New Court Ruling Marks Departure on Equitable Subrogation

By Thomas A. Stoops

In the recent case of The Weitz Company, L.L.C. v. Nicholas Heth, 674 Ariz. Adv. Rep. 29, the Arizona Court of Appeals, Division One, has made a significant ruling on the issue of whether the Arizona statutory provision governing the priority of mechanic’s liens permits the court to shift lien priorities by applying the doctrine of equitable subrogation. The case’s chief significance may be for title companies who have for years relied strongly on the principle of equitable subrogation to override priorities set forth in the mechanic’s lien statutes. An application for review to the Arizona Supreme Court has been made.

By way of factual background, First National Bank of Arizona provided a $44 million dollar construction loan to Summit at Copper Square, LLC (“Summit”) to build a 165-unit mixed-use commercial and residential condominium project in downtown Phoenix. The bank recorded a deed of trust on the project to secure payments under the construction loan. The Weitz Company was hired as General Contractor, but as the project neared completion the developer, Summit, was unable to pay for about $4 million dollars worth of work performed by Weitz Company. Despite the pendency of this claim, Summit began selling individual units before construction was completed. The proceeds from the sale of the units were used to pay off the construction loan, but Weitz Company’s construction balance remained unpaid. Weitz Company recorded a mechanic’s lien against the project in May 2008, and began foreclosing its lien against the purchasers of the units and the lenders who provided funds to finance the purchases.

The question was whether these purchasers and lenders were entitled to a position superior to Weitz under the theory of equitable subrogation since their payments went to pay off a portion of the construction loan which was superior to the Weitz Company’s mechanic’s lien. The court held that the language of the mechanic’s lien statute, A.R.S. § 33-992(A) is unambiguous and expressly provides that mechanic’s liens have priority over “all liens, mortgages and other encumbrances” attaching subsequent to the time the labor was commenced or materials provided. In this case, it was undisputed that the Weitz Company perfected this mechanic’s lien and that the deeds of trust relating to the purchased units did attach to the subject property after the Weitz Company commenced work on the project. The Court of Appeals held that under the plain language of A.R.S. § 33-992(A), the Weitz Company had priority over the lenders of the deeds of trust. The lenders, and more importantly for this discussion, the title companies which had insured the lenders’ position, argued that the doctrine of equitable subrogation is a valid exception to the statutory order of priority. Equitable subrogation allows “[o]ne who fully performs an obligation of another, secured by a mortgage, [to] become [] by subrogation the owner of the obligation and the mortgage to the extent necessary to prevent unjust enrichment.”

The lenders relied on three prior decisions from the Court of Appeals. In reviewing these cases, the Court of Appeals distinguished the case of Cont’l Lighting & Contracting, Inc. v. Premier Grading & Utils., LLC, 227 Ariz. 382, 258 P.2d 542 (App. 2011) which relied on the “Replacement Doctrine”, noting that was inapplicable. Replacement Doctrine deals with a situation where a senior lender and borrower agree to certain changes in the terms of the secured debt, and the lender retains its priority to the extent that the changes do not materially prejudice junior lien holders.

The court then dealt with the cases of Peterman-Donnelly Eng’rs & Contractors Corp. v. First Nat’l Bank of Ariz., 2 Ariz. App. 321, 408 P.2d 841 (1965) and Lamb Excavation, Inc. v. Chase Manhattan Mortgage Corp., 208 Ariz. 478, 95 P.3d 542 (App. 2004), both of which applied the principle of equitable subrogation to elevating the priority of a later lien above a mechanic’s lien. The Court of Appeals analyzed both cases and concluded the “court failed to recognize that § 33-992 does not provide an exception for altering the lien priority our legislature has afforded to mechanic’s liens.”

The Court of Appeals apparently conceded that its decision was a departure from previous case law; however, it held that the doctrine of “stare decisis and the need for stability in the law do not preclude us from determining that a prior Court of Appeals decision was incorrectly decided.”

Because of the nature of mechanic’s liens, which may go unrecorded for extended periods of time and yet still attach to real property, the complications for insuring subsequent purchasers of land in development projects without reliance on the doctrine of equitable subrogation may be increased significantly. The fact that this decision is of great concern to title companies and will impact the marketing of properties subject to mechanic’s liens may mean that the Arizona Supreme Court is more likely to grant review of the Court of Appeals’ decision. However, if the ruling stands in the future it may be substantially more difficult to purchase title insurance for properties purchased from failed construction projects.