Subrogation – A Lifeline for Mortgagees and Lenders

Mr Smith decided to give it a go. He loaned $700,000 to a company, guaranteed by its directors. One director gave him a first mortgage over their property, worth more than $1.5 million.

At settlement, $650,000 of his advance paid out an existing mortgage; the balance went to the company. Mr Smith’s mortgage was registered, and for a while, all went well.

Then things unravel. The company went into liquidation and defaulted. Mr Smith was forced to take legal action to take possession of the mortgaged property and sell it to recover the loan, confident that the sale would more than cover his loan.

However, after his lawyers started legal action, the director who gave Mr Smith the mortgage claims that their signature on the mortgage was forged and the required ID verification (passports, driver’s licences etc) wasn’t obtained. If proven, the mortgage will be void, leaving Mr Smith an unsecured creditor. To make matters worse, the company has no assets, and the guarantors have numerous other creditors and no income or other assets other than the property.

Subrogation to the rescue?

Mortgagees and secured lenders in this position, where security is invalid or unenforceable due to issues such as forgery or fraud by third parties, may be thrown a lifeline by the doctrine of subrogation.

The term subrogation derives from the verb “to subrogate” meaning to substitute one person for another with reference to a legal claim or entitlement. In this context, Mr Smith’s money was partly used to pay out the previous mortgage and he is “deemed” to have been assigned rights of the mortgagee under that previous mortgage.

In other words, even though his mortgage is invalid, he can enforce the other secured creditor’s rights under their mortgage against the borrower.

Rationale for subrogation

Subrogation is not based upon, and does not require, any agreement or intention. It is a doctrine developed by Courts to prevent unjust enrichment. Without it, a borrower could:

1. Obtain the benefit of being released from their own secured obligation by the lender’s payment
2. While at the same time denying the validity of the lender’s security, therefore denying them that security.

Benefits of subrogation

• Recover through sale: A lender who is subrogated to another mortgage or security can take possession of the property and sell it, relying on the rights and powers contained in that other security.
• Priority preserved: A lender is treated as if they always had that other security from the time that it was granted. This means that they have priority over all subsequent mortgages and securities, even though those later mortgages and securities predate their payment.
• Negligence irrelevant: If the lender’s failure to obtain the security they bargained for was due to negligence, this is irrelevant. Negligence does not prevent a lender from claiming subrogation because it rests on the notion of an unconscionable denial of the lender’s claim to the benefit of the prior security. 
• Third-party fraud is no barrier: Fraud by someone other than the lender does not block their right.
• Sub-subrogation recognised: Sub-subrogation has been recognised by the Courts.  If lender’s loan pays out an earlier mortgage which is also invalid, but that earlier mortgagee had paid out a valid mortgage before that, the lender can rely upon the rights of the mortgagee under that still earlier and valid mortgage.

Limits of subrogation

• There must have been a bargain for security: If a lender agrees to be an unsecured creditor, subrogation will not apply. Subrogation will only apply where the bargain was that the lender would get a security, but the bargained-for security does not materialise for some reason. 
• Limited to the amount paid off: A lender can only be subrogated for the amount that was used to pay off the earlier secured debt. This is often less than the amount of the lender’s loan under the invalid security.
• Interest rate uncertainty: A lender may be able to claim interest at either the rate under the subrogated mortgage security or at the rate under their own security, whichever is less. However, the cases on this are conflicting, and some state that the appropriate interest rate to apply is the statutory rate under the Penalty Interest Rates Act 1983, (currently 10% p.a.). 
• Full discharge required for partial payments: If a lender pays off only part of the other security or mortgage, they cannot enforce subrogation until the whole debt has been repaid.

A lender’s worst nightmare, Mr Smith’s conclusion

In Mr Smith’s case, $650,000 was used to pay out the prior mortgage; only that portion of the $700,000 was protected by subrogation. This meant he could take possession of the property and sell it to recover up to $650,000 from the proceeds

While this didn’t cover the full $700,000 he loaned, it is certainly better than being left as an unsecured creditor for $700,000 with no realistic prospect of recovery.

Key Takeaways

• Subrogation can be a valuable lifeline for lenders who find themselves in the unfortunate situation of the security that they bargained for being unenforceable or invalid through no fault of their own.
• It allows lenders to “step into the shoes” of a previous lender when their own security fails.
• It can preserve lenders’ recovery rights and priority, even in cases of fraud or invalid documentation.
• The protection is generally limited to the amount used to pay out the earlier mortgage.
• It applies even if the shortfall was partly due to the leader’s negligence, provided they bargained for security.

More information
If you advise clients who lend against property, or if you’re personally considering (or already involved in) mortgage-backed lending, understanding subrogation could make the difference between a partial recovery and a total loss.

For tailored advice on how subrogation may apply to your situation or to discuss strategies for protecting secured lending arrangements, contact:

This is a guide only and does not constitute legal advice.

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