Cont’l Lighting & Contracting, Inc. v. Premier Grading & Utils., LLC – 6/2/2011

June 6, 2011

Arizona Court of Appeals Division Two Adopts the Doctrine of Replacement of Mortgages to Hold That when a Senior Lien Is Refinanced by the Same Lender, the New Lien Retains the Same Priority as Its Predecessor, Except to the Extent That Any Change in Terms Is Materially Prejudicial to a Junior Lienholder’s Interest.

In 2005, Real Estate Equity Lending, Inc. (“REEL”) loaned $825,000 to Karl Conover for the purchase of property and recorded a deed of trust on the property.  In 2006, Conover conveyed the property to Casa Villa Subdivision, LLC (“Casa Villa”), which contracted with Premier Grading & Utilities, LLC and its subcontractor, Continental Lighting & Contracting, Inc. (collectively, the “Contractors”), to work on the property.  The Contractors recorded mechanics’ liens on the property.  In 2007, REEL refinanced its original loan to Conover with a new promissory note to Casa Villa in the amount of $1,000,000, approximately $803,000 of which was used to pay the outstanding balance of the original loan.  The new deed of trust was to be recorded in first position.  Ultimately, Casa Villa defaulted and REEL exercised its power of sale under the new deed of trust.  The Contractors then filed mechanics lien foreclosure actions against REEL, which were consolidated.  Both REEL and the Contractors moved for summary judgment.  The trial court granted the Contractors summary judgment, holding that their mechanic’s liens had priority over REEL’s new deed of trust.  REEL timely appealed.  

The Arizona Appeals Court reversed and remanded.  The Court first held that the doctrine of equitable subrogation did not apply because under that doctrine, a subsequent lender who supplies funds used to pay off a primary and superior lien may be substituted into the priority position of the primary lienholder only if the subsequent lender is a different lender than the holder of the original, senior lien.  In this case, REEL could not be subrogated to its own previous deed of trust.

The Court, however, adopted the doctrine of replacement, which applies when a loan secured by a deed of trust is refinanced by the same lender.  Citing Restatement (Third) of Property § 7.3, the Court held that where a senior lien is released of record and, as part of the same transaction, is replaced with a new lien, the latter retains the same priority as its predecessor, except to the extent that any change in the terms of the lien or the underlying debt is materially prejudicial to a junior lienholder’s interest.  The Court explained that the doctrine has been adopted in other jurisdictions and comports with public policy because it encourages lenders to be flexible in restructuring arrangements with borrowers under difficult economic and business conditions, while also preventing the material impairment of junior lienholders’ interests.  Applying the doctrine to this case, the Court held that the second deed of trust assumed the priority of the original deed of trust it replaced, but only to the extent of $803,000 – the outstanding balance of the original loan that was paid by the second loan.  The Contractors’ mechanics liens thus had priority over the remainder of the replacement loan, ensuring that the Contractors remained in the same position they occupied before replacement.  

The Court rejected the Contractors’ argument that the doctrine of replacement did not apply because the original deed of trust and the refinance deed of trust involved different borrowers.  The Court cited cases from other jurisdictions holding that a change in borrower is not relevant to the application of either the doctrine of replacement or equitable subrogation.

Presiding Judge Vasquez authored the opinion; Judges Eckerstrom and Kelly concurred