Washington State Supreme Court rejects the “volunteer rule” bar to equitable subrogation, and adopts the Third Restatement’s more liberal approach towards equitable subrogation in the refinancing context.
Columbia Community Bank v. Newman Park, LLC, 177 Wash.2d 566 (2013).
Newman Park, LLC (the “Mortgagor”) was a development company owned by twelve members, one of which was a company owned by Joseph Sturtevant (“Sturtevant”), whose membership interest in the Mortgagor was 39 percent. In 2004, the Mortgagor purchased a piece of real property and obtained a loan for $400,000 from Hometown National Bank (the “First Mortgagee”) secured by a mortgage on the property. All members of the Mortgagor ratified the loan.
In 2008, Sturtevant, without knowledge of the other members of the Mortgagor, obtained a loan for his company from Columbia Community Bank (the “Second Mortgagee”) for $1.5 million. Sturtevant secured the loan with a second mortgage on the Mortgagor’s property and he signed on behalf of his company. As a condition for the loan, the Second Mortgagee required Sturtevant to use $400,000 of the $1.5 million to pay off the First Mortgagee’s prior loan. This transaction was in effect a refinancing, because the Second Mortgagee knew about the First Mortgagee’s existing lien and expected to acquire a first priority lien on the property.
However, Sturtevant had no authority to grant the mortgage in favor of the Second Mortgagee because the Mortgagor’s operating agreement required at least 80 percent of the membership interest to approve the transaction. Sturtevant’s company only held a 39 percent interest in the Mortgagor. The Second Mortgagee was unaware of this fact because Sturtevant had forged some of the documents it had reviewed for the loan, which indicated that Sturtevant’s company controlled 100 percent of the Mortgagor. In 2009, when Sturtevant’s company defaulted on its loan and the Second Mortgagee tried to foreclose on the property, the Mortgagor objected stating that it never granted a security interest in the property. The Second Mortgagee contended that the mortgage it received from Sturtevant was valid under various agency theories, and in the alternative, it had a lien on the property through equitable subrogation.
The trial court held that the mortgage to the Second Mortgagee was invalid because Sturtevant’s company lacked the requisite 80 percent membership interest in the Mortgagor needed to bind the company. However, because the Second Mortgagee had paid off the First Mortgagee’s $400,000 secured loan, it was equitably subrogated to the First Mortgagee’s position and had an equitable lien on the property for $400,000. The state Court of Appeals affirmed, and rejected the Mortgagor’s argument that the Second Mortgagee was a mere “volunteer”, and therefore could not benefit from equitable subrogation. The state Supreme Court accepted review on narrow issue of applicability of the “volunteer rule” as a bar to an equitable subrogation claim.
The Supreme Court began by observing that equitable subrogation allows one party to step into the shoes of a second party that is owed a debt or obligation and to receive the benefit of that debt or obligation in the absence of any contractual agreement or assignment of rights between the parties or the debtor. The court further observed that the purpose of this equitable doctrine is to prevent unjust enrichment. In the refinancing context, equitable subrogation allows a new mortgagee to pay off a senior mortgagee and receive the same priority as the senior mortgagee, so that an existing junior mortgagee does not become unjustly enriched by default. The court then discussed the traditional rule in Washington State that restricts equitable subrogation to parties who are not acting as mere “volunteers” to the transaction — in other words, parties who have a preexisting legal interest to protect.
The state Supreme Court expressly rejected the “volunteer rule” and adopted the more liberal principles of the Restatement (Third) of Property regarding equitable subrogation in the mortgage refinancing context. It noted that although some past equitable subrogation cases contained language suggesting strict application of the “volunteer rule”, many of the court’s precedents did not require a preexisting legal interest in refinancing cases because a refinancing lender often acts for future profit rather than to protect an existing legal interest. The Restatement has rejected the volunteer rule and instead uses a more liberal “protect some interest” rule, which only requires that “the subrogees pay to protect some interest.” The court found the Restatement to be the better approach because it facilitates refinancings while still preventing true intermeddlers from benefiting from equitable subrogation.
Applying equitable subrogation to the facts, the state Supreme Court affirmed the trial court’s decision that the Second Mortgagee was equitably subrogated to the First Mortgagee’s interest. Although the Second Mortgagee failed to conduct full diligence into Sturtevant’s assets, the court pointed out that the Second Mortgagee was misled by the forged documents, which factored in favor of equitable subrogation. Furthermore, granting subrogation would not harm the Mortgagor because the Second Mortgagee would merely step into the shoes of the First Mortgagee — i.e., the Mortgagor would still owe $400,000, except now the debt would be owed to the Second Mortgagee instead of the First Mortgagee. pacerun:yes’> Applying these precedents to the instant case, the court found that the Side Letter materially impaired the Seller’s security without the knowledge or consent of the Seller.
The court considered and rejected several arguments raised by the Construction Lender. The Construction Lender argued that the Side Letter existed before the Subordination Agreement made by the Seller. However, the court stated that what mattered was whether the Seller knew and consented to the Side Letter, which it did not. The Construction Lender also pointed to certain language in the Subordination Agreement suggesting that the Seller had given an implied consent to the Sider Letter. The court rejected that argument largely because of public policy considerations aimed at protecting sellers from material impairment of their rights, which they do not expressly consent to. Lastly, the court observed that the Construction Lender was not a benign actor in this transaction, and that the balance of equities rested with the Seller. Thus, the appellate court affirmed the judgment of the trial court granting the Seller relief.
