When a lender fails to perfect its lien, the Bankruptcy Code provides a mechanism for a trustee (or debtor-in-possession (DIP)) to avoid that unperfected lien. 11 U.S.C. §544. These so-called "strong-arm" powers grant a trustee the powers that a hypothetical junior lien creditor would have under applicable nonbankruptcy law. Id.

Under the appropriate circumstances and depending on the applicable nonbankruptcy law, a trustee can avoid a lien that a debtor willingly granted a lender in exchange for the advancement of credit, even when the lender refinanced another secured lender's debt. When the latter circumstance occurs, however, the subsequent unperfected lender may, depending on applicable law, have a defense to the trustee's "strong-arm" powers.

For example, under certain state's laws, when a lender fails to perfect a lien and the borrower uses the funds to pay off a prior, secured creditor whose lien is perfected, the subsequent unsecured lender may be able to apply the doctrine of equitable subrogation and step into the shoes of the prior, perfected, secured creditor. By doing so, the subsequent, unperfected lender can prevent the avoidance of its otherwise unperfected lien under the doctrine of equitable subrogation.

Though an occasional saving grace, the doctrine of equitable subrogation does not necessarily exist in all states, and therefore its application is case-specific. Nonetheless, when available, it provides a defense for a lender that fails to properly perfect.

The Doctrine of Equitable Subrogation

Broadly defined, subrogation is the substitution of one person in the place of another with reference to a lawful claim or right. Rinn v. First Union Nat'l. Bank of Maryland, 176 B.R. 401, 407 (D. Md. 1995) (citing 73 Am.Jur.2d Subrogation §1 at 598 (1974)); see, also, Am. Surety Co. v. Bethlehem Nat'l. Bank, 314 U.S. 314, 317, 62 S.Ct. 226, 86 L.Ed. 241 (1941) (holding that "one who has been compelled to pay a debt which ought to have been paid by another is entitled to exercise all the remedies which the creditor possessed against the other"). The party subrogated steps into the shoes of the creditor. Rinn, 176 B.R. at 407 (citing Levenson v. Capital Mortgage, 643 A.2d 505, 510 (Maryland 1994)). In addition, the party subrogated acquires all rights, securities and remedies the creditor has against the debtor and is regarded as one and the same with the creditor whom he succeeds. Id., citing Peek v. Wachovia Nat'l Bank & Trust Co., 86 S.E.2d 745, 755 (N.C. 1955); United States v. Munsey Trust Co., 332 U.S. 234, 242, 67 S.Ct. 1599, 1603, 91 L.Ed. 2022 (1947) (one who rests on subrogation stands in the place of one whose claim he has paid, as if the payment giving rise to the subrogation had not been made)).

Because equitable subrogation is a state law doctrine, it may differ from state to state or may not exist at all, and its application will differ. For example, the Ninth Circuit, in applying California law, has described equitable subrogation as being generally appropriate where (1) the subrogee made the payment to protect his or her own interest, (2) the subrogee did not act as a volunteer, (3) the subrogee was not primarily liable for the debt paid, (4) the subrogee paid off the entire encumbrance and (5) subrogation would not work any injustice to the rights of the junior lienholder. See Mort. v. United States, 86 F.3d 890, 894 (9th Cir. 1996); see, also, In re Fiesole Trading Corp., 315 B.R. 198, 202 (Bankr. D. Mass. 2004) (citing E. Boston Sav. Bank v. Oregon, 701 N.E.2d 331, 334 (Mass. 1998), for application of Massachusetts law); In re Pearce, 236 B.R. 261, 264-65 (Bankr. S.D. Ill. 1999) (citing American Nat'l. Bank & Trust Co. of Chicago v. Weyerhauser Co., 692 F.2d 455, 461-63 (7th Cir. 1982), for application of Illinois law).¹

Though the specific factors may vary, the doctrine of equitable subrogation is applied only for the purpose of achieving equity and is therefore governed by equitable principles. Rinn, 176 B.R. at 407 (citing Compania Anonima Venezolana de Navegacion v. A.J. Perez Export Co., 303 F.2d 692, 697 (5th Cir. 1962), cert. denied, 371 U.S. 942, 83 S.Ct. 321, 9 L.Ed.2d 276 (1962)); see, also, In re Bevlan, 327 F.3d 994, 997 (9th Cir. 2003). As a result, under certain state's laws, the equity of the putative subrogee's actions is the overriding concern. See, e.g., In re Simms, 300 B.R. 877, 879 (Bankr. S.D. Va. 2003) (citing Ohio state law for the proposition that equitable subrogation will not be used to benefit parties who were negligent in their business transactions and who were obviously in the best position to protect themselves); see, also, In the Matter of American Appliance, 272 B.R. 587, 598 (Bankr. D. N.J. 2002) (holding under Delaware law that equitable subrogation applies where a lender's new security proves defective due to fraud or some kind of mistake, but not upon negligence grounds); In re Lewis, 270 B.R. 215, 217 (Bankr. W.D. Mich. 2001) (holding under Michigan law that equitable subrogation applies only in extreme cases bordering on, if not reaching, fraud).

When facts are fraudulently concealed from the lender, however, then equitably subrogating that lender to a prior, perfected lender is appropriate. See, e.g., Bridge v. Midlantic Nat'l. Bank, 18 F.3d 195, 201-02 (3d Cir. 1994) (applying New Jersey law).

Though generally accepted in many states, the acceptance of the equitable subrogation doctrine in a bankruptcy proceeding, depending on the forum, is not as clear. In fact, the codification of equitable subrogation principles in 11 U.S.C. §509 has led to inconsistency in its bankruptcy application.

Equitable Subrogation and §509

It is well accepted that while federal law defines a trustee's avoidance powers, state law governs the determination of property rights, including the perfection of liens. Bridge, 18 F.3d at 200; Matter of Chaseley's Foods Inc., 726 F.2d 303, 307 (7th Cir. 1983); see, also, 4 King, Lawrence P., Collier on Bankruptcy ¶544.02 at 544-5, 544-14 (15th ed. 1993). Despite this general rule, courts are not in agreement as to whether, or to what extent, the requirements of state law equitable subrogation affect the interpretation and application of the requirements for subrogation under 11 U.S.C. §509. Fiesole, 315 B.R. at 203 (citing In re Photo Chem. Servs. Inc., 179 B.R. 604, 618 (Bankr. D. Minn. 1995)).

In relevant part, §509 provides:

(a) Except as provided in subsection (b) or (c) of this section, an entity that is liable with the debtor on...a claim of a creditor against the debtor, and that pays such claim, is subrogated to the rights of such creditor to the extent of such payment.
(b) Such entity is not subrogated to the rights of such creditor to the extent that—

(2) as between the debtor and such entity, such entity received the consideration for the claim held by such creditor.

(c) The court shall subordinate to the claim of a creditor and for the benefit of such creditor an allowed claim, by way of subrogation under this section...of an entity that is liable with the debtor on...such creditor's claim, until such creditor's claim is paid in full...

While seemingly the basis for circuit appeals court and/or Supreme Court determination,² the majority of courts hold that §509 differs from state law equitable subrogation, and a party may, under the appropriate circumstances, avail itself to either. Id. What is clear, however, is that when a trustee seeks to avoid a lien through his strong-arm powers, it requires a fact-intensive analysis.

Equitable Subrogation and §544

Pursuant to 11 U.S.C. §544, a trustee has the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable, by—

(1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists;
(2) a creditor that extends credit to the debtor at the time of the commencement of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or not such a creditor exists; or
(3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.

Despite the trustee's strong-arm powers, these powers confer on the trustee no greater rights than those accorded by the applicable state law to a creditor holding a lien by legal or equitable proceedings. Havee v. Belk, 775 F.2d 1209, 1218-19 (4th Cir. 1985); Bridge, 18 F.3d at 200 (holding that §544(a) does not transform a trustee into a super-priority creditor and the scope of the trustee's avoidance powers is governed entirely by state law). Thus, if a hypothetical lien creditor could not avoid an unperfected creditor's security interest under the principles of equitable subrogation, then neither could a trustee under §544. Id.; Rinn, 176 B.R. at 413-14.

Indeed, a trustee's powers are subject to any equitable claim recognized by applicable state law, including subrogation. Rinn, 176 B.R. at 413. Subrogation rights, and the ability to use equitable subrogation to defeat a trustee's strong-arm powers, again depend on the application of the particular state's law. For example, in Morgan, a bankruptcy court declined to apply equitable subrogation in a §544 avoidance adversary proceeding because of the negligence of the lender—a relevant factor under Tennessee law—and the potential harm to unsecured creditors. In re Morgan, 291 B.R. 795, 803-05 (Bankr. E.D. Tenn. 2003). Thus, consideration must be given to the applicable state's law as opposed to the law from a particular circuit.

Though trustees argue that the failure to properly perfect a lien makes that lien subject to its strong-arm avoidance powers, courts have consistently held that nothing in the provisions of the Uniform Commercial Code expressly or implicitly refutes the application of subrogation. See, e.g., In re Bridge, 18 F.3d at 202; Finance Co. of America v. U.S. Fid. & Guar. Co., 353 A.2d 249, 253 (Md. 1976); French Lumber Co. v. Commercial Realty & Finance Co., 195 N.E.2d 507, 510 (Mass. 1964). As a result, the formal procedures of the UCC may be supplemented by principles of equitable subrogation. Rinn, 176 B.R. at 410.

However, these cases only address a trustee's attempt to avoid liens on personalty. Based on the language of §544(a)(3), the application of equitable subrogation to realty differs. Bridge, 18 F.3d at 202-04. In Bridge, the Third Circuit held under New Jersey law that the trustee's standing as a hypothetical, bona fide purchaser of real property prevailed over a mortgagee's rights as a holder of an unrecorded equitable lien because bona fide purchasers of real property, without actual or constructive notice of a competing lien, take the property free from unrecorded equitable liens. Id.; see, also, In re Cowan, 273 B.R. 98, 107 (6th Cir. 2002) (holding under Ohio law that a lender who did not explain its failure to timely note its mortgage on a certificate of title was not entitled to equitable subrogation).

Thus, the application of equitable subrogation differs from realty to personalty in addition to differing state by state. What is abundantly clear is that the application of equitable subrogation depends on, and is limited to, its existence and applicability under applicable state law.

Conclusion

Although equitable subrogation is a formidable defense in certain circumstances and in certain courts, the doctrine is not universally accepted or applied. When it is accepted and applied, however, the doctrine can significantly undermine a trustee's §544 strong-arm powers.

It is important to remember that subrogation is not an absolute right, but rather a doctrine contingent upon the equities and attending circumstances of each case. As such, lenders should not consider equitable subrogation an alternative to proper perfection, but as a potential defense to an avoidance action, depending on the applicable state law and forum.

Footnotes

¹ These are but a few examples of the application of varying states' equitable subrogation principles in bankruptcy and is not a survey of courts applying equitable subrogation principles—a topic that is beyond the scope of this article. Return to article

² See In re Fiesole Trading Corp., 315 B.R. 198, 203 (Bankr. D. Mass. 2004), for a discussion of the split in decisions reconciling §509 and state law equitable subrogation principles, which is beyond the scope of this article. Return to article