party in interest here certainly was the lender’s title insurance company, so it is somewhat ironic that the court indicates that the test of “reasonable conduct” that gets the title insurance company off the hook is the fact that lender turned to the title insurance company in the first place.  The court doesn’t evaluate whether the title company might have been negligent in failing to discover Judgment Creditor, even though the title company, arguably was the agent of the lender for this purpose.  Assuming that Judgment Creditor’s claim was indexed and discoverable, isn’t it negligence for a professional title searcher to fail to discover it?   If not, then why would it be reasonable for anyone to rely on a title company for record information?

Note that our friends in the title insurance industry scream loudly that they are not the suppliers of title information to the industry - they are only insurers of title.  If so, then perhaps people should not be relying upon them for title searches, and consequently subrogation results, arguably, should be different.  What a puzzle!!

In fact, the editor has always maintained that the industry does and should rely upon title insurance companies to supply accurate title reports, and that the title insurance not only knows that it does but encourages such reliance, and is in an awkward position claiming otherwise.

Editor’s Comment 4:  It is noteworthy also  that we have a state supreme court attempting a clear statement of its test for equitable subrogation in a loan payoff situation.  Unfortunately, the court middies the clarity a bit by stating five discrete elements of a test and then proceeding to discuss an unlisted sixth element - whether the party seeking subrogation was “forgivably negligent” in failing to discover the recorded judgment lien.  This will create some unfortunate problems for future researchers, who might extract the quote that the “five factors” test is the Colorado rule, only to discover that in fact there is a sixth factor.  

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