Contributed by Blaire Cahn
Delaying perfection of a security interest may become a critical mistake for a refinancing lender. If the lender perfects its lien during the 90-day window (often known as the “preference period”) prior to its borrower’s bankruptcy, the new lien may be susceptible to avoidance under section 547 of the Bankruptcy Code, transforming the refinancing lender into an unsecured creditor of the debtor. Should the lender have to pay such a steep price for its delay when it presumably intended to hold the same lien the prior lender held? Sometimes, the answer is yes. One court, however, didn’t seem to think so recently and allowed a refinancing lender to avoid this fate under principles of equitable subrogation.
In Logan v. Citi Mortgage, Inc. (In re Schubert), Bankr. No. 08-17653, 2010 WL 4007639 (Bankr. D. Md. Oct. 12, 2010), the trustee brought a preference action under section 547(b) of the Bankruptcy Code seeking to avoid the transfer a deed of trust that the debtor’s refinancing lender, Citi Mortgage, Inc., had perfected during the preference period. Prior to the preference period, the original promissory note (also owned by Citi Mortgage) was refinanced and a certificate of satisfaction was filed in the Maryland land records, but Citi Mortgage waited nearly two months from the time of the refinancing (and well into the preference period) to perfect its new lien. Against this backdrop, the trustee argued the lien was avoidable as a preference.
The court preliminarily found that the deed of trust recorded by Citi Mortgage (as a result of the refinancing) within the preference period constituted a preferential transfer and that Citi Mortgage had failed to meet the statutory exceptions to avoidance. Though that determination could have ended the court’s review, the court agreed to consider whether Citi Mortgage, through the doctrine of equitable subrogation, could be placed in the position it (as the original lender) held prior to the refinancing, defeat the trustee’s preference attack, and because the property at issue had since been sold, receive the proceeds of the sale to the extent of the amount of the refinanced note.
Some courts have used the doctrine of equitable subrogation to correct technical errors made by lenders in the context of a refinancing where the lender intended to be subrogated to the prior loan. Under the doctrine of equitable subrogation, one who has discharged the debt of another may, under certain circumstances, succeed to the rights and position of the satisfied creditor if: (1) the payment was made by the subrogee to protect its own interest; (2) the subrogee did not act as a volunteer; (3) the subrogee was not primarily liable on the debt paid; (4) the entire debt was paid; and (5) subrogation would not work any injustice to the rights of others. 73 Am. Jur. 2d, Subrogation § 5 (2001).
Opposing the application of the equitable subrogation doctrine, the trustee argued that equitable subrogation was inapplicable where (1) the refinancing party and the holder of the original deed of trust were the same party; (2) the original lien was released prior the recordation of the new lien; and (3) there was no evidence that Citi Mortgage intended to maintain its priority when it closed on the refinancing transaction. The trustee, however, did not provide any evidence of harm that would befall other creditors were the court to apply the doctrine of equitable subrogation.
Because equitable subrogation is premised on equity, the court declined to find, as a per se matter, that the doctrine of equitable subrogation could apply only where the subrogee and subrogor were different entities. Noting that, under applicable state law, equitable subrogation occurred at the time of the refinancing (and not when the new lien was recorded), the court also declined to hold that the timing of the filing of the new deed of trust was a bar to equitable subrogation.
Instead, the court focused on the intent of the parties to the transaction and the effect of equitable subrogation on other creditors. It concluded that applying the doctrine of equitable subrogation would not harm the debtor’s existing creditors, in light of the fact that, for example, the debtor’s other secured creditor was aware of Citi Mortgage’s original deed of trust.
Ultimately, the court found that the balance of the equities favored Citi Mortgage and not the trustee. It held that Citi Mortgage had become equitably subrogated to the original loan and the date of recordation of the refinanced deed of trust would be considered to be that of the original loan. The court also considered whether its finding of equitable subrogation should mean that the transfer of the refinanced deed of trust was not avoided or was avoided (but Citi Mortgage would hold the rights it held under the original deed of trust to which it had become equitably subrogated) and intimated that the latter construct would be preferable if the new loan exceeded the amount owed on the original note.
Interestingly, the court appeared to say that equitable subrogation might not necessarily defeat avoidance, but, regardless, could make avoidance moot. Under either construct, the court held that, as a result of equitable subrogation, Citi Mortgage held a first priority lien on the sale proceeds held by the trustee, subject to any intercreditor agreements it may have made with the other secured lender, and that the estate’s title to the proceeds was junior to that of the secured lenders.
The doctrine of equitable subrogation ultimately saved the day for Citi Mortgage, preventing it from becoming an unsecured creditor of the debtor. While the Schubert decision may provide a ray of hope for refinancing lenders who accidentally delay the recording of a lien, the application of the equitable subrogation doctrine is a highly subjective task. In fact, other courts have not allowed a refinancing lender to use principles of equitable subrogation to overcome a preference action. Because the balance of equities may not necessarily weigh in its favor under each circumstance, a refinancing lender is better served by recording its new lien as soon as possible than by banking on equitable subrogation prospects.