Arizona Supreme Court to Contractor: Sorry But Equitable Subrogation of a Bank’s Later Deed of Trust Trumps Earlier Mechanics’ Lien Rights

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The smoke has finally cleared in a hard and long-fought battle between a bank and contractor both claiming priority to foreclose millions of dollars on a Phoenix condominium project. The project, well-known as Summit at Copper Square in central Phoenix (“Summit”), went broke in 2007. The foreclosure case began in 2008, and the construction and real estate industries have been keeping a close eye on the outcome. In the end, the Arizona Supreme Court weighed in for its “first opportunity to address the interplay between equitable subrogation and the priority granted to mechanics’ liens by [Arizona Revised Statutes] § 33-992(A).”

The Arizona Supreme Court issued its decision in The Weitz Company L.L.C. v. Heth et. al, No. CV-13-0378-PR (“Weitz”) on August 27th. The Weitz decision vacated all lower court rulings and concluded that Arizona’s lien statute, § 33-992(A), allows “assignment by equitable subrogation of a lien that attached before construction began on the project at issue.” The bank holding deeds of trust by subrogation (or substitution) was allowed to move ahead of the contractor to foreclose against the remaining value in the property.

The facts of the Summit project followed a very typical chronology of events:

April 2005 The bank records its first deed of trust securing the developer’s “dirt loan” before construction starts.
November 2005 Shovel hits the ground and construction officially begins to signify the contractor’s right to mechanic’s liens.
December 2005 The bank records an amended deed of trust securing the developer’s construction loan and modifying the original deed of trust.
September 2007 Developer begins selling condominium units and the bank agrees to release the owners from both deeds of trust when the unit loans are paid off.
May 2008 Contractor records its mechanic’s lien for billings unpaid by the developer.
November 2008 Contractor files a foreclosure lawsuit claiming its lien rights in November 2005 have priority over the bank’s later deed of trust that modified the original deed of trust.

The contractor argued (and the lower courts agreed) that the 2005 modification did not subrogate to the original deed of trust because § 33-992(A) required the bank to “fully discharge” the prior deed of trust. Since the modification was not a full discharge, the bank could not regain priority over the mechanics’ lien. The Supreme Court disagreed and established the following principles for the future of Arizona lien law:

● “When equitable subrogation occurs, the superior lien and attendant obligation are not discharged but are instead assigned by operation of law to the one who paid the obligation.”

● “Because an equitably subrogated lien ‘attaches’ when the superior lien was recorded, § 33-992(A) does not require that an intervening mechanics’ lien be given priority.”

● “[N]othing in § 33-992(A) suggests that the legislature intended to preclude equitable subrogation in the mechanics’ lien context. … When a lien that is superior to a mechanics’ lien is assigned to another through equitable subrogation, the mechanics’ lien remains in the same position it occupied before subrogation.”

● “[P]ermitting equitable subrogation of a lien that is superior to a mechanics’ lien is consistent with the legislature’s treatment of junior lienholders’ interests in foreclosure actions.”

● “[A] prospective subrogee is required to discharge only the portion of an obligation that is secured by the property at issue.”

All of these principles culminated in the Supreme Court’s summary holding “that when a single mortgage is recorded against multiple parcels, a third party is not precluded from attaining equitable subrogation rights when it pays the pro rata amount of the superior obligation and obtains a full release of the parcel at issue from the mortgage lien.”

The important takeaway for contractors is to guard against the seemingly uninhibited ability for holder of the original security interest to subrogate back to the beginning. Contractors should more seriously consider the owner/developer’s financial wherewithal (via the property or otherwise) to pay until construction is complete. This may avoid long and expensive foreclosure fights as the only means of getting paid on a failed project. Bonds and other financing alternatives may be better suited for contractors in light of the Weitz case.