Subrogation: further perils for a mortgagee

21 April 2010 Topics: Banking and financial services

Incurring a shortfall is of concern for a mortgagee. However dealing with surplus sale proceeds after exercising power of sale or dealing with remaining securities after being fully repaid can also be matters for concern.

For example, it is not uncommon for a guarantor or a collateral mortgagor who is not the borrower to make a payment to the lender. A lender might also realise some collateral security in reduction of the borrower’s debt.

Can the guarantor or collateral mortgagor claim any surplus sale proceeds or claim the remaining security held by the mortgagee in priority to a subsequent registered mortgagee?

The High Court decision of Bofinger v Kingsway Group Limited [2009] HCA 44 provides a warning for an unwary mortgagee.

Case facts

The Bofingers were guarantors on loans made by different lenders to a borrower. The lenders were registered as first and subsequent mortgagees over properties owned by the borrower. The guarantors also provided collateral mortgages to the lenders.

The guarantors sold their properties and applied the proceeds of $1,519,234.40 in reduction of the borrower’s indebtedness to the first mortgagee.

The first mortgagee later exercised power of sale in relation to the borrower’s securities, resulting in a surplus of $701,019.86. The first mortgagee paid the surplus to the second registered mortgagee.

The Bofingers claimed they had rights of subrogation and that they were entitled to receive the surplus in priority to the second mortgagee.

Subrogation principles

When, for example, a guarantor makes payments in satisfaction of the guaranteed obligations of a borrower, the guarantor is entitled to the benefit of any remaining security and any surplus sale proceeds held by the lender.

Except in the most unusual cases, subrogation will only arise once the borrower’s debt has been fully satisfied.

Where a debt has been fully satisfied, a surety who has contributed to the satisfaction of the debt, even if only in part, will be able to seek subrogation.

A guarantor’s equitable right of subrogation may be excluded by the terms of the guarantee document.

Decision

On the evidence, the High Court said the guarantors were entitled to receive the surplus sale proceeds in priority to the subsequent registered mortgagee.

The following principles are apparent from the High Court decision and other cases:

  • There is no inconsistency between the doctrine of a subrogation and the principles of indefeasibility.
  • The statutory provisions relating to the disbursement of surplus mortgagee sale proceeds, such as section 58(3) of the Real Property Act 1900 (NSW) and section 88(1)(c) of the Property Law Act 1974 (Qld), are subject to a surety’s rights of subrogation.
  • A surety who has a right of subrogation can lodge a caveat over the lender’s security to protect those rights.
  • Where a right of subrogation exists, the applicable mortgagee holds the surplus sale proceeds and remaining security as trustee for the person entitled to the right of subrogation.
  • A lender who acts inconsistently with the rights of subrogation will be in breach of its fiduciary obligations to account to the surety and can be held liable for the loss suffered.
  • Rights of subrogation can be excluded by agreement or by conduct or circumstances that make it inequitable for the surety to enjoy the rights of subrogation.

In Bofinger it was not inequitable that the guarantors voluntarily sold their properties and paid the proceeds to the first mortgagee without any demand being made to the guarantors. The first mortgagee would have known of the payment, as it had released its security on the guarantors’ properties to enable settlement to take place.

Implications

The specific wording of any exclusion clause in the lender’s documentation is important.

For example in Bofinger,  when interpreting the specific wording in the second mortgagee’s documentation, the High Court said the exclusion clause only applied to rights of subrogation in respect of  the second mortgagee’s loan and did not exclude any rights of subrogation relating to the loan of the first mortgagee.

A lender should include appropriate clauses in their loan and security documentation excluding the exercise of any rights of subrogation in respect of their own loan and any other loan made by any other lender.

Subsequent lenders should ascertain the identity of the guarantors in respect of any prior security when making the decision to lend. During the course of their loan they should continue to monitor the guarantee and subrogation position, as it can potentially impact upon their equity position.

In Bofinger before the second mortgagee agreed to release its mortgages on the guarantors’ properties, the second mortgagee could have, for example, protected its position by obtaining an agreement with the first mortgagee and guarantors that the guarantors would not exercise any subrogation rights in respect of the loan made by the first mortgagee.

Warning for lenders

The warning for a lender is that before they disburse any surplus sale proceeds or provide a discharge or transfer of their security, the lender should enquire as to whether any surety is entitled to claim any rights of subrogation in relation to the surplus sale proceeds or security.

Rights of subrogation may also apply where there has not been any default action, the loan has been fully repaid and where the borrower requests a discharge of the mortgage from the lender.

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