As a follow-up to their previous article published almost 15 years ago, authors Adam Leitman Bailey and Dov Treiman discuss the law of equitable subrogation including many of the possible consequences from this doctrine in foreclosure practice.
Almost 15 years ago, we authored “Split Between Departments Muddies Subrogation Doctrine” on this very page and this same publication, noting that Appellate Decisions in the Second and Third Departments had conflicting views on equitable subrogation rule while the First and Second Department Appellate Divisions remained silent. Today, all four Appellate Divisions are now synchronized on the law of equitable subrogation. This article goes into the law and many of the possible consequences from this doctrine in foreclosure practice.
Priority of Debts Introduced
There are a variety of possible theories as to how a debtor’s debts should be paid off. Among the contenders are priority based on seniority, strict proportionality, and first come first served. Even as to these, there could be subgroupings. New York selects from these options and others, choosing that debts, if made into liens, be paid off in order of their seniority.
However, defining that seniority is a rather complicated task. It is not as simple as looking on the calendar to see which debt arose when. The first question that comes to mind is whether the debt is to be treated as a lien on the debtor’s property or whether it is merely a general indebtedness. In New York, the most certain general mechanism to transform a general indebtedness into a lien is to sue on the debt and reduce it to a judgment. As for other mechanisms, liens are possible both on real property and on personal property and can arise from a number of possible scenarios: mortgages, chattel mortgages, and statutory liens, to name a few.
New York’s Normal Rule
In New York, the normal priority of liens is adherence to the calendar: Older recorded obligations have priority over later recorded obligations.
However, there are exceptions to that, the exception known as “equitable subrogation” being the focus of this article. Simply put, equitable subrogation is a process by which a junior lien can have its priority adjusted to a more senior position, although not necessarily the most senior position.
In order to clarify the issue, let us start with a look at some arithmetic. Let us assume a piece of property has a distressed sale value of one million dollars and there are liens against it totaling three quarters of a million dollars. Then, regardless of the priority of the liens, any of the lienors can force a foreclosure and theoretically see both its lien and everyone else paid off 100 cents on the dollar. In this scenario, seniority simply does not matter because all the creditors can theoretically get paid in full and the property owner is left with a quarter million dollars in cash (less expenses, of course).
Now reverse the scenario: The property is worth $750,000 and the liens come to an even million. Now, in a foreclosure action brought by the most senior lienholder, there is going to be a quarter million dollar shortfall in this scenario where we have a bidder who bids the $750,000 market value. Upon whom is that shortfall inflicted? Dollar for dollar, the shortfall is inflicted on the most junior lienors until they add up to a quarter million dollars. One of the lienors in that group may wind up receiving some payment, but all the lienors more senior than that lienor will be paid in full.
Under the first scenario, since the lienors can all get paid in full, there is less incentive for a priority battle between lienholders. However, under the second scenario, the lienholders are more likely to battle over seniority as there is a limited supply of funds.By far, the second scenario is the more common one.
Equitable Subrogation: Purpose
Enter equitable subrogation. In a manner we will discuss below, equitable subrogation enables a lienor to improve its seniority. Note that there is no scenario under which this lienor receives more than it was owed. If there are funds left from the foreclosure sale, those move down the line of seniority in the same manner as if this lienor had always had its adjusted position in the line. However, this lienor is entitled both to repayment of its original debt and the money it spent to jump the line.
The balance of this article therefore deals with the rules as to how one may come under the doctrine of equitable subrogation to improve one’s seniority as a lienor. We note that a number of years ago we wrote on this issue, but in the intervening years, the Appellate Divisions have answered some questions we had then to leave open.
How to Jump the Line
Subject to certain qualifications we will discuss below, the line-jumping is simple. The junior lienor pays the senior lienor’s whose position the junior seeks to acquire whatever it takes to remove the senior lienor’s claim, thus purchasing that senior position and now able to lay claim at the foreclosure sale the funds it just expended to buy its superior position, plus as much of the excess funds from the foreclosure sale as it takes to liquidate the lien-purchaser’s original lien King v. Pelkofski, 20 N.Y.2d 326 (1967) (subject to an exception we will discuss below). Anything above that from the foreclosure sale goes to the still more junior lienors in the same order, dollar for dollar, as they would have gotten if the lien-purchaser had always held the senior position, but with its original debt piled on top of the just-retired debt.
We note, in this, the borrower has no particular interest. It is seeing all the equity it had in the property going to other persons. The doctrine leaves the borrower neither better nor worse off than before. The borrower goes in and comes out owing the same amounts as it would have after the liquidation in any event.
Technicalities
Not every would-be line-jumper qualifies for the protection of the doctrine of equitable subrogation. However, in Bank of N.Y. v. Penalver, 125 A.D.3d 795 (2nd Dept. 2015), the Second Department gives it broad application. Under that department’s ruling, the doctrine applies broadly to (1) whenever one party pays a debt on behalf of another party and (2) it was fair of them to do so. This applies if the payment of debt was made in order to (a) protect the interests of the paying party, and (b) to cover an existing debt that was already owed.
Naturally, one would want to know what would make someone not qualified under these criteria. The answer lies with what we will call the “sweetheart line-jumper.” We authors, with our extensive landlord-tenant background, have often encountered “sweetheart leases” which a landowner enters at an artificially low rent just prior to either selling or forfeiting the building. Typically, this is either a close relative of the debtor or someone who has secretly prepaid a pile of rent in order to get the cheap rent for the longer term.
A sweetheart line-jumper would be one who ostensibly lent the debtor a pittance for the specific purpose of being positioned to jump ahead in line, ahead of a second or more junior lienor whom the debtor wanted to ensure would not get paid and whose lien would be extinguished by the successful foreclosure. By this maneuver, the secured creditors down the line of seniority would be fraudulently transformed into unsecured creditors. Such a scheme would not qualify for equitable subrogation treatment under the Second Department’s rule in Penalver.
When both the junior mortgage and the senior mortgage to which senior position the junior mortgagor hoped to jump are invalid for some reason, the jump in priority under equitable subrogation does not occur. The reason is simple. If the target position was itself invalid, there is no jump because there is no place for the jumper to land.Wilmington Sav. Fund Soc’y v. Moretta, 2024 NY Slip Op 05548 (App. Div. 1st Dept.)
The statute of limitations to assert a cause of action for equitable subrogation, it sounding in equity, is six years from the time of the payment. Deutsche Bank Nat’l Tr. Co. v. Weinfeld, 227 A.D.3d 662 (2nd Dept. 2024); Gulf Coast Bank & Tr. Co. v. Virgil Resort Funding Grp., Inc., 180 A.D.3d 1297 (3rd Dept. 2020)
In order to be subrogated to the rights of the first lien, it will always be necessary to examine the nature of the first lien. Otherwise put, a first lien that was limited in nature does not suddenly become unlimited in nature if a junior lienor comes along and equitably subrogates to it. We alluded to this idea at the very beginning of this article when we noted that New York recognizes a large variety of liens. But more broadly than that, New York recognizes a variety of interests in property.
Nothing is plain and simple, like the classic fee simple absolute. There are other more limited interests: joint interests, interests in common, interests by the entirety, life estates, to name a few. Then, you put that together with the variety of liens that exist, recognizing that they also have their own varieties of enforceability. Put those two factors together, and one realizes that a younger lien who steps into the shoes of an older lien does so limited both by the nature of the original lien and by the nature of the property ownership right it encumbered. For just an example, a classic mortgage given by a holder of a life estate does not survive the life of that holder. Therefore, its lien does not survive and again therefore, a junior lien stepping into its shoes does not acquire a longer lifetime for itself. Nationstar Mortg. LLC v. Adee, 172 A.D.3d 1693 (3rd Dept. 2019).
Fraud and Mistake
Earlier in this article, we stated the general proposition that the lien-purchaser at the foreclosure sale is entitled to be reimbursed not only what it paid to purchase the lien and its attendant seniority, but the amount the lien-purchaser was itself into the debtor. Fraud, however, carves out two lines of exception to this idea. Harris v. Thompson, 117 A.D.3d 791 (2nd Dept. 2014) teaches that if the lien-purchaser participated in a fraud that took place in the chain of title, then the advance in seniority will not take place.
Further, if there is a flaw in which the lien-purchaser got its own lien, paying off the more senior lien will entitle it neither to prioritized entitlement to the foreclosure proceeds on account of the purchased lien nor any entitlement to the foreclosure proceeds on its own lien.
However, what Harris does not address is whether the lien purchaser would have a simple money claim against both the original debtor and the lienor whose priority it purchased. In our view, the money claim from the bought-out-lienor would be absolute, and from the debtor, dependent only on the bona fides of the debt the lien-purchaser was asserting in the first place.
If the one seeking to use equitable subrogation to jump position in the priority of liens is itself engaging in fraud in the transactions, the jump in position will not occur. This analysis is simple. Equitable subrogation derives its name not merely from the concept of fairness, but also from the concept of the body of law generally called “equity.” Thus, the person invoking any equitable concept encounters the maxim of equity, “One who seeks equity must act equitably.”
Fraud therefore disqualifies the invocation of equity and thus disqualifies equitable subrogation. Lucia v. Goldman, 145 A.D.3d 767 (2nd Dept. 2016). That is to say that the fraud alone does not disqualify the equitable subrogation so long as the one invoking it was not a participant in the fraud. Carver Fed. Sav. Bank v. Baptiste, 180 A.D.3d 748 (2nd Dept. 2020); First Franklin Fin. Corp. v. Beniaminov, 144 A.D.3d 975 (2nd Dept. 2016); Wells Fargo Bank, N.A. v. Dalfin, 169 A.D.3d 970 (2nd Dept. 2019).
Timing of the actual execution of the mortgages can be more important than the timing of their recording. Where a second mortgage’s proceeds are used to pay off the first mortgage, a flaw in the recording of the second mortgage is not going to give the third mortgage priority over it, if the third mortgage came into existence after the payoff of the first mortgage. US Bank Nat’l Ass’n v. Juliano, 184 A.D.3d 597 (2nd Dept. 2020); Rite Capital Grp., LLC v. LMAG, LLC, 91 A.D.3d 741 (2nd Dept. 2012).
This is logical because even with a flaw in recording of the second mortgage, the first mortage’s proper recording was sufficient to place the third mortgagee on notice of the existence of the first mortgage. So, either it was unpaid off and therefore a prior lien or whatever paid it off had acquired its position. Thus, the third lender had acted with full notice that something was going on with the first mortgage and it was not going to get priority over what had satisfied that first mortgage.
So long as the party seeking to invoke equitable subrogation believed in good faith that the satisfaction of the prior mortgage was legitimate and actually did pay off the first mortgage, fraud in the satisfaction pieces of other intervening mortgages will not disqualify its entitlement to equitable subrogation. Filan v. Dellaria, 144 A.D.3d 967 (2nd Dept. 2016).
Other Liens In the Middle
Among the various departments, there had been a rule that some level of knowledge (including the constructive notice of recording) of intervening liens disqualified the equitable subrogation. E.g. R.C.P.S. Assocs. v. Karam Developers, 238 A.D.2d 492 (2nd Dept. 1997); Bank One v. Mon Leang Mui, 38 A.D.3d 809 (2nd Dept. 2007); Roth v. Porush, 281 A.D.2d 612 (2nd Dept. 2001). This is no longer the law in the Second Department. Arbor Commercial Mortg., LLC v. Assocs. at the Palm, LLC, 95 A.D.3d 1147 (2nd Dept. 2012). Constructive notice is not sufficient to effect the disqualification; actual knowledge is. Matter of Kissous v. Futerman, 217 A.D.3d 1002 (2nd Dept. 2023); Green Tree Servicing, LLC v. Feller, 159 A.D.3d 1246 (3rd Dept. 2018); Nationstar Mortg. LLC v. Adee, 172 A.D.3d 1693 (3rd Dept. 2019); RTR Props., LLC v. Sagastume, 145 A.D.3d 697 (2nd Dept. 2016).
When the Junior Lienor Only Gets the Seniority for the Debt It Satisfied
Obviously, there is no advantage to a junior lienor who, having satisfied an older debt, only gets reimbursed the amount it paid on the older debt. The only motivation it has to pay the older debt is that it would get its loan paid off as well. However, that is not always the case. Only getting reimbursed for what it paid on the oldest debt and none of its loan befalls a lienor who participated in some kind of fraud when it got its own lien. Lombard v. Yacoob, 168 A.D.3d 919 (2nd Dept. 2019).
Difficult Territory
While this article has endeavored to set forth bright line rules and clear explanations, the subject, equitable subrogation is elusive in both regards. It is an extraordinarily subtle area of the law with rules that are both subtle and changing. A researcher facing a question in this area of the law is not always going to have to look for the latest rule on the subject, but the latest rule in the Judicial Department where the facts arose and the trends in which those rules appear to be heading.
Adam Leitman Bailey is the founding partner of Adam Leitman Bailey, P.C. Dov Treiman is the landlord-tenant managing partner of the firm. Francyne Belle-Pesce, an extern at the firm and a third-year law student at Syracuse University College of Law, assisted with the research of this article.
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