Illinois appellate court holds refinancing lender entitled to conventional subrogation even where the proceeds were insufficient to pay prior indebtedness in full

In Wilmington Savings Fund Society, FSB v. Zarkhin, 2019 IL App (2d) 180439 (March 26, 2019) the Plaintiff filed a foreclosure on property owned by mortgagors, alleging in part that its mortgage, although recorded later, had priority over the defendants’ mortgage because it was intended and used to pay off at least in part two mortgages that had been recorded before the defendant’ mortgage. The trial court agreed with the Plaintiff that it did not matter that the proceeds of its loan were insufficient to pay prior indebtedness in full.

The appellate court affirmed. For conventional subrogation to apply (1) there must be an express agreement to the effect that the party paying the debt on behalf of the third party will be able to assert the rights of the original creditor, (2) the loan proceeds were used to refinance the mortgage(s) as to which the lender seeks subrogation, (3) no harm will come to an innocent third party if the lender is granted priority, and (4) there has been no gross negligence. Each of these requirements was met.

The court found, first, there was an express agreement between Plaintiff and the mortgagors to the effect that, having paid off the two prior mortgages, Plaintiff would be subrogated to the rights of those lenders to the extent of its loan. This was based on the standard language in the mortgage, found in paragraph 4, that the mortgagors agreed to discharge any lien that can attain priority over Plaintiff’s mortgage. The defendants argued that the intent of the parties had been to pay off not only these two mortgages but also their mortgage lien, but the court was unmoved. The fact that the mortgagor deviated from his intent did not undermine the fact that Plaintiff’s loan was intended to refinance the two prior mortgages. The mortgagor’s subsequent conduct could not negate the clear intent of their agreement with Plaintiff.

The court noted that as a general rule, partial subrogation is improper because it would divide the security between the original obligee and the subrogee, imposing unexpected burdens and potential complexities of division of the security and marshaling upon the original mortgagee. However, the general rule does not require the subrogee to pay the entire debt, so long as the entire debt has been paid by some other source. “It stands to reason that, when the entire debt has been paid, even if not completely out of funds supplied by the would-be subrogee, the rights of the original obligee against the debtor will not be endangered.”

The court also agreed that the defendants would not be unfairly harmed by allowing Plaintiff to be subrogated to the rights of the two prior mortgages because those liens would have been ahead of defendants’ mortgage lien had Plaintiff not acted. Finally, the court rejected the defendants’ argument that Plaintiff was grossly negligent. Defendants’ “argument is tantamount to contending that conventional subrogation itself is gross negligence. Were a request to an intervening lender for permission to subrogate a prerequisite to conventional subrogation, there would be little if any vitality to the doctrine.”

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