In an article entitled, "Equitable Subrogation: Not-So-Secret-Defense Weapon," in the July- August, 1994, edition of Title News, I extolled the virtues of the doctrine of equitable subrogation which can be invoked to salvage the priority of a supposed first mortgage when the mortgagee discovers an intervening superior lien. Under the doctrine, which is based upon principles of equity and fairness, a mortgagee whose loan proceeds were used to pay off a prior mortgage will be subrogated or substituted into the position of that earlier mortgage and accorded priority over subsequent liens and creditors to the extent it satisfied the earlier debt.
In the article, I described equitable subrogation as a "widely favored" doctrine which had been applied to many different types of liens, even IRS tax liens. I also noted that the fact that the plaintiff mortgagee has a title insurance policy does not constitute a defense to the application of the doctrine. In June, 1997, the United State Court of Appeals for the Seventh Circuit dissented from that position when it handed down First Federal Savings Bank of Wabash v. United States, 118 F. 3d 532 (7th Cir. 1997), a decision which has serious ramifications for the title insurance industry.
The facts presented by First Federal are typical of equitable subrogation cases. The owners of the property refinanced their first mortgage with First Federal Savings Bank of Wabash ("First Federal Savings Bank") but a tax lien which was recorded four years earlier was missed. According to the Seventh Circuit, the bank was unaware of the tax lien because its title insurer had failed to discover it.
When the IRS sought to foreclose the tax lien, First Federal Savings Bank brought a wrongful levy action against the United States, arguing that under Indiana law it was entitled to be equitably subrogated to the rights of the first mortgagee which it had paid off. The district court denied the bank's request for equitable subrogation, observing that the bank should have been on guard when the owners doubled their mortgage debt in the refinance and noting that the title insurance company had been negligent in failing to discover the tax lien. The district court dismissed the bank's complaint and denied its motion for reconsideration. First Federal Savings Bank appealed to the Seventh Circuit.
The Seventh Circuit's affirmation of the lower court's decision is not so unsettling as the rationale for that decision. In surveying Indiana law on equitable subrogation, the Seventh Circuit noted that the doctrine is to be applied liberally. It also noted, as had the United States Court of Appeals for the First Circuit in Progressive Consumers Federal Credit Union v. United States, 79 F. 3d 1228 (1st Cir. 1996), that the application of equitable subrogation would not leave the government in any worse position than it would have been prior to the discharge of the previous first mortgage. The Seventh Circuit focused, however, on two factors in holding that the bank was not entitled to equitable subrogation. The Seventh Circuit characterized First Federal Savings Bank as a "sophisticated commercial lender." (Has anyone alive today seen an "unsophisticated" commercial lender other than George Bailey in It's A Wonderful Life?) The bank's sophistication had been dispositive in the District Court's view and significant in the eyes of the Seventh Circuit.
It is the Seventh Circuit's consideration of the second factor that is the most alarming aspect of the First Federal decision. The Seventh Circuit found it noteworthy that the bank's title insurer was paying the costs of the litigation. (I wonder how that fact was established during the argument of the appeal. While the bank's counsel was expounding on the doctrine of equitable subrogation and its supporting rationale, did the court just come right out and ask him who was paying his fees?) The Seventh Circuit concluded that the title insurer was the real party-in- interest and that equitable subrogation was not appropriate because it would relieve the title insurance company of its contractual obligation. Thus, First Federal Savings Bank was denied equitable relief because it had procured title insurance!
The United States Court of Appeals for the Ninth Circuit took a decidedly different view of the impact of title insurance on a claim for equitable subrogation in Mort v. United States, 886 F. 3d 890 (9th Cir. 1996). As was the case in First Federal, the intervening lien in Mort was an IRS lien. The Morts held a deed of trust which secured a loan whose proceeds had been used to satisfy and release a previous deed of trust. The Morts also had a title insurance policy but the title insurer had failed to discover the federal tax lien, just as the title insurer had in First Federal.
When the IRS seized the subject property the Morts filed a complaint in the United States District Court for the District of Nevada asking the court to restrain the IRS and declare that their trust deed interest was superior to the federal tax lien. The district court ultimately dismissed the Morts complaint without prejudice, ruling that the Morts could not bring their claim for equitable subrogation without first pursuing their legal remedies against their title insurer.
The district court's decision in Mort sent shivers through title insurance claims counsel. In the district court's eyes, equitable subrogation was nothing more than a means for the title insurer to avoid its contractual obligations. This weighed heavily in the district court's balancing of the equities. The government was an innocent party. It had done nothing wrong. The IRS merely recorded its tax lien and secured first position when the prior deed of trust was extinguished. The title insurer was the villain in this piece. The title insurer's negligence had caused injury when it missed the intervening tax lien but now it sought to benefit from its own mistake at the expense of the innocent IRS.
On appeal, the Ninth Circuit held that the District Court had abused its discretion in ruling that the Morts must first seek relief from their title insurer before bringing an action for equitable subrogation against the IRS. The Ninth Circuit further held that the Morts were entitled to be equitably subrogated to the position of the previous deed of trust, thus awarding them priority over the IRS lien. The Ninth Circuit acknowledged the basic tenet of equity jurisprudence that courts should not exercise their equitable authority - - their authority to issue injunctions and enter declarations concerning the parties' relative rights and positions - - when the moving party has an adequate legal remedy, i.e., when the moving party can recover monetary damages from another.
The Ninth Circuit, however, pointed out the limit of that principle and the error in the lower court's decision. Equitable relief such as subrogation should not be denied unless the alternate legal remedy is available against the same person or entity from whom equitable relief is sought. In Mort, the plaintiffs sought equitable relief against the IRS. They asked the court to declare that their deed of trust was superior to the IRS lien. The Morts did not have any legal remedy against the IRS - - they could not recover monetary damages from the IRS because it had done nothing wrong to them - - so the court's consideration of equitable relief was appropriate. In the opinion of the Ninth Circuit, the fact that the Morts had a legal remedy against a third party, i.e. a title insurer, did not bar equitable relief against the IRS.
I submit that the Ninth Circuit's approach is the correct one, that the existence of title insurance should not bar the application of equitable subrogation or any other equitable remedy. The object of equitable subrogation is the prevention of unjust enrichment. As I wrote three and a half years ago in Title News:
Why should a junior lienholder vault into first position because another party (the insured mortgagee) satisfied a first mortgage under the mistaken belief that it would then become the first mortgagee? Why should the junior lienholder enjoy such a windfall as a result of another's error or fraud?
I would pose a slightly different question in the context of the First Federal and Mort decisions. Why should a junior lienholder such as the IRS be allowed to move into first position and seize property just because another party obtained title insurance? Why should the IRS or other lienholder benefit from insurance for which it did not pay and to which it is not a party? The foundation of equitable subrogation is fairness and prevention of unjust enrichment. The existence of title insurance does not change the fact that the intervening lienholder will be unjustly enriched unless the doctrine of equitable subrogation is applied. Hopefully, other federal and state courts will recognize this distinction and follow the lead of the United States Court of Appeal for the Ninth Circuit.