On 13 October 2009 the High Court in Bofinger v Kingsway Group Limited  HCA 44, on appeal from the NSW Court of Appeal, considered the nature and scope of the equitable doctrine of subrogation.
A significant component of securities law, roughly put the doctrine entitles a guarantor who pays a lender the principal debt in full, to the benefit of all the lender’s remaining securities against the principal debtor with respect to the debt, and to stand in the shoes of the lender to enforce those securities. This principle arises both under the general law, and pursuant to s 3 of the Law Reform (Miscellaneous Provisions) Act 1965.
A development company borrowed funds secured over a development site being a block of units. The money was borrowed on a first mortgage from the respondent, Kingsway Group Limited and second and third mortgages from other financiers over the units. The Bofingers were the directors of the development company and provided a guarantee of all three facilities secured by mortgages over their house. When the development got into trouble the Bofingers sold their house, with the agreement of the financiers, and used the proceeds to reduce the first mortgage over the units. It was by this payment that they later claimed to be subrogated to the rights of the first mortgagee and entitled to the surplus sale proceeds of the units (after the first mortgage had been paid out).
The claim was made and the dispute arose before the final units were sold and the surplus fully realised. The first mortgagee paid the surplus proceeds to the second mortgagee, to whom it also delivered the certificates of title over the unsold units along with discharges of the first mortgage over those properties. The Bofingers brought proceedings in the Supreme Court and by agreement the surplus proceeds were quarantined in a controlled monies account pending the outcome of the trial and the remaining units were sold on this basis by the second mortgagee exercising power of sale.
Before the trial judge
The parties agreed to put a separate question to Young CJ in Eq (as His Honour then was) for preliminary determination being whether the surplus proceeds and the securities held by Kingsway over the unsold units were held on trust for the Bofingers before Kingsway paid the money to Rekley and discharged the securities. Young CJ in Eq answered the separate question against the Bofingers, finding that there was no trust, holding “whether the court applies subrogation does depend on whether unconscionability is involved” His Honour noted that “to recognise a right of subrogation and require the second mortgagee to account to the Bofingers for those funds would give the Bofingers an unconscionable advantage over the second mortgagee”. His Honour also noted that if he was wrong, the right to subrogation was waived in the terms of the second mortgage.
In the Court of Appeal
The three justices of the Court of Appeal upheld the decision of the trial judge. Giles JA agreed with the trial judge that the critical issue was to adjust the interests of the parties to avoid an unconscionable result and that the doctrine of subrogation was not an assignment of the rights of the discharged mortgagee but rather a device to secure the guarantor’s right of indemnity. His Honour held that because the plain intention as between the Bofingers and the second mortgagee was that the second mortgagee would have prior resort to the sale proceeds of all the mortgaged properties a claim of priority by way of subrogation would be unconscionable. Handley AJA agreed with both of the trial judge’s bases’ but noted there was an even more direct answer, which he preferred, being the estoppel rule in Otter v Vaux (1856) 2 K&J 650 which His Honour stated “prevents a mortgagor, who has paid off the mortgage debt, keeping that mortgage alive against a later mortgage created by himself”. Sackville AJA focused on the conscionability of the result asking “In what way is the doctrine of subrogation needed to avoid an unconscionable result? Or, to put the question another way, what would be unjust or inequitable about the net surplus from the sale of the Principal Debtor’s assets going to the second mortgagee, as envisaged by s 58(3) of the Real Property Act 1900 (NSW)?”
In the High Court
The High Court overturned the decisions of both the trial judge and the Court of Appeal finding, in a joint judgment of Gummow, Hayne, Heydon, Kiefel and Bell JJ, found that Kingsway was a constructive trustee of the surplus and securities for the Bofingers, and was liable to pay equitable compensation to the Bofingers for failing to pay the surplus and transfer the securities to the Bofingers. The High Court then left it to the Bofingers to restore the matter to the Supreme Court to agitate the remaining issues in the proceedings.
In relation to the unconscionable result principle the High Court found, that when the doctrine of subrogation was enlivened by a guarantor paying out the principal debt, then absent contrary agreement or inequitable conduct, subrogation could be claimed whether or not it was found that there would otherwise be an unconscionable result. The High Court dismissed the arguments which had persuaded Giles JA relating to the “plain intention as to priority” on the grounds that the terms of the second mortgage did not express such intention.
The High Court dealt with the express waiver of the Bofingers’ rights as surety under the second mortgage, finding, as a matter of construction that this clause only applied to Bofingers’ rights as guarantors under the second mortgage, not their rights as guarantors under the first mortgage. Another clause in the second mortgage restricted the rights of the Bofingers to “make a claim or enforce a right against any other Obligated Person” until the second mortgagee had been repaid in full, but the High Court found that a claim for subrogation against Kingsway as first mortgagee was not a claim against an “Obligated Person”, and noted the principle of construction that any ambiguity in a guarantee is to be construed in the way which favours the guarantors. In the circumstances, the challenges to subrogation founded upon the terms of the second mortgage all failed.
The High Court rejected Handley AJA’s application of the principle in Otter v Lord Vaux, finding that estoppel principle rested on a generally assumed state of facts between the parties, and that such a general assumption had not been demonstrated on the facts of the case. Further, the ratio of the rule in Otter v Lord Vaux was found by the High Court to be the doctrine of merger, being that a lesser estate is lost when merged with a greater estate; thus a mortgagor cannot pay out a first mortgage and then claim priority over the second mortgage because the first mortgage interest in the hands of the mortgagor is merged with the mortgagor’s pre-existing interest (being a fee simple) and thus the first mortgage is lost in the process. As this same analysis was inapplicable to the case of a guarantor seeking subrogation (there is no merger of estates as the guarantor does not have an estate in the mortgagor’s property other than through subrogation), the High Court found that the rule in Otter v Lord Vaux had no application.
Lessons for lenders
As is apparent from the above, the subrogation rights of the guarantors could have been defeated by a clearly worded and unambiguous contractual provision that prevented as a matter of agreement the guarantors asserting their rights of subrogation over the first mortgage to obtain priority over the second mortgagee. Examples of clauses that could be included in a mortgage to defeat a claim for subrogation are as follows. The first deals with subrogation claims over prior mortgages; the second bars suits brought by a guarantor against a mortgagee for distributing surplus proceeds to a subsequent mortgagee.
- The guarantors agree that they (and each of them) will not exercise (and hereby waive) any and all rights of subrogation that may exist or may come to exist with respect to any prior mortgage, charge or other security interest over any land, chattel or chose in action which is subject to the present mortgage, or to any proceeds of sale of the same. The guarantors acknowledge that even if, by reason of their payment (or the payment by any one or more of them) of such prior mortgage, charge or other security interest (or otherwise) the guarantors would, but for this clause, enjoy a superior right to the present mortgagee over any land, chattel or chose in action which is subject to the present mortgage (or to any proceeds of sale of the same), by reason of this clause no such right arises.
- The guarantors agree that if, at the time this mortgage is paid out, there exists any subsequent mortgage, charge or other security interest over any land, chattel or chose in action which is subject (or was subject prior to payment out) to the present mortgage, the guarantors (and each of them) will not exercise (and hereby waive) any and all rights of subrogation that may exist or may come to exist with respect to the present mortgage and any other securities held by the present mortgagee. The guarantors acknowledge that even if, by reason of their payment (or the payment by any one or more of them) of all monies owing under the present mortgage (or otherwise) the guarantors would, but for this clause, enjoy a superior right to any such subsequent mortgagee, chargee or other security interest holder (collectively a “subsequent interest holder”) over any land, chattel or chose in action which is or was subject to the present mortgage (or to any proceeds of sale of the same), by reason of this clause no such right arises. The guarantors (and each of them) hereby agree to waive any right they would otherwise have had against the present mortgagee, its servants or agents, with respect to the payment by the present mortgagee, its servants or agents of any monies, or the transfer of any securities, to any subsequent interest holder, and with respect to the discharge or cancellation of any securities held by the present mortgagee.