Equitable subordination is an equitable remedy that in certain circumstances allows a new lender who pays off an existing loan to retain the benefit from the payoff lender’s priority. Let’s start with a common example. A homeowner has a first and second mortgage on their property. The homeowner refinances, and the new lender pays off the first mortgage but not the second. Maybe the second verbally agreed to subordinate but never did. Perhaps the subordination agreement was defective, or the second was missed in the title search. Or, maybe the second was a HELOC that the new lender paid down to zero but the HELOC lender did not release their lien nor close the account, and the borrower subsequently drew against it. If the homeowner stops making loan payments on the previous second that was never released, that lender will file foreclosure asserting they’re now in first position.
Colorado is a race-notice state. The previous second won the race as it was recorded ahead of the new loan, and the new lender had both constructive (recorded) notice and maybe even actual notice. However, based on the doctrine of unjust enrichment, the new lender can still be deemed to be in first lien position based on the doctrine of equitable subrogation. See Colorado National Bank v. Biegert, 438 P.2d (Colo. 1968).
Interestingly, Colorado has gone a step further from the norm of limiting the use of equitable subordination in the context of refinance transactions and has allowed it in a sale transaction. See Hicks v. Londre, 125 P.3d 452 (Colo. 2005). In that case, a $400,000 judgment lien was missed. This case is fascinating for two additional reasons as the court allowed equitable subordination despite the fact that the lien previously in first position was not satisfied in full, and the court also gave the benefit of equitable subordination to the new buyer’s down payment of $500,000 thereby putting their purchase money equity ahead of the missed judgment lien.
Of course, the Public Trustee (if in Colorado) will not serve as the arbiter of lien priority so the priority issue will be decided through a judicial process. In the event the new refinance lender is given the benefit of equitable subordination, it will be capped at the amount that was paid off on the previous first mortgage lien. Any remaining amounts will be junior to the missed second.
Let’s now take it a step further and assume the refinance loan that benefited from equitable subordination is subsequently refinanced and again that previous second is not released. This can happen for a variety of reasons. Title searchers examining the deed of trust being paid off recognize the form of the documents as typical first mortgage documents so they assume it’s in first position. And, the searcher often relies on the previous title company’s efforts in insuring the “first” they’re now paying off and presume junior liens were all paid. So, does the new lender also get to stand in the shoes of the lender they’re paying off who prevailed previously in establishing equitable subordination? Almost certainly, the answer is “no”. This concept is referred to as derivative subordination, and the only state I’ve seen it applied is in New Jersey.
Finally, do not confuse equitable subrogation with equitable subordination. Not only do they sound similar, but they accomplish similar ends. However, equitable subordination is used solely in bankruptcy cases pursuant to Section 510 (C) of the Bankruptcy Code. It allows the Bankruptcy Court the ability to subordinate liens or even disregard them entirely in certain circumstances based on equitable grounds.
This article is intended for educational purposes only and not as legal advice.